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FTNT > SEC Filings for FTNT > Form 10-Q on 30-Oct-2012All Recent SEC Filings

Show all filings for FORTINET INC

Form 10-Q for FORTINET INC


30-Oct-2012

Quarterly Report


ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements include, among other things, statements concerning our expectations regarding:

variability in sales in certain product categories from year to year and between quarters;

expected impact of sales of certain products;

continued sales into large enterprises;

mix of billings between products and services;

mix of service sales containing multi-year support and subscription contracts;

the significance of stock-based compensation as an expense;

            the proportion of our revenue that consists of our product and
             service revenues and future trends with respect to service revenue
             as we renew existing services contracts and expand our customer
             base;

the impact of our product innovation strategy;

trends in revenue, costs of revenue, and gross margin;

            trends in our operating expenses, including personnel costs,
             research and development expense, sales and marketing expense and
             general and administrative expense;

our effective tax rate; and

the sufficiency of our existing cash and investments to meet our cash needs for at least the next 12 months;

as well as other statements regarding our future operations, financial condition and prospects and business strategies. These forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q and, in particular, the risks discussed under the heading "Risk Factors" included elsewhere in this Quarterly Report on Form 10-Q and in our other SEC filings, including our Form 10-K. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Business Overview

We provide network security solutions, which enable broad, integrated and high performance protection against dynamic security threats while simplifying the IT security infrastructure for enterprises, service providers and governmental entities worldwide. As of September 30, 2012, we had shipped over 1,000,000 appliances to more than 10,000 channel partners and to more than 140,000 end-customers worldwide, including a majority of the Fortune Global 100.

Our core Unified Threat Management ("UTM") product line of FortiGate physical and virtual appliances ships with a set of security and networking capabilities, including firewall, VPN, application control, antivirus, intrusion prevention, Web filtering, antispam and WAN acceleration functionality. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20 series, designed for small businesses, to the FortiGate-5000 series for large enterprises, telecommunications carriers, and service providers. Sales of FortiGate products are generally balanced across entry-level (FortiGate-20 to -100 series), mid-range (FortiGate-200 to -800 series) and high-end (FortiGate-1000 to -5000 series) models with each product category representing approximately one-third of FortiGate sales. Our UTM solution also includes our FortiGuard security subscription services, which end-customers can subscribe to in order to obtain access to dynamic updates to intrusion prevention, application control, antivirus, Web filtering, vulnerability management and antispam functionality included in our appliances. End-customers can also choose to purchase FortiCare technical support services for our products. End-customers also often use FortiManager and FortiAnalyzer products in conjunction with a FortiGate


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deployment to provide centralized management, analysis and reporting capabilities. We complement our core FortiGate product line with other appliances and software that offer additional protection from security threats to other critical areas of the enterprise, such as messaging, Web application firewalls, databases, protection against denial of service attacks (DDoS) and endpoint security for employee computers and mobile devices. Sales of these complementary products have grown in recent quarters, although these products still represent less than 10% of our revenue.

In October 2012, we announced our new FortiOS 5.0 operating system. FortiOS 5.0 is our fifth generation security operating system, and this release brings more than 150 new features to our FortiGate product line. In addition, we announced version 5.0 operating systems for our FortiManager, FortiAnalyzer, and FortiClient products, to address the need for increasingly sophisticated management and analysis of the network infrastructure and endpoint devices in various environments.

In October 2012, we also announced our new FortiASIC-SoC2 processor. FortiASIC-SoC2 is our second-generation processor that combines general purpose processing power with Fortinet's custom technology to provide hardware-accelerated network security performance for our FortiGate appliances. It provides more than double the general processing capacity than its predecessor.

Financial Highlights

            We recorded revenue of $136.3 million and $382.5 million during the
             three and nine months ended September 30, 2012, respectively. This
             represents an increase of 17% and 22% during the three and nine
             months ended September 30, 2012, respectively, compared to the same
             periods last year. Revenue included $1.8 million and $2.6 million
             from the sales of previously-acquired patents during the three
             months ended September 30, 2012 and September 30, 2011,
             respectively. Product revenue was $63.0 million and $177.9 million
             during the three and nine months ended September 30, 2012,
             respectively, an increase of 19% and 27% during the three and nine
             months ended September 30, 2012, respectively, compared to the same
             periods last year. Services revenue was $69.8 million and $197.3
             million during the three and nine months ended September 30, 2012,
             respectively, an increase of 21% and 24% during the three and nine
             months ended September 30, 2012, respectively, compared to the same
             periods last year.



            We generated cash flows from operating activities of $133.6 million
             during the nine months ended September 30, 2012, an increase of 21%
             compared to the same period last year.



            Cash, cash equivalents and investments were $690.3 million as of
             September 30, 2012, an increase of $151.6 million from December 31,
             2011.

Deferred revenue was $340.1 million as of September 30, 2012, an increase of $45.2 million from December 31, 2011.

During the three months ended September 30, 2012, revenues grew as a result of the successful execution of our global sales strategy and the continued product innovation that has strengthened our technology advantages and resulted in market share gains. The recent introduction of several new FortiGate entry-level appliances such as the FortiGate-20C and -40C with their WIFI counterparts and the FortiGate-100D; the FortiGate-600C and FortiGate-800C mid-range appliances; and the FortiGate-1000C, FortiGate-3240C and FortiGate-5101C for large enterprises and service providers continued to gain traction and contributed to the revenue growth.

We continue to invest in research and development to strengthen our technology leadership position, as well as sales and marketing to expand brand awareness, strengthen our value proposition, and expand our global sales team and distribution channels. We experienced healthy deal volumes driven by traction in enterprise data center deployments, large enterprise deals, with particular strength in the retail, financial and telecommunications sectors. The number of deals involving sales greater than $100,000 was 168 in the three months ended September 30, 2012, compared to 130 in the three months ended September 30, 2011. The number of deals involving sales greater than $250,000 was 61 in the three months ended September 30, 2012, compared to 39 in the three months ended September 30, 2011. The number of deals involving sales greater than $500,000 was 16 in the three months ended September 30, 2012, compared to 13 in the three months ended September 30, 2011. We expect some variability in this metric, and remain focused on investing in our sales and research and development resources in order to expand our reach into new high-growth verticals and emerging markets, and meet increasing customer expectations about the quality and functionality of our products, as we continue to sell to large customers, such as enterprise and service providers. While we have experienced some success selling into certain vertical customer segments, such as service providers and enterprise, we have experienced less traction selling into other verticals such as the U.S. federal government and there can be


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no assurance we will be successful selling into certain vertical customer segments.

During the three months ended September 30, 2012, operating expenses increased by 23% compared to the same period last year. The increase was primarily driven by additional headcount to support our growth as we continued to invest in the development of new products and expand our sales coverage. We also incurred $1.3 million of litigation settlement expense in the three months ended September 30, 2012. These increases were partially offset by favorable foreign currency exchange rates compared to the same period last year. Headcount increased to 1,854 at September 30, 2012 from 1,527 at September 30, 2011. Our accelerated pace of hiring continued this quarter, particularly in support, sales and marketing and research and development as we increased headcount by 92 from June 30, 2012.
Key Metrics

We monitor the key financial metrics set forth below on a quarterly basis to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. Our total deferred revenue increased by $8.7 million from $331.4 million at June 30, 2012 to $340.1 million at September 30, 2012. Revenue recognized plus the change in deferred revenue from the beginning to the end of the period is a useful metric that management identifies as billings. Billings for services drive deferred revenue, which is an important indicator of the health and visibility of our business, and has historically represented a majority of the quarterly revenue that we recognize. We also ended the three months ended September 30, 2012 with $690.3 million in cash, cash equivalents and investments and have had positive cash flow from operations for every fiscal year since 2005. We discuss revenue, gross margin, and the components of operating income and margin under "Results of Operations," and we discuss our cash, cash equivalents, and investments under "Liquidity and Capital Resources." Deferred revenue and cash flow from operations are discussed immediately below the following table.

                                                           For The Three Months Ended Or As Of
                                                         September 30,               September 30,
                                                              2012                       2011
                                                                  ($ amounts in 000's)
Revenue                                                      136,268                       116,426
Gross margin                                                      72 %                          73 %
Operating income(1)                                           25,770                        26,160
Operating margin                                                  19 %                          22 %
Total deferred revenue                                       340,078                       275,126
Increase in total deferred revenue over prior
quarter                                                        8,710                         1,927
Cash, cash equivalents and investments                       690,303                       502,967
Cash flows from operating activities                          40,770                        36,039
Free cash flow(2)                                             24,342                        34,704
----------
(1)  Includes:
 Stock-based compensation expense                              8,830                         5,734
 Patent settlement income                                        478                           478


(2) Free cash flow is a non-GAAP financial measure, which is defined as net cash provided by operating activities less capital expenditures, as further described below.

Deferred revenue. Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue. The majority of our deferred revenue balance consists of the unamortized portion of services revenue from subscription and support service contracts. We monitor our deferred revenue balance because it represents a significant portion of revenue to be recognized in future periods. The following table reflects the calculation of billings as discussed in the paragraph above. For a discussion of the limitations of non-GAAP financial measures, see "-Other Non-GAAP Financial Measures" below.


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                                   Three Months Ended
                             September 30,    September 30,
                                  2012             2011
                                  ($ amounts in 000's)
Billings:
Revenue                         136,268             116,426
Increase in deferred revenue      8,710               1,927
Total billings (Non-GAAP)       144,978             118,353

Cash flow from operations. We monitor cash flow from operations as a measure of our overall business performance. Our cash flow from operations is driven in large part by advance payments for both new and renewal contracts for subscription and support services, consistent with our billings for the period. Monitoring cash flow from operations and free cash flow enables us to analyze our financial performance excluding the non-cash effects of certain items such as depreciation, amortization and stock-based compensation expenses, thereby allowing us to better understand and manage the cash needs of our business. Free cash flow, an alternative non-GAAP financial measure of liquidity, is defined as net cash provided by operating activities less capital expenditures. For a discussion of the limitations of non-GAAP financial measures, see "-Other Non-GAAP Financial Measures" below.

                                                Three Months Ended
                                          September 30,    September 30,
                                               2012             2011
                                               ($ amounts in 000's)
Free Cash Flow:
Net cash provided by operating activities      40,770            36,039
Less purchases of property and equipment      (16,428 )          (1,335 )
Free cash flow (Non-GAAP)                      24,342            34,704

Other Non-GAAP Financial Measures

To supplement our condensed consolidated financial statements presented in accordance with U.S. GAAP, we consider certain financial measures that are not prepared in accordance with GAAP, including billings and free cash flow discussed above as well as non-GAAP gross margin, non-GAAP income from operations and non-GAAP operating margin, non-GAAP operating expenses and non-GAAP net income. These non-GAAP financial measures are not based on any standardized methodology prescribed by GAAP and are not necessarily comparable to similar measures presented by other companies.

We use these non-GAAP financial measures internally in analyzing our financial results and believe they are useful to investors, as a supplement to GAAP measures, in evaluating our ongoing operational performance and enhancing an overall understanding of our past financial performance, as they help illustrate underlying trends in our business that could otherwise be masked by the effect of the expenses that we exclude in these non-GAAP financial measures. Furthermore, we use many of these measures to establish budgets and operational goals for managing our business and evaluating our performance. We also believe that the use of these non-GAAP financial measures provides an additional tool for investors to use in comparing our recurring core business operating results over multiple periods with other companies in our industry, many of which present similar non-GAAP financial measures to investors.

These non-GAAP financial measures should not be considered in isolation from, or as a substitute for, financial information prepared in accordance with GAAP. There are a number of limitations related to the use of these non-GAAP financial measures versus the nearest GAAP equivalent of these financial measures. First, these non-GAAP financial measures exclude certain recurring, non-cash charges such as stock-based compensation expense and a patent settlement. Stock-based compensation has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and is an important part of our employees' overall compensation. Second, the expenses that we exclude in our calculation of these non-GAAP financial measures may differ from the expenses, if any, that our peer companies may exclude when they report their results of operations. We compensate for these limitations by providing the nearest GAAP equivalents of these non-GAAP financial measures and describing these GAAP equivalents in our Results of Operations below.

Non-GAAP gross margin is gross margin as reported on our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense, which is a non-cash charge. Non-GAAP income from operations is operating


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income, as reported on our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense and the income from a patent settlement. Non-GAAP operating margin is non-GAAP income from operations divided by revenue. The following tables reconcile GAAP gross margin, income from operations, and operating margin to non-GAAP gross margin, non-GAAP income from operations, and non-GAAP operating margin for the three months ended September 30, 2012 and September 30, 2011.

                                                         Three Months Ended
                                               September 30,            September 30,
                                                    2012                     2011
                                                           % of                     % of
                                             Amount      Revenue      Amount      Revenue
                                                        ($ amounts in 000's)
Total revenue                                136,268                  116,426

GAAP gross profit and margin                  98,460          72       85,287          73
Stock-based compensation expense               1,103           1          628           1
Non-GAAP gross profit and margin              99,563          73       85,915          74

GAAP income from operations and margin        25,770          19       26,160          22
Stock-based compensation expense:
Cost of revenue                                1,103           1          628           1
Research and development                       2,525           1        1,516           1
Sales and marketing                            3,879           3        2,708           2
General and administrative                     1,323           1          882           1
Total stock-based compensation                 8,830           6        5,734           5
Patent settlement                               (478 )         -         (478 )         -
Non-GAAP income from operations and margin    34,122          25       31,416          27

Non-GAAP operating expenses exclude the impact of stock-based compensation expense and the income from a patent settlement. The following tables reconcile GAAP operating expenses to non-GAAP operating expenses for the three months ended September 30, 2012 and September 30, 2011.


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                                                      Three Months Ended
                                           September 30,               September 30,
                                               2012                        2011
                                                      % of                        % of
                                       Amount       Revenue        Amount       Revenue
                                                     ($ amounts in 000's)
Operating Expenses:
Research and development expenses:
GAAP research and development
expenses                               20,498           15         16,834           14
Stock-based compensation               (2,525 )         (1 )       (1,516 )         (1 )
Non-GAAP research and development
expenses                               17,973           14         15,318           13

Sales and marketing expenses:
GAAP sales and marketing expenses      44,743           33         36,934           32
Stock-based compensation               (3,879 )         (3 )       (2,708 )         (2 )
Non-GAAP sales and marketing
expenses                               40,864           30         34,226           30

General and administrative expenses:
GAAP general and administrative
expenses                                7,449            5          5,359            5
Stock-based compensation               (1,323 )         (1 )         (882 )         (1 )
Patent settlement                         478            -            478            -
Non-GAAP general and administrative
expenses                                6,604            4          4,955            4

Total operating expenses:
GAAP operating expenses                72,690           53         59,127           51
Stock-based compensation               (7,727 )         (5 )       (5,106 )         (4 )
Patent settlement                         478            -            478            -
Non-GAAP operating expenses            65,441           48         54,499           47

Non-GAAP net income is net income, as reported in our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense and income from a patent settlement. The following tables reconcile GAAP net income as reported on our condensed consolidated statements of operations to non-GAAP net income for the three months ended September 30, 2012 and September 30, 2011.

                                                        Three Months Ended
                                                  September 30,    September 30,
                                                       2012             2011
                                                       ($ amounts in 000's)
Net Income:
GAAP net income                                         17,206           17,917
Stock-based compensation expense(1)                      8,830            5,734
Patent settlement(2)                                      (478 )           (478 )
Provision for income taxes(3)                            9,565            9,207
Non-GAAP income before provision for income taxes       35,123           32,380
Tax effects related to non-GAAP adjustments(4)         (11,942 )        (10,685 )
Non-GAAP net income                                     23,181           21,695

Non-GAAP net income per share - diluted                   0.14             0.13

Shares used in per share calculation - diluted         166,791          163,869


---------


(1) Stock-based compensation expense is added back to GAAP net income to reconcile to non-GAAP income before taxes.

(2) The patent settlement income is removed from GAAP net income to reconcile to non-GAAP income before taxes.

(3) Provision for income taxes is our GAAP provision that must be added to GAAP net income to reconcile to non-GAAP


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income before taxes.
(4) Tax provision related to non-GAAP income before tax reflects 34% and 33% effective tax rates in the three months ended September 30, 2012 and September 30, 2011, respectively. Based on the annual estimate for geographic split of income, as well as various tax credits we expect to achieve in various locations, we currently plan to use a 34% tax rate for the year, subject to discrete items that may occur in a particular quarter.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, cash flow and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, stock-based compensation, valuation of inventory, warranty liabilities and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

There have been no significant changes to our critical accounting policies and estimates since the fiscal year ended December 31, 2011.

Revenue Recognition-In October 2009, the Financial Accounting Standards Board ("FASB") amended the Accounting Standards Codification ("ASC") as summarized in ASU No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements ("ASU 2009-13"), and ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements ("ASU 2009-14"). ASU 2009-13 amended the accounting for multiple-element arrangements to provide guidance on . . .

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