Fortinet, Inc. — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018. Fortinet provides cybersecurity hardware, software and services, primarily through distributors and other channel partners. Comparisons with Q1 2017 require caution: 2018 results reflect adoption of Topic 606, while prior-period figures were not restated.
Financial performance
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Revenue | $399.0 million | $340.6 million | +17% |
| Product revenue | $142.8 million | $135.3 million | +6% |
| Service revenue | $256.2 million | $205.3 million | +25% |
| Gross margin | 75.6% | 73.4% | +2.2 percentage points |
| Operating income | $32.4 million | $5.4 million | +$27.0 million |
| Net income | $41.6 million | $10.7 million | +$30.9 million |
| Diluted EPS | $0.24 | $0.06 | +$0.18 |
| Operating cash flow | $139.7 million | $129.7 million | +$10.0 million |
| Free cash flow (non-GAAP) | $128.1 million | $116.2 million | +$11.9 million |
Service growth was driven by FortiCare technical support and FortiGuard security subscriptions; management reported year-over-year growth of 35% and 20%, respectively. Service gross margin rose to 84.8% from 82.8%; product gross margin was 59.2%, versus 59.1%.
Liquidity, balance sheet and cash flow
- Cash and cash equivalents were $835.6 million; investments totaled $550.8 million. Combined cash, cash equivalents and investments were $1.386 billion at March 31, up $37.1 million from year-end.
- Working capital was $706.1 million. Current assets were $1.736 billion and current liabilities $1.030 billion.
- Deferred revenue was $1.396 billion, up $60.1 million from December 31. Remaining performance obligations were also reported at $1.40 billion; approximately 75% is expected to be recognized over the next one to two years.
- Operating cash flow was $139.7 million; capital expenditures were $11.6 million. Investing activities used $25.5 million and financing activities used $89.6 million, including $115.5 million of share repurchases.
- The balance sheet does not show a borrowing or debt balance. Total liabilities were $1.707 billion, including $1.396 billion of deferred revenue.
Changes, accounting and unusual items
- Topic 606 adoption on January 1, 2018 increased accumulated equity by $117.3 million at transition, principally because certain service-contract sales commissions are now capitalized and amortized. Q1 2018 net income was $41.6 million as reported versus $28.8 million on a “without Topic 606” basis; operating income was $32.4 million versus $15.8 million. The filing attributes $11.7 million of lower sales and marketing expense to commission deferral and $6.4 million of higher revenue to the new standard.
- Operating margin improved, but management says Topic 606 raised it by 4.1 percentage points; excluding the standard’s commission benefit, sales and marketing expense would have been 49% of revenue, compared with 50% reported in Q1 2017.
- The company repurchased 2.5 million shares for $115.5 million at an average $45.96 per share; $327.3 million remained authorized.
- The Q1 tax benefit was $4.9 million, reflecting a 13% effective tax benefit rate. Tax accounting under the 2017 Tax Act remained provisional. Unrecognized tax benefits were $77.6 million; up to $7.0 million could decrease in the next 12 months, potentially benefiting the tax rate.
Outlook, commentary and risks
- Management expects research and development, sales and marketing, and general and administrative expenses to increase in absolute dollars during 2018. No specific full-year revenue or earnings guidance is provided in the supplied filing text.
- Construction of a new headquarters is expected to begin in the second half of 2018, with estimated 2018 spending of $20 million to $30 million. Management believes available cash and investments are sufficient for anticipated needs for at least 12 months and expects to repatriate an additional $150 million of foreign earnings during 2018, subject to Singapore distribution constraints.
- Key stated risks include quarterly variability, competition and pricing pressure, dependence on channel partners and service renewals, inventory and component availability, product defects or security failures, international and currency exposure, tax uncertainty, and the execution and costs of growth and real-estate plans.
- Exclusive Networks Group represented 29% of Q1 revenue and 34% of accounts receivable at March 31, creating distributor concentration exposure. The filing also notes that Exclusive acquired Fine Tec U.S. in 2017.
- The U.S. Attorney’s Office for the Northern District of California continues an inquiry requesting information on Trade Agreements Act compliance; Fortinet says it is cooperating. The company reports other litigation but says it does not believe existing claims are likely to materially adversely affect its financial position. French and Israeli tax examinations are also disclosed.
- Fortinet reported effective disclosure controls as of March 31. Keith Jensen, previously interim CFO, became CFO effective May 2018 following the prior CFO’s resignation.
Investor verification points
- Separate underlying operating trends from Topic 606’s accounting effects, especially the commission capitalization and timing of product revenue.
- Track billings, deferred revenue, service renewals and the conversion of the $1.40 billion remaining performance obligations into revenue and cash.
- Monitor distributor concentration, particularly Exclusive Networks Group’s share of revenue and receivables.
- Assess the outcome of the Trade Agreements Act inquiry, tax examinations and provisional Tax Act accounting.
- Compare planned repurchases and headquarters spending with operating cash generation, liquidity and future investment needs.