Fortinet, Inc. — Q1 2014 Form 10-Q
Reporting period: Three months ended March 31, 2014; comparisons are with the three months ended March 31, 2013 unless noted. Fortinet provides network security products and related subscription, support, and other services.
Financial performance
| Metric | Q1 2014 | Prior period | Change |
|---|---|---|---|
| Total revenue | $168.9 million | $135.8 million | +24% |
| Product revenue | $76.8 million | $58.0 million | +32% |
| Services and other revenue | $92.2 million | $77.9 million | +18% |
| Gross profit / margin | $118.2 million / 70.0% | $96.7 million / 71.2% | Margin down 1.2 percentage points |
| Operating income | $12.8 million | $15.4 million | Down 17% |
| Net income | $8.4 million | $12.2 million | Down 31% |
| Diluted earnings per share | $0.05 | $0.07 | Down |
| Operating cash flow | $60.9 million | $38.1 million | +60% |
| Free cash flow (non-GAAP) | $49.6 million | $36.6 million | +36% |
| Deferred revenue | $451.3 million | $376.4 million | Up year over year; up $18.7 million from year-end |
Cash, cash equivalents, and investments totaled $888.3 million at quarter-end, versus $843.0 million at December 31, 2013. Working capital was $386.6 million. The balance sheet reports no borrowings or debt line item. Total liabilities were $589.9 million, including $451.3 million of deferred revenue. Cash and investments included $136.7 million held by international subsidiaries and not immediately available for domestic operations without repatriation.
Changes and operating drivers
- Revenue increased across all regions: Americas +38%, EMEA +20%, and APAC +11%. Americas contributed the largest portion of the increase.
- Management attributed growth to FortiGate demand across product ranges, newer high-end appliances, subscription and support revenue from a larger customer base, and increased enterprise and service-provider activity.
- Gross margin declined mainly because product gross margin fell to 58.1% from 60.4%, reflecting higher personnel and occupancy costs, warranty costs, and excess inventory write-offs. Services gross margin edged up to 79.8% from 79.2%.
- Operating expenses rose 30% to $105.4 million, with sales and marketing up 35% and R&D up 25%. Management cited hiring and investment in sales coverage, product development, and customer support; headcount rose to 2,389 from 2,077 a year earlier.
- The effective tax rate increased to 39% from 28%, primarily due to limits on using foreign tax credits and expiration of the U.S. federal R&D tax credit. Higher expenses and taxes contributed to lower operating income and net income despite revenue growth.
Outlook, liquidity, risks, and unusual items
- Management said existing cash and investments should cover anticipated cash needs for at least 12 months. It expected up to $15 million of spending on headquarters improvements and ERP implementation during the remainder of 2014.
- Management expected R&D and G&A expense as a percentage of revenue to remain at comparable levels for the rest of fiscal 2014; sales and marketing expense as a percentage of revenue was expected to remain comparable or increase. No numerical revenue or earnings guidance was provided.
- Operating cash flow included a $20 million payment under a six-year mutual covenant-not-to-sue and release agreement with Palo Alto Networks. The quarter’s cash generation also reflected working-capital movements; it should not be viewed solely as recurring earnings conversion.
- Fortinet repurchased 0.3 million shares for $7.5 million under a $200 million authorization; $153.5 million remained available at quarter-end. The cash flow statement reports $12.3 million of repurchases and a $0.7 million related liability.
- Quarter-end contractual commitments totaled $93.6 million, including $38.9 million of potentially non-cancelable manufacturer purchase orders, $24.2 million of other commitments, and $30.6 million of net operating lease commitments.
- Key risks include quarterly variability and concentration of shipments near quarter-end; reliance on channel partners and subscription renewals; competition and pricing pressure; inventory, component, and contract-manufacturer constraints; product defects or security vulnerabilities; foreign-exchange exposure; and tax uncertainty. Management reported no litigation expected to have a material adverse effect and no material loss-contingency accrual.
- Other notable items: the company moved into its new headquarters in March; it prospectively changed its stock-option expected-term methodology and useful-life estimates for certain fixed assets; and it reduced the Coyote Point contingent-consideration liability by $1.1 million.
Important facts for investors to verify
- Whether deferred-revenue and billings growth continues to support reported revenue growth, given the timing of subscription and support revenue recognition.
- Whether product gross margin stabilizes after the reported inventory write-offs, warranty costs, and higher personnel and occupancy costs.
- How much operating cash flow is repeatable without the $20 million Palo Alto Networks payment and other working-capital timing effects.
- The effects of increased sales and marketing investment, headquarters and ERP spending, share repurchases, and the higher effective tax rate on future profitability and liquidity.