Fortinet, Inc. — Q3 2018 Form 10-Q Summary
Reporting period: Quarter ended September 30, 2018; comparisons are with Q3 2017 unless stated otherwise. Financial amounts are in millions of dollars except per-share data. The filing also reports results for the nine months ended September 30, 2018.
Business context
Fortinet sells cybersecurity products, including FortiGate appliances, and recurring security subscription and technical support services through a predominantly distributor and reseller channel. It reports one operating segment. Management cited growth in FortiGate shipments, Security Fabric and cloud products, and service renewals.
Key financial metrics
| Metric | Q3 2018 | Q3 2017 | Change |
|---|---|---|---|
| Revenue | $453.9 | $374.2 | +21% |
| Product revenue | $164.5 | $137.1 | +20% |
| Service revenue | $289.4 | $237.1 | +22% |
| Gross profit / gross margin | $342.3 / 75.4% | $280.6 / 75.0% | Margin +0.4 percentage points |
| Operating income / margin | $62.8 / 14% | $33.7 / 9% | Income +86% |
| Net income | $58.7 | $26.7 | |
| Diluted EPS | $0.33 | $0.15 | |
| Billings (non-GAAP) | $527.5 | $431.7 | +22% |
Nine months ended September 30: Revenue was $1,294.2, up 20%; operating income was $145.9, up 116%; net income was $149.6 versus $60.4; and diluted EPS was $0.86 versus $0.34. Gross margin was 75.1%, compared with 74.0%. Operating cash flow was $458.7 versus $436.9.
Cash and liquidity at September 30: Cash and cash equivalents were $1,169.3 and investments were $503.5, totaling $1,672.8, up from $1,349.3 at December 31, 2017. Working capital was $966.2. Current and long-term deferred revenue totaled $1,544.4, up 16% from year-end. The filing reports no debt balance on the balance sheet; it does disclose $9.5 of payments on debt assumed in a business combination during the nine-month period.
Cash flows and capital allocation: Nine-month investing cash flow was negative $7.4 and financing cash flow was negative $93.0. Capital expenditures were $41.4; share repurchases were $117.1, with $825.8 remaining under the repurchase authorization. Q3 operating cash flow was $176.7 and free cash flow, a non-GAAP measure, was $158.5.
Material changes and comparability
- Fortinet adopted Topic 606 on January 1, 2018 using the modified retrospective method; prior-year figures were not restated. Adoption increased opening equity by $117.3, principally because qualifying service-contract sales commissions are now capitalized and amortized rather than expensed upfront.
- Topic 606 also accelerated recognition of some software license revenue. For the nine-month period, the company reported $13.6 more revenue and $35.2 more net income than it would have reported without adoption; the operating-income benefit was $45.1. The company attributed $32.5 of lower reported sales and marketing expense to commission-cost deferral. These accounting effects make year-over-year comparisons less directly comparable.
- Reported nine-month effective tax rate fell to 6% from 24%, reflecting the lower U.S. federal tax rate and an $18.0 release of uncertain-tax-position reserves, among other items. Q3 rate was 17% versus 30%.
- Product gross margin declined year over year (Q3 56.2% versus 57.6%; nine months 56.9% versus 58.0%), while service gross margin improved. Management attributed overall margin gains mainly to a higher mix of service revenue.
Outlook, commentary, risks and unusual items
- No specific revenue or earnings guidance is stated in the supplied filing text. Management expected research and development, sales and marketing, and general and administrative expense to increase in absolute dollars during the remainder of 2018. It plans continued investment in product development, sales resources and marketing.
- Management said construction on its new headquarters was expected to begin in Q4 2018, with estimated project spending of $10–$20 in 2018 and $60–$80 in 2019. It stated existing cash and investments should meet anticipated cash needs for at least 12 months.
- Remaining performance obligations were $1.54 billion; approximately 80% was expected to be recognized over the next one to two years, with the balance over three to five years.
- Bradford Networks was acquired in June 2018; preliminary purchase price was $6.8, with a potential $2.0 cash earn-out dependent on performance conditions. Fortinet acquired ZoneFox for approximately $18 in October 2018, after quarter-end.
- Fortinet reported ongoing settlement discussions with the U.S. Attorney’s Office concerning a Trade Agreements Act inquiry. The filing also identifies patent litigation, including a British Telecommunications lawsuit filed in July 2018 and a Finjan lawsuit filed in October 2018; outcomes and potential effects are uncertain.
- Key risks include dependence on distributors and resellers (Exclusive Networks Group represented 29% of Q3 revenue and 33% of receivables), reliance on third-party manufacturers and constrained component suppliers, product and service security or performance failures, competitive and pricing pressure, international and currency exposure, and tax and regulatory uncertainty. The company also disclosed $174.0 in potentially non-cancelable inventory purchase orders and $52.0 in operating lease commitments.
Important facts for investors to verify
- Separate underlying growth and profitability from Topic 606’s timing effects, especially commission capitalization and accelerated product revenue recognition.
- Track billings, deferred revenue, renewals and service growth to assess the durability of recurring revenue and future revenue conversion.
- Monitor product gross margin, operating expenses and stock-based compensation; nine-month stock-based compensation was $120.3.
- Assess channel concentration, distributor receivables, inventory commitments and component-supply risks.
- Follow resolution of the Trade Agreements Act inquiry, patent litigation, tax uncertainties and the integration and accounting outcomes of Bradford and ZoneFox.
- Confirm actual headquarters construction spending, capital expenditures, repurchases and cash availability, including the location and accessibility of international cash.