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FTNT > SEC Filings for FTNT > Form 10-Q on 5-Nov-2013All Recent SEC Filings

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Form 10-Q for FORTINET INC


5-Nov-2013

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, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended ("Exchange Act"). 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;

the expected impact of certain acquisitions, asset purchases and strategic investments;

expected impact of sales of certain products;

the significance of stock-based compensation as an expense;

            the proportion of our revenue that consists of our product and
             service revenues, and the mix of billings between products and
             services;

the impact of our product innovation strategy;

            expanding our reach into new high growth verticals and emerging
             markets and continuing to sell to large enterprises and service
             providers;

our ability to meet increasing customer expectations about the quality and functionality of our products;

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, and expectations regarding these
             expenses as a percentage of revenue;

continued investments in research and development to strengthen our technology leadership position and in sales and marketing;

expectations regarding uncertain tax benefits and our effective tax rate;

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

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 in Part II, Item 1A. Risk Factors and elsewhere in this Quarterly Report on Form 10-Q and in our other SEC filings, including the 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. From inception through September 30, 2013, we shipped over 1,300,000 appliances via more than 19,000 channel partners to more than 170,000 end-customers worldwide, including a majority of the 2012 Fortune Global 100.

Our core Unified Threat Management ("UTM")/Next Generation Firewall ("NGFW") and Data Center Firewall ("DCFW") product line of FortiGate physical and virtual appliances ships with a set of security and networking capabilities,


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including firewall, VPN, application control, anti-malware, intrusion prevention, Web filtering, anti-spam and WAN acceleration functionality. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20, designed for small businesses, to the FortiGate-5000 series for large enterprises, telecommunications carriers, and service providers. Our UTM/NGFW/DCFW 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, anti-malware, Web filtering, vulnerability management and anti-spam 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 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 DDoS, endpoint security for employee computers and mobile devices, wireless access points and application delivery controllers. Although sales of these complementary products have grown in recent quarters, these products still represent less than 10% of our total revenue.

On September 13, 2013, we acquired certain assets of Xtera Communications, Inc. ("Xtera") in order to add products to enhance our load balancing solutions and to add patents to our patent portfolio .

In August 2013, we invested in and entered into a strategic go-to-market alliance agreement with HyTrust, a privately-held company, that specializes in cloud security automation in order to strengthen our commitment to virtualization and data center security.

Financial Highlights

            We recorded total revenue of $154.7 million and $437.9 million
             during the three and nine months ended September 30, 2013,
             respectively. This represents an increase of 14% and 15% during the
             three and nine months ended September 30, 2013, respectively,
             compared to the same periods last year. Product revenue was $69.7
             million and $194.2 million during the three and nine months ended
             September 30, 2013, respectively, an increase of 11% and 9%,
             respectively, compared to the same periods last year. Services
             revenue was $83.9 million and $239.4 million during the three and
             nine months ended September 30, 2013, respectively, an increase of
             20% and 21%, respectively, compared to the same periods last year.



            We generated cash flows from operating activities of $100.7 million
             during the nine months ended September 30, 2013, a decrease of 25%
             compared to the same period last year.



            Cash, cash equivalents and investments were $841.0 million as of
             September 30, 2013, an increase of $101.4 million from December 31,
             2012.

Deferred revenue was $400.2 million as of September 30, 2013, an increase of $37.0 million from December 31, 2012.

During the three and nine months ended September 30, 2013, revenue grew as a result of a slightly better business environment, along with our focus on improving sales execution and productivity of our sales force. We also continued to gain traction with several recently introduced products, including new FortiGate entry-level appliances such as the FG-60D and FG-90D with its WIFI counterparts; the FG-200D and FG-800C mid-range appliance; and the FG-3600C and FG-5001C for large enterprises and service providers.

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. During the three and nine months ended September 30, 2013, we experienced higher sales volume in our FortiGate product family, particularly entry-level products, wireless security and access point products, which contributed to the largest portion of the growth during this period. During the three and nine months ended September 30, 2013, we experienced an increase in the number of deals involving sales greater than $100,000 when compared to the same periods last year as the number of deals involving sales greater than $100,000 was 187 and 547 in the three and nine months ended September 30, 2013, respectively, compared to 168 and 489 in the three and nine months ended September 30, 2012, respectively. The number of deals involving sales greater than $250,000 was 61 and 174 in the three and nine months ended September 30, 2013, respectively, compared to 61 and 163 in the three and nine months ended September 30, 2012, respectively. Additionally, the number of deals involving sales greater than $500,000 was 19 and 52 in the three and nine months ended September 30, 2013,


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respectively, compared to 16 and 54 in the three and nine months ended September 30, 2012, respectively. We expect some variability in this metric, and remain focused on investing in our sales and marketing and research and development resources in order to expand our reach into new high-growth verticals and emerging markets. Moreover, we expect such investments to help us to meet increasing customer expectations about the quality and functionality of our products, as we continue to sell to large enterprises and service providers. While we have experienced some success selling to large enterprises, across key verticals, including service provider, government, retail, financial services and education, we experienced increased pressure from the macro-economic environment in APAC during the three and nine months ended September 30, 2013, and there can be no assurance we will be successful selling into these vertical customer segments.

During the three and nine months ended September 30, 2013, operating expenses increased by 27% and 25% compared to the same periods last year. The increase was primarily driven by additional headcount as we continued to invest in the development of new products and expand our sales coverage. Headcount increased to 2,238 as of September 30, 2013 from 1,854 as of September 30, 2012. Our accelerated pace of hiring continued during the three and nine months ended September 30, 2013, particularly in sales and marketing, research and development, and technical support.

Key Metrics

We monitor the key financial metrics set forth below 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 $10.5 million from $389.7 million as of June 30, 2013 to $400.2 million as of September 30, 2013. Revenue recognized plus the change in deferred revenue from the beginning to the end of the period less any deferred revenue balances acquired from business combinations 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 revenue that we recognize in a typical quarter. As of September 30, 2013, we had $841.0 million in cash, cash equivalents and investments and have had positive cash flow from operations every fiscal year since 2005. We discuss revenue, gross margin, and the components of operating income and margin below 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.

                                                   Three Months Ended Or As Of
                                                September 30,        September 30,
                                                     2013                 2012
                                                      ($ amounts in 000's)
Revenue                                              154,699              136,268
Gross margin                                              72 %                 72 %
Operating income (1)                                  18,279               25,770
Operating margin                                          12 %                 19 %
Total deferred revenue                               400,173              340,078
Increase in total deferred revenue                    10,491                8,710
Cash, cash equivalents and investments               841,005              690,303
Cash provided by operating activities                 25,384               40,770
Free cash flow (Non-GAAP)(2)                          22,224               24,342
___________________
(1) Includes:
Stock-based compensation expense                      11,778                8,830
Patent settlement income                                 478                  478

(2) See "-Cash flow from operations" below for a definition of free cash flow.

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. We define billings as revenue recognized during a period plus the change in deferred revenue from the beginning to the end of the period less any deferred revenue balances acquired from business combination(s) during the period. The following table reflects the reconciliation of billings to revenue. 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,
                                      2013             2012
                                      ($ amounts in 000's)
Billings:
Revenue                             154,699             136,268
Add increase in deferred revenue     10,491               8,710
Total billings (Non-GAAP)           165,190             144,978

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 our billings growth, profitability, and our ability to successfully manage our working capital. 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. The following table provides a reconciliation of free cash flow to cash provided by operating activities. 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,
                                               2013             2012
                                               ($ amounts in 000's)
Free Cash Flow:
Net cash provided by operating activities      25,384            40,770
Less purchases of property and equipment       (3,160 )         (16,428 )
Free cash flow (Non-GAAP)                      22,224            24,342

Other Non-GAAP Financial Measures

To supplement our consolidated financial statements presented in accordance with 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 operating income, 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, offset by patent settlement income. Effective second quarter of fiscal 2013, our non-GAAP financial measures exclude amortization expense of certain intangible assets. Prior period amounts have been adjusted to conform to current period presentation. Stock-based compensation expense 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


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operations. We compensate for these limitations by providing the nearest GAAP equivalents of these non-GAAP financial measures and describing these GAAP equivalents in the section entitled "-Results of Operations" below. Non-GAAP gross margin represents gross margin as reported in our consolidated statements of operations, excluding the impact of stock-based compensation expense and amortization expense of certain intangible assets, both of which are non-cash charges. Non-GAAP operating income is operating income, as reported in our consolidated statements of operations, excluding the impact of stock-based compensation expense, amortization expense of certain intangible assets, and the income we receive from a patent settlement. Non-GAAP operating margin is non-GAAP operating income divided by revenue. The following table reconciles GAAP gross profit, GAAP gross margin, GAAP operating income, and GAAP operating margin to non-GAAP gross profit, non-GAAP gross margin, non-GAAP operating income, and non-GAAP operating margin for the three months ended September 30, 2013 and September 30, 2012.

                                                            Three Months Ended
                                                  September 30,            September 30,
                                                       2013                     2012
                                                              % of                     % of
                                              Amount ($)    Revenue    Amount ($)    Revenue
                                                           ($ amounts in 000's)
Total revenue                                   154,699                  136,268
GAAP gross profit and margin                    110,769           72      98,460           72
Stock-based compensation expense                  1,388            1       1,103            1
Amortization expense of certain intangible
assets (1)                                          423            -         226            -
Non-GAAP gross profit and margin                112,580           73      99,789           73
GAAP operating income and margin                 18,279           12      25,770           19
Stock-based compensation expense:
Cost of revenue                                   1,388            1       1,103            1
Research and development                          3,548            2       2,525            1
Sales and marketing                               5,215            3       3,879            3
General and administrative                        1,627            1       1,323            1
Total stock-based compensation expense           11,778            7       8,830            6
Amortization expense of certain intangible
assets (1)                                          423            -         226            -
Patent settlement income                           (478 )          -        (478 )          -
Non-GAAP operating income and margin             30,002           19      34,348           25

(1) Effective second quarter of fiscal 2013, amortization expense of certain intangible assets is excluded from GAAP gross profit and margin, and GAAP operating income and margin to reconcile to non-GAAP financial metrics. Prior period amounts have been adjusted to conform to current period presentation.


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Non-GAAP operating expenses represent operating expenses, as reported in our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense and the income from a patent settlement. The following table reconciles GAAP operating expenses to non-GAAP operating expenses for the three months ended September 30, 2013 and September 30, 2012.

                                                               Three Months Ended
                                                    September 30,               September 30,
                                                        2013                        2012
                                                               % of                        % of
                                              Amount ($)      Revenue     Amount ($)      Revenue
                                                              ($ amounts in 000's)
Operating Expenses:
Research and development expenses:
GAAP research and development expenses           26,421          17          20,498          15
Stock-based compensation expense                 (3,548 )        (2 )        (2,525 )        (1 )
Non-GAAP research and development expenses       22,873          15          17,973          14
Sales and marketing expenses:
GAAP sales and marketing expenses                56,687          37          44,743          33
Stock-based compensation expense                 (5,215 )        (3 )        (3,879 )        (3 )
Non-GAAP sales and marketing expenses            51,472          34          40,864          30
General and administrative expenses:
GAAP general and administrative expenses          9,382           6           7,449           5
Stock-based compensation expense                 (1,627 )        (1 )        (1,323 )        (1 )
Patent settlement income                            478           -             478           -
Non-GAAP general and administrative expenses      8,233           5           6,604           4
Total operating expenses:
GAAP operating expenses                          92,490          60          72,690          53
Stock-based compensation expense                (10,390 )        (6 )        (7,727 )        (5 )
Patent settlement income                            478           -             478           -
Non-GAAP operating expenses                      82,578          54          65,441          48


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Non-GAAP net income represents net income, as reported in our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense, amortization expense of certain intangible assets, and income from a patent settlement. The following table reconciles GAAP net income to non-GAAP net income for the three months ended September 30, 2013 and September 30, 2012.

                                                                Three Months Ended
                                                           September 30,    September 30,
                                                               2013              2012
                                                          ($ and share amounts in 000's,
                                                            except per share amounts)
Net Income:
GAAP net income                                              11,029               17,206
Stock-based compensation expense (1)                         11,778                8,830
Amortization expense of certain intangible assets (2)           423                  226
Patent settlement income (3)                                   (478 )               (478 )
Provision for income taxes (4)                                7,381                9,565
Non-GAAP income before provision for income taxes            30,133               35,349
Non-GAAP provision for income taxes (5)                      (9,944 )            (12,019 )
Non-GAAP net income                                          20,189               23,330
Non-GAAP net income per share-diluted                          0.12                 0.14
Shares used in per share calculation-diluted                168,666              166,791


____________________


(1) Stock-based compensation expense is excluded from GAAP net income to reconcile to non-GAAP income before provision for income taxes.

(2) Effective second quarter of fiscal 2013, amortization expense of certain intangible assets is excluded from GAAP net income to reconcile to non-GAAP income before provision for income taxes. Prior period amounts have been adjusted to conform to current period presentation.

(3) The patent settlement income is excluded from GAAP net income to reconcile to non-GAAP income before provision for income taxes.

(4) Provision for income taxes is our GAAP tax provision that is included in GAAP net income to reconcile to non-GAAP income before provision for income taxes.

(5) We used non-GAAP effective tax rates of 33% and 34%, which could differ from the GAAP tax rates, to calculate non-GAAP net income for the three months ended September 30, 2013 and September 30, 2012, respectively.

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