Fortinet, Inc. quarterly report, Q2 FY2015

Business context and reporting period

Fortinet, Inc. provides cybersecurity appliances, software, subscriptions, and technical support. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2015, with comparisons to the same 2014 periods. Results are not necessarily indicative of full-year performance.

Financial performance and liquidity

Amounts below are in millions of dollars except per-share data and percentages.

Q2 basic and diluted earnings per share were reported as a dash (less than one cent when rounded); six-month EPS was $0.01 versus $0.09 in 2014. Q2 gross margin improved as product mix shifted toward higher-end appliances and service delivery efficiencies continued. However, operating expenses rose 45% in Q2, led by sales and marketing (+50%), and 43% for the first half, reducing operating income despite strong revenue growth. The Q2 effective tax rate was 77% versus 49%; the six-month rate was 54% versus 44%, affected by unrecognized tax benefits and non-deductible stock compensation.

At June 30, cash and cash equivalents were $481.4 million and investments were $667.0 million, totaling $1.148 billion, up from $991.7 million at year-end 2014. Working capital was $630.2 million. Total liabilities were $854.0 million, including $657.6 million of deferred revenue; the balance sheet reports no borrowings or debt. Deferred revenue increased 18% from year-end, and Q2 billings, a non-GAAP measure, were $297.2 million versus $213.0 million. Q2 free cash flow, also non-GAAP, was $73.5 million versus $34.1 million; first-half capital expenditures were $15.7 million.

Material changes versus prior periods

• Revenue grew across all regions. Q2 Americas revenue rose 39%, EMEA 33%, and APAC 11%; U.S. enterprise demand was a key driver. High-end FortiGate products represented 45% of Q2 billings, up from 40% a year earlier.
• Operating expenses increased materially as the company expanded sales, marketing, R&D, and support staffing. Headcount increased to 3,336 from 2,532 a year earlier. Stock-based compensation was $40.7 million for the first half versus $27.6 million.
• Operating cash flow increased year over year, supported in part by a $97.2 million increase in deferred revenue during the first half. First-half 2014 operating cash flow included a $20 million payment under a settlement agreement; 2015 had no comparable receipt.
• Cash and investments rose by $156.6 million from December 31, 2014. First-half financing cash flow was positive, primarily from equity issuance; no shares were repurchased in the first half, although $122.5 million remained authorized.

Outlook, commentary, risks, and unusual items

• Management cited continued market-share gains, enterprise sales expansion, and product and service investment as growth priorities. It expected R&D and G&A as a percentage of revenue to remain at comparable levels for the rest of 2015 and planned continued investment in sales and marketing.
• Management expected $35–$45 million of capital expenditures, mainly for office expansion and ERP implementation, and believed available cash and cash equivalents would cover anticipated needs for at least 12 months. $317.7 million of cash and investments were held by foreign subsidiaries and may incur U.S. tax if repatriated.
• In July 2015, after quarter-end, Fortinet acquired Meru Networks for approximately $44 million to expand its secure wireless offering. Purchase accounting was still being evaluated at filing.
• Contractual commitments totaled $158.3 million, including $74.3 million of inventory purchase commitments, largely due in the remainder of 2015. Operating lease commitments, net of sublease income, were $50.0 million.
• Unrecognized tax benefits were $52.4 million, with $5.2 million of accrued interest. Legal matters include ongoing disputes and patent litigation; the company had not recorded a significant loss-contingency accrual and said no existing matter was likely to materially affect its financial position, while acknowledging outcomes are uncertain.
• Key risks include quarterly sales variability and late-quarter shipment concentration, reliance on distributors and resellers, customer and distributor concentration, competition and pricing pressure, product vulnerabilities, component and contract-manufacturer supply constraints, foreign currency exposure, tax uncertainty, and ERP implementation and acquisition-integration risks. One distributor accounted for 17% of Q2 revenue and 20% of receivables at quarter-end.

Important facts for investors to verify

1. Whether revenue and billings growth, deferred-revenue expansion, and enterprise demand continue, especially given reliance on distributor channels and one distributor’s material contribution.
2. Whether operating-expense growth moderates and converts into improved operating margins; assess the impact of stock-based compensation and the elevated effective tax rate.
3. Cash-flow quality and sustainability, including the contribution of deferred-revenue growth and working-capital movements.
4. Meru’s final purchase accounting, integration costs, and contribution to growth and profitability; also track planned capital expenditures and ERP implementation.
5. Developments in uncertain tax positions, patent and other litigation, supply commitments, and the availability of cash held outside the United States.