Fortinet, Inc. — Form 10-Q Summary
Reporting period: Three and six months ended June 30, 2014. Fortinet provides network security appliances, subscriptions, support, and related services. Amounts below are in U.S. dollars; financial statement amounts are in millions unless otherwise noted.
Financial performance
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Revenue | $184.1 | $147.4 | $353.0 | $283.2 |
| Product revenue | $85.4 | $66.5 | $162.1 | $124.5 |
| Services and other revenue | $98.7 | $80.9 | $190.9 | $158.8 |
| Gross margin | 68.6% | 70.4% | 69.3% | 70.8% |
| Operating income | $11.1 | $13.8 | $24.0 | $29.2 |
| Net income | $6.1 | $9.0 | $14.5 | $21.2 |
| Diluted EPS | $0.04 | $0.05 | $0.09 | $0.13 |
- Revenue grew 25% year over year in both Q2 and the first half. Q2 product revenue rose 28% and services and other revenue rose 22%; first-half increases were 30% and 20%, respectively.
- Q2 product gross margin was 56.1% (59.5% prior year); services and other gross margin was 79.4% (79.3%). First-half product gross margin was 57.1% (59.9%) and services and other was 79.6% (79.3%).
- Operating expenses increased 28% in Q2 and 29% in the first half, driven principally by hiring and sales and marketing investment. Headcount was 2,532 at June 30, versus 2,182 a year earlier.
- Q2 operating cash flow was $43.8 million versus $37.2 million; free cash flow, a non-GAAP measure, was $34.1 million versus $35.2 million. For the first half, operating cash flow was $104.7 million versus $75.3 million.
- At June 30, cash and cash equivalents were $203.9 million and investments were $706.6 million, totaling $910.6 million. Working capital was $380.9 million. The filing reports no borrowings or debt balance.
- Deferred revenue was $480.2 million, up from $432.6 million at December 31, 2013. Q2 billings, a non-GAAP measure, were $213.0 million versus $160.7 million in Q2 2013.
Material changes and notable items
- Despite revenue growth, Q2 operating income fell to $11.1 million from $13.8 million and net income fell to $6.1 million from $9.0 million. First-half operating income and net income also declined year over year.
- Gross margin compression was primarily associated with lower product margin. The company recorded a $2.4 million impairment charge on Coyote Point acquired technology, included in cost of product revenue; higher warranty costs and inventory write-offs also weighed on product margin.
- The company received $20.0 million in the first half under a six-year mutual covenant-not-to-sue and release agreement with Palo Alto Networks. This contributed to operating cash generation.
- First-half capital expenditures were $21.0 million, compared with $3.6 million in the prior-year period. Fortinet expected to spend up to a further $20.0 million on capital expenditures during the remainder of fiscal 2014, mainly for facilities and its ERP implementation.
- Fortinet repurchased 1.0 million shares for $22.5 million in the first half. $138.6 million remained authorized under its $200 million repurchase program, which runs through December 31, 2014.
Outlook, risks, and contingencies
- No numerical revenue or earnings guidance is provided. Management said it intended to continue investing in R&D and sales and marketing; it expected R&D expense as a percentage of revenue to remain at similar levels, sales and marketing expense as a percentage of revenue to remain similar or increase, and G&A expense as a percentage of revenue to remain similar during the remainder of fiscal 2014.
- Management attributed growth to sales and marketing expansion, increased sales capacity, and traction in recently introduced FortiGate products, including high-end enterprise data-center appliances. High-end FortiGate products represented 40% of Q2 billings.
- Fortinet stated existing cash and cash equivalents were expected to cover anticipated cash needs for at least the next 12 months. However, $180.5 million of cash and investments was held by international subsidiaries and would not be immediately available for domestic operations without repatriation, which could trigger U.S. federal tax.
- The Q2 effective tax rate was 49%, versus 40%; the first-half rate was 44%, versus 34%. Management cited jurisdictional earnings mix, nondeductible stock compensation, foreign tax-credit limitations, and expiration of the U.S. federal R&D credit as contributing factors. Unrecognized tax benefits were $35.7 million at June 30.
- Key risks include quarterly sales variability and quarter-end shipment concentration; dependence on distributors and resellers; competition and pricing pressure; product defects or security vulnerabilities; reliance on contract manufacturers and limited-source components; foreign currency exposure; and execution risks from rapid hiring and ERP implementation.
- Fortinet disclosed ordinary-course legal matters but had not recorded a material loss-contingency accrual; it said it did not expect current litigation to have a material adverse effect. Total contractual commitments were $95.9 million, including $46.4 million of potentially non-cancelable purchase orders.
- The company was evaluating the impact of the new revenue recognition standard, ASU 2014-09, which was effective for Fortinet beginning January 1, 2017.
Important facts for investors to verify
- Whether billings and deferred-revenue growth translate into sustained recognized revenue, particularly for subscriptions and support.
- Whether product gross margins recover after the Coyote Point impairment and higher warranty and inventory costs.
- Whether rising sales and marketing spending and headcount produce sufficient growth and operating leverage.
- The repeatability of cash flow, given the $20.0 million Palo Alto Networks payment and working-capital movements.
- How the elevated effective tax rate, unrecognized tax benefits, and international cash holdings affect future earnings and liquidity.
- Whether repurchases, planned capital spending, and manufacturing commitments remain consistent with the company’s liquidity plans.