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FTNT > SEC Filings for FTNT > Form 10-K on 3-Mar-2014All Recent SEC Filings

Show all filings for FORTINET INC

Form 10-K for FORTINET INC


3-Mar-2014

Annual Report


ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the 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;

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;

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 Annual Report on Form 10-K and, in particular, the risks discussed under the heading "Risk Factors" in Part I, Item 1A of this Annual Report on Form 10-K and those discussed in other documents we file with the SEC. 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 high performance 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. Since inception through December 31, 2013, we had shipped over 1,400,000 appliances via more than 20,000 channel partners to more than 184,000 end-customers worldwide, including a majority of the 2013 Fortune Global 100.

Our core DCFW/UTM/NGFW 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,


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vulnerability management, anti-spam, wireless controller, 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 DCFW/UTM/NGFW 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 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 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 total revenue. During fiscal 2013, we expanded and enhanced our FortiGate DCFW/UTM/NGFW and FortiAP secure wireless access product lines. We also introduced software-based virtual appliances for many of our FortiGate and FortiManager product lines, which help secure the end-customer's cloud-based network infrastructures with the same functionality as the traditional physical appliance in their respective product lines.

In fiscal 2013, we completed certain acquisitions as part of our strategy to expand our product offerings, around load balancing solutions and add patents to our patent portfolio.

Financial Highlights

We recorded total revenue of $615.3 million in fiscal 2013. This represents an increase of 15% in fiscal 2013, compared to fiscal 2012. Revenue in fiscal 2013 and fiscal 2012 included $2.8 million and $3.7 million, respectively, from the sales of previously-acquired patents. Product revenue was $278.0 million, an increase of 12% in fiscal 2013, compared to fiscal 2012. Services revenue was $329.7 million in fiscal 2013, an increase of 20% in fiscal 2013, compared to fiscal 2012.

Cash, cash equivalents and investments were $843.0 million as of December 31, 2013, an increase of $103.5 million from December 31, 2012.

Deferred revenue was $432.6 million as of December 31, 2013, an increase of $69.4 million from December 31, 2012.

We generated cash flows from operating activities of $147.4 million in fiscal 2013, a decrease of 20% compared to fiscal 2012.

In December 2013, our board of directors authorized a Share Repurchase Program ("the Program"), which authorizes us to repurchase up to $200.0 million of our outstanding common stock. In fiscal 2013, we repurchased 2.1 million shares of common stock under the Program in open market transactions for an aggregate purchase price of $38.9 million.

We continue to invest in research and development to strengthen our technology leadership position. We believe that continued product innovation has strengthened our technology advantage and resulted in market share gains, as evidenced by the recent introduction of several noteworthy new FortiGate appliance models, including new FortiGate entry-level appliances, such as the FG-60D and FG-90D with its WIFI counterparts and FG-100D; the FG-200D and FG-800C mid-range appliance; and the FG-3600C and FG-5001C for large enterprises and service providers. During fiscal 2013, we also made a significant investment in sales and marketing to increase brand awareness and grow our global sales force and distribution channels to expand our global presence both geographically and by industry segment. As a result, we experienced increased deal volumes driven by traction in enterprise data center deployments and large enterprise deals, with particular strength in the retail, financial and telecommunication sectors.

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


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Sales of FortiGate products have generally been 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, with some degree of variability from year to year and between quarters over the three-year period ended December 31, 2013. The percentage of our FortiGate related billings from the entry-level category increased from 32% in fiscal 2012 to 38% in fiscal 2013, while the mid-range category decreased from 33% in fiscal 2012 to 29% in fiscal 2013 and the high-end category decreased from 35% to 34%.

In fiscal 2013, operating expenses increased by 27% compared to fiscal 2012. The increase was primarily driven by our accelerated pace of hiring to support our growth as we continued to invest in expanding our sales coverage, developing new products and scaling our customer support organization to meet the needs of our growing customer base. This resulted in revenue per employee, defined as annual revenue divided by average headcount, of $286,000, down from $303,000 for fiscal 2012.

Business Model

Our sales strategy is based on a distribution model whereby we primarily sell our products and services directly to distributors who sell to resellers and service providers, who, in turn, sell to our end-customers. In certain cases, we sell directly to government-focused resellers, large service providers and major systems integrators, who have significant purchasing power and unique customer deployment requirements. Typically, FortiGuard security subscription services and FortiCare technical support services are purchased along with our physical and virtual appliances. We invoice at the time of our sale for the total price of the products and subscription and support services, and the invoice generally becomes payable within 30 to 90 days. We generally recognize product revenue up-front based on the allocated revenue value and defer revenue for the sale of new and renewal subscription and support services contracts. We recognize the related services revenue over the service period, which is typically one year from the date the end-customer registers for these services (the date on which the services can first be used by the customer), although it can be as long as five years. Sales of new and renewal services increase our deferred revenue balance, which contributes significantly to our positive cash flow from operations.

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 $69.4 million from $363.2 million as of December 31, 2012 to $432.6 million as of December 31, 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. We ended fiscal 2013 with $843.0 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 "-Components of Operating Results," 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.


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                                                    Fiscal Year or as of Fiscal Year End
                                                   2013               2012             2011
                                                            ($ amounts in 000's)
Revenue                                           615,297            533,639          433,576
Gross margin                                           71 %               72 %             74 %
Operating income (1)                               72,090            100,475           88,904
Operating margin                                       12 %               19 %             21 %
Total deferred revenue                            432,628            363,185          294,833
Increase in total deferred revenue                 69,443             68,352           42,202
Cash, cash equivalents and investments            843,045            739,586          538,687
Cash provided by operating activities             147,384            183,866          132,842
Free cash flow (2)                                133,507            161,783          135,218
___________________
(1)  Includes:
Stock-based compensation expense                   44,471             30,690           19,015
Amortization expense of certain intangible
assets                                              1,551                826              394
Impairment charges related to certain
intangible assets                                     469                  -                -
Patent settlement income                            1,912              1,912            1,911

(2) Free cash flow is defined as net cash provided by operating activities less capital expenditures.

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 combinations. 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.

                                                            Fiscal Year
                                               2013            2012            2011
                                                       ($ amounts in 000's)
Billings:
Revenue                                        615,297         533,639         433,576
Increase in deferred revenue                    69,443          68,352          42,202
Less deferred revenue balance acquired in
business combination                              (550 )             -               -
Total billings (Non-GAAP)                      684,190         601,991         475,778

Cash flow from operations and free cash flow. 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 payments for both new and renewal contracts for subscription and support services. 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.


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                                                     Fiscal Year
                                            2013        2012        2011
                                                ($ amounts in 000's)
Free Cash Flow:
Net cash provided by operating activities 147,384     183,866     132,842
Less purchases of property and equipment  (13,877 )   (22,083 )    (3,624 )
Free cash flow (Non-GAAP)                 133,507     161,783     129,218

Other Non-GAAP Financial Measures

To supplement our consolidated financial statements presented in accordance with U.S. generally accepted accounting principles ("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, amortization expense and impairment charges related to certain intangible assets, offset by patent settlement income. 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 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 is gross margin as reported on our consolidated statements of operations, excluding the impact of stock-based compensation expense, amortization expense and impairment charges related to certain intangible assets, all of which are non-cash charges. Non-GAAP operating income is operating income, as reported on our consolidated statements of operations, excluding the impact of stock-based compensation expense, amortization expense and impairment charges related to certain intangible assets, and the income we received from a patent settlement. Non-GAAP operating margin is non-GAAP operating income divided by revenue. The following tables reconcile GAAP gross margin, operating income, and operating margin to non-GAAP gross margin, non-GAAP operating income, and non-GAAP operating margin for fiscal 2013, 2012 and 2011.


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                                                             Fiscal Year
                                      2013                      2012                      2011
                                             % of                      % of                      % of
                             Amount ($)     Revenue    Amount ($)    Revenue    Amount ($)      Revenue
                                                         ($ amounts in 000's)
Total revenue                  615,297                   533,639                  433,576

Gross and Non-GAAP gross
profit and margin
GAAP gross profit and margin   434,654          71       386,219           72     319,978          74
Stock-based compensation
expense                          5,224           1         4,069            1       1,973           -
Amortization expense of
certain intangible assets        1,551           -           826            -         394           -
Impairment charges related
to certain intangible assets       469           -             -            -           -           -
Non-GAAP gross profit and
margin                         441,898          72       391,114           73     322,345          74

Gross and Non-GAAP operating
income and margin
GAAP operating income and
margin                          72,090          12       100,475           19      88,904          21
Stock-based compensation
expense:
Cost of revenue                  5,224           1         4,069            1       1,973           -
Research and development        13,271           2         9,226            1       4,691           1
Sales and marketing             19,526           3        12,793            2       9,325           3
General and administrative       6,450           1         4,602            1       3,026           -
Total stock-based
compensation expense            44,471           7        30,690            5      19,015           4
Amortization expense of
certain intangible assets        1,551           -           826            -         394           -
Impairment charges related
to certain intangible assets       469           -             -            -           -           -
Patent settlement income        (1,912 )         -        (1,912 )          -      (1,911 )        (1 )
Non-GAAP operating income
and margin                     116,669          19       130,079           24     106,402          24


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Non-GAAP operating expenses represent operating expenses, as reported on our consolidated statements of operations, excluding 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 fiscal 2013, 2012 and 2011.

                                                                Fiscal Year
                                       2013                        2012                        2011
                                              % of                        % of                        % of
                             Amount ($)      Revenue     Amount ($)      Revenue     Amount ($)      Revenue
                                                           ($ amounts in 000's)
Operating Expenses:
Research and development
expenses:
GAAP research and
development expenses           102,660          17          81,078          15          63,577          15
Stock-based compensation
expense                        (13,271 )        (2 )        (9,226 )        (1 )        (4,691 )        (1 )
Non-GAAP research and
development expenses            89,389          15          71,852          14          58,886          14
Sales and marketing
expenses:
GAAP sales and marketing
expenses                       224,991          36         179,155          33         145,532          34
Stock-based compensation
expense                        (19,526 )        (3 )       (12,793 )        (2 )        (9,325 )        (3 )
Non-GAAP sales and marketing
expenses                       205,465          33         166,362          31         136,207          31
General and administrative
expenses:
GAAP general and
administrative expenses         34,913           6          25,511           5          21,965           4
Stock-based compensation
expense                         (6,450 )        (1 )        (4,602 )        (1 )        (3,026 )         -
Patent settlement income         1,912           -           1,912           -           1,911           1
Non-GAAP general and
administrative expenses         30,375           5          22,821           4          20,850           5
Total operating expenses:
GAAP operating expenses        362,564          59         285,744          53         231,074          53
Stock-based compensation
expense                        (39,247 )        (6 )       (26,621 )        (4 )       (17,042 )        (4 )
Patent settlement income         1,912           -           1,912           -           1,911           1
Non-GAAP operating expenses    325,229          53         261,035          49         215,943          50


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Non-GAAP net income represents net income, as reported in our consolidated statements of operations, excluding the impact of stock-based compensation expense, amortization expense and impairment charges related to certain intangible assets, and income from a patent settlement. The following tables reconcile GAAP net income as reported on our consolidated statements of operations to non-GAAP net income for fiscal 2013, 2012 and 2011.

                                                                       Fiscal Year
                                                   2013                     2012                    2011
                                                 ($ and share amounts in 000's, except per share amounts)
Net Income:
GAAP net income                                      44,273                   66,836                   62,492
Stock-based compensation expense (1)                 44,471                   30,690                   19,015
Amortization expense of certain intangible
assets (1)                                            1,551                      826                      394
Impairment charges related to certain
. . .
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