Fortinet, Inc. — Q2 2016 Form 10-Q
Reporting period: Three and six months ended June 30, 2016. Figures are unaudited; dollar amounts below are in millions unless noted.
Business context and financial performance
Fortinet sells cybersecurity products and related subscription and technical-support services, primarily through distributors and resellers. Service revenue is generally recognized over contract terms, typically one to three years. The company reports one operating segment.
| Metric | Q2 2016 | Q2 2015 | First half 2016 | First half 2015 |
|---|---|---|---|---|
| Revenue | $311.4 (+30%) | $239.8 | $596.0 (+32%) | $452.7 |
| Product revenue | $136.6 (+19%) | $114.8 | $261.2 (+23%) | $212.3 |
| Service revenue | $174.8 (+40%) | $125.0 | $334.8 (+39%) | $240.4 |
| Gross margin | 72.9% | 71.0% | 72.8% | 70.6% |
| Operating income (loss) | $(4.0) | $3.0 | $(7.7) | $3.9 |
| Net income (loss) | $(1.4) | $0.8 | $0.7 | $2.4 |
Higher product gross margin, attributed in part to lower warranty expense and software-product mix, supported overall margin expansion. Operating expenses rose 38% in Q2 and 40% in the first half, led by sales and marketing investment. First-half operating results turned to a loss despite revenue growth; a $7.7 million income-tax benefit contributed to positive first-half net income. Q2 included a $2.3 million tax benefit.
Cash flow, liquidity and capital
- At June 30, cash and cash equivalents were $596.4 million; investments were $625.6 million; combined cash, cash equivalents and investments totaled $1.222 billion. Working capital was $621.9 million. The filing reports no material debt balance; it does not provide a clear total debt figure.
- For the six months, operating cash flow was $168.5 million, versus $148.9 million a year earlier. Investing cash flow was $(69.4) million and financing cash flow was $(46.0) million. Cash increased $53.1 million to $596.4 million.
- First-half capital expenditures were $44.4 million. Management expects 2016 capital expenditures of $80–$90 million, primarily for office expansion and ERP implementation. Q2 free cash flow, a non-GAAP measure, was $53.5 million, down from $73.5 million.
- Deferred revenue was $904.0 million, up 14% from year-end 2015. Q2 billings, a non-GAAP measure, were $373.8 million, versus $297.2 million. The company said more than 40% of Q2 billings occurred in the final two weeks of the quarter, compared with an eight-quarter average of 33%.
- Fortinet repurchased $50.0 million of stock in the first half (2.0 million shares at an average $24.97); $150.0 million remained authorized. It held $455.2 million of cash and investments at international subsidiaries, not immediately available for domestic operations without repatriation.
Material changes and management commentary
- Revenue growth was broad-based across regions; EMEA provided the largest contribution to growth. Service revenue growth reflected the expanding deferred-revenue base, customer additions, renewals and enhanced service offerings.
- Headcount increased 37% year over year to 4,562 employees and contractors. Management cited hiring and spending to expand sales coverage, marketing, product development and customer support. It expected R&D expense as a percentage of revenue to remain relatively comparable and sales and marketing expense as a percentage of revenue to decrease slightly in the remainder of 2016.
- Fortinet acquired network-security monitoring and analytics provider AccelOps in June for $22.3 million cash consideration. The preliminary allocation included $9.5 million of goodwill and $15.8 million of finite-lived intangible assets. Up to $4.0 million of earnout payments may be due if specified remaining targets are met; no fair value was assigned at June 30, and the first stated target was not met.
- The company early adopted ASU 2016-09 on stock-based compensation. Adoption included a $32.4 million cumulative increase to retained earnings for previously unrecognized tax benefits, partly offset by a $0.8 million cumulative decrease for the forfeiture-policy change. The new guidance reduced the income-tax provision by $3.6 million in Q1 and $2.6 million in Q2.
- Management stated existing cash and cash equivalents should meet anticipated needs for at least 12 months. No formal revenue or earnings guidance was provided in the supplied filing text.
Risks, contingencies and unusual items
- Operating results may be volatile due to quarter-end order concentration, channel and customer purchasing patterns, product mix, competition, pricing, inventory and supply constraints, and the timing of service renewals. Two distributors represented 20% and 10% of Q2 revenue, respectively; Exclusive Networks Group represented 20% of first-half revenue.
- Key risks include reliance on channel partners and contract manufacturers, component shortages, cybersecurity product defects or vulnerabilities, foreign-exchange exposure, international operations, and the execution and cost of the recently implemented ERP system.
- Operating lease commitments totaled $76.0 million; inventory purchase commitments were $86.4 million, and other contractual commitments and open purchase orders were $52.1 million. These are commitments, not reported debt.
- The company disclosed ongoing litigation and patent disputes but reported no significant loss-contingency accrual and said it believed no current claim was likely to materially affect its financial position. Outcomes remain uncertain; intellectual-property litigation could lead to legal costs, damages or royalties.
- Unrecognized tax benefits were $63.7 million, with $7.9 million accrued interest. The IRS was examining tax years 2012–2014; French authorities were making preliminary inquiries into intercompany relationships. Management did not expect a significant decrease in uncertain tax benefits within 12 months.
Important facts for investors to verify
- Whether rapid service-revenue and deferred-revenue growth translates into sustainable billings growth and operating profitability.
- Whether rising sales and marketing costs, headcount and ERP-related spending deliver the growth and operating leverage management expects.
- How the AccelOps integration, final purchase-price allocation and contingent earnout develop.
- Whether the quarter-end concentration in billings and distributor exposure create heightened revenue and collection volatility.
- Potential effects of tax examinations, uncertain tax positions, international cash repatriation and the stated contractual commitments.