Fortinet, Inc. — Q2 2019 Form 10-Q
Reporting period: Three and six months ended June 30, 2019; comparison is with the same periods in 2018. Figures are in U.S. dollars, in millions except per-share amounts. Fortinet provides cybersecurity hardware, software, subscriptions and support services and reports one operating segment.
Financial performance
| Metric | Q2 2019 | Q2 2018 | Six months 2019 | Six months 2018 |
|---|---|---|---|---|
| Revenue | $521.7 | $441.3 | $994.3 | $840.3 |
| Product revenue | $189.9 | $166.3 | $352.6 | $309.1 |
| Service revenue | $331.8 | $275.0 | $641.7 | $531.2 |
| Gross profit | $393.4 | $328.2 | $753.0 | $630.0 |
| Operating income | $75.2 | $50.7 | $125.8 | $83.1 |
| Net income | $72.7 | $49.3 | $131.5 | $90.9 |
| Diluted EPS | $0.42 | $0.28 | $0.75 | $0.53 |
- Q2 revenue rose 18% year over year: product revenue grew 14% and service revenue 21%. Security subscription revenue growth was 24%; technical support and other service revenue grew 16%.
- Q2 gross margin was 75.4%, up 1.0 percentage point; product margin was 56.5% and service margin 86.3%. Operating margin was approximately 14.4%, versus 11.5% a year earlier.
- For the first half, gross margin was 75.7%, up 0.7 point; operating margin was approximately 12.7%, versus 9.9%. Product margin declined 0.7 point while service margin improved 0.9 point.
- Operating expenses increased 15% in Q2 to $318.2 million; sales and marketing was the largest expense at $226.5 million. Expenses were 61% of revenue, down from 63%.
Cash, liquidity and balance sheet
- At June 30, cash and cash equivalents were $1,022.1 million and investments were $957.6 million, totaling $1,979.7 million, up from $1,716.6 million at December 31, 2018. Working capital was $1,067.0 million.
- First-half operating cash flow was $396.4 million, versus $282.0 million. Capital expenditures were $27.5 million; the company-defined Q2 free cash flow was $177.8 million, versus $130.6 million. First-half free cash flow calculated as operating cash flow less capital expenditures was $368.9 million.
- Cash declined $90.3 million during the first half. Investing used $375.6 million, largely reflecting net investment purchases; financing used $111.1 million, including $94.2 million for repurchases.
- Deferred revenue totaled $1,866.5 million, up $179.7 million from year-end. Remaining performance obligations were $1.87 billion; approximately $1.03 billion was expected to be recognized over the next 12 months.
- The balance sheet presents no borrowings as a separate debt line; it includes operating lease liabilities of $37.5 million. Total liabilities were $2,247.1 million.
Changes, outlook and notable items
- Growth was led by services and was broad across regions. Q2 revenue grew 19% in the Americas, 17% in EMEA and 19% in APAC. Management attributed product growth to higher unit shipments and a shift toward mid-range FortiGate products.
- Management expects research and development, sales and marketing, and general and administrative expenses to increase in absolute dollars during the remainder of 2019. It estimated 2019 spending on the new headquarters project at $50–$70 million and said existing cash and cash equivalents should cover anticipated needs for at least 12 months. The filing does not provide a clear numerical revenue or earnings forecast.
- Fortinet repurchased 1.3 million shares for $91.1 million in the first half; $642.7 million remained authorized. The board-approved program was authorized through December 31, 2019.
- Q2 included a $10.3 million tax expense related to the Ninth Circuit’s Altera decision, offset in part by a $10.0 million release of uncertain-tax-position reserves. The six-month effective tax rate was 10%, compared with a 3% tax benefit in 2018.
- In Q2 the company discovered an unauthorized party had targeted it using sophisticated techniques, including theft of technical data to impersonate firewall update servers and potentially seek access to customer systems. The investigation and evaluation were ongoing; impact was not determinable in the filing.
- Open inventory purchase commitments that may be non-cancelable were $218.9 million, mostly due in 2019; other potentially non-cancelable contractual commitments with terms over one year were $22.8 million. Litigation outcomes were described as uncertain, with no known existing matter believed likely to materially harm financial position.
- Operating results remain exposed to competition, variable demand and sales timing, channel and distributor concentration, inventory and component supply risks, international and foreign-exchange exposure, tariffs, and tax and regulatory uncertainty. Exclusive Networks accounted for 31% of revenue and 35% of net receivables at quarter-end.
- Operating lease accounting was adopted January 1, 2019, adding $39.1 million of right-of-use assets and $40.6 million of lease liabilities at adoption; the company reported no material impact on income or cash flows. On July 31, 2019, it amended change-of-control severance agreements for four executives, effective August 7.
Most important facts for investors to verify
- Progress and any customer, operational, legal or reputational effects of the cybersecurity incident under investigation.
- Whether service growth, deferred revenue and remaining performance obligations continue to convert into recognized revenue and cash flow.
- Distributor concentration, particularly Exclusive Networks, and the collectability of its receivables.
- Execution and cash requirements for headquarters construction, share repurchases, and the $218.9 million of inventory commitments.
- Developments in the Altera-related tax position, foreign tax audits and other uncertain tax liabilities.