Fortinet, Inc. — FY2013 Form 10-K
Reporting period: Fiscal year ended December 31, 2013. This is an annual filing; fourth-quarter figures are included where relevant. All financial amounts below are in U.S. dollars.
Business context
Fortinet sells network-security appliances and related subscription, support, and other services worldwide, primarily through distributors and resellers. FortiGate appliances are its core product line; subscription and support services are an important recurring revenue source. Services revenue is generally recognized over the service term, while qualifying product revenue is recognized upon shipment or customer acceptance.
Financial performance and liquidity
| Metric | FY2013 | FY2012 | Change |
|---|---|---|---|
| Revenue | $615.3 million | $533.6 million | +15% |
| Product revenue | $278.0 million | $248.9 million | +12% |
| Services revenue | $329.7 million | $274.0 million | +20% |
| Gross margin | 70.6% | 72.4% | Down 1.8 percentage points |
| Operating income / margin | $72.1 million / 12% | $100.5 million / 19% | Income down 28% |
| Net income | $44.3 million | $66.8 million | Down 34% |
| Diluted EPS | $0.26 | $0.40 | Down $0.14 |
| Cash provided by operating activities | $147.4 million | $183.9 million | Down 20% |
| Free cash flow (non-GAAP) | $133.5 million | $161.8 million | Down 17% |
| Deferred revenue at year-end | $432.6 million | $363.2 million | Up $69.4 million |
At December 31, 2013, cash, cash equivalents, and investments totaled $843.0 million, versus $739.6 million a year earlier; working capital was $322.5 million. Total assets were $1.168 billion and stockholders’ equity was $585.8 million. The balance sheet presents no borrowings or debt; the filing does not report an interest-bearing debt balance. Cash and investments included $88.9 million held by international subsidiaries and not immediately available for domestic operations without repatriation.
Revenue growth was driven by higher FortiGate sales and recognition of revenue from a larger base of subscription and support contracts. The margin and earnings decline reflected faster growth in operating expenses—up 27%, including higher sales and marketing and R&D spending—alongside lower product and services gross margins. The effective tax rate increased to 42% from 36%.
Fourth-quarter FY2013 revenue was $177.4 million, up from $151.2 million in Q4 FY2012. Q4 operating income was $24.6 million versus $35.0 million, and net income was $12.0 million versus $21.5 million.
Material changes, outlook, and commentary
- Services rose to 54% of revenue from 51%; product revenue was 45%, compared with 47%. Services’ growth supports deferred revenue, but reflects revenue recognized over time rather than fully at contract signing.
- Gross margin fell to 70.6% from 72.4%. Management cited entry-level product mix, higher warranty, freight and occupancy costs, and increased inventory write-offs; service margin also declined as support capacity and professional services expanded.
- Management said it expects overall gross margin in the near term to remain comparable to or slightly below FY2013 levels. For FY2014, it expected R&D expense as a share of revenue to remain comparable, sales and marketing as a share of revenue to increase, and G&A as a share of revenue to remain comparable. These are directional expectations, not full-year revenue or earnings guidance.
- Management expected about $15 million of FY2014 spending to improve the new Sunnyvale headquarters and said existing cash and investments should meet anticipated cash needs for at least 12 months. The company also had $161.1 million remaining under its share repurchase authorization through December 31, 2014.
- FY2013 operating cash flow was pressured by working-capital uses, including a $35.1 million increase in inventory and a $22.1 million increase in accounts receivable, partly offset by higher deferred revenue. Management attributed the inventory build in part to reducing stockout risk and supporting new product releases.
Risks, contingencies, and unusual items
- Sales depend substantially on channel partners; one distributor, Exclusive Networks Group, represented 12% of FY2013 revenue and 13% of year-end accounts receivable. Management also reported that, on average over the prior eight quarters, about 36% of quarterly billings occurred in the final two weeks.
- Supply-chain exposure includes contract manufacturers and limited- or single-source components, with no long-term agreements guaranteeing capacity or pricing. The company reported component shortages and long lead times, and had $37.8 million of open manufacturer purchase commitments at year-end.
- Competitive pricing, product obsolescence or defects, evolving security threats, customer renewal rates, international operations, foreign-exchange movements, and dependence on large enterprise and service-provider sales could adversely affect results. Management noted slower-than-expected billings in Q1 2013, including softness in service providers, Latin America, and EMEA.
- Operating expenses include substantial recurring stock-based compensation: $44.5 million in FY2013. Reported non-GAAP results exclude stock-based compensation and certain other items; investors should assess these measures alongside GAAP results.
- The company settled an SRI International patent matter in December 2013. In January 2014, Palo Alto Networks paid Fortinet $20 million under a six-year mutual covenant-not-to-sue and release of past claims. Management stated it had no other litigation expected to materially adversely affect the business; outcomes of legal proceedings remain uncertain.
- FY2013 included a $0.5 million impairment of acquired technology and $2.8 million of revenue from a sale of previously acquired patents. A $1.5 million stock-award forfeiture adjustment increased Q4 FY2012 operating income and net income. A $3.0 million balance-sheet reclassification recorded in FY2013 related to a prior share repurchase was described as immaterial to current and prior periods.
- In December 2013, Fortinet repurchased 2.1 million shares for $38.9 million under a $200 million authorization. The company also completed acquisitions including Coyote Point Systems; the Coyote deal included potential earn-out payments of up to $5.5 million, partly contingent on a former stockholder’s continued employment.
- Unrecognized tax benefits were $29.6 million at year-end, with $30.2 million of long-term tax liabilities, including interest, recorded; timing of potential cash outflows was not estimable. The company said it did not expect a significant adverse effect from the California audit of its 2010 and 2011 returns.
- Management and the independent auditor concluded that internal control over financial reporting was effective as of December 31, 2013; the financial statements received an unqualified audit opinion. The former CFO and COO departed in December 2013.
Important facts for investors to verify
- Whether services billings, renewals, and deferred-revenue growth continue to support reported revenue and cash generation.
- Whether gross margins stabilize and operating-expense growth—particularly sales and marketing—produces sustainable revenue growth and improved operating leverage.
- Inventory quality and turnover, component availability, and exposure to the concentrated distributor and manufacturing channels.
- The cash-flow impact of share repurchases, headquarters investment, acquisitions, and international cash balances.
- Developments in tax examinations and uncertain tax positions, litigation and indemnification exposure, and execution following senior finance leadership changes.