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FTNT > SEC Filings for FTNT > Form 10-Q on 7-May-2014All Recent SEC Filings

Show all filings for FORTINET INC

Form 10-Q for FORTINET INC


7-May-2014

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 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 and the
             impact of those investments;

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 Quarterly Report on Form 10-Q and, in particular, the risks discussed under the heading "Risk Factors" in Part II, Item 1A of 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 high performance network security solutions, which enable broad, integrated and high performance protection against advanced security threats while simplifying the IT security infrastructure for enterprises, service providers and governmental entities worldwide. Since inception through March 31, 2014, we had shipped over 1,500,000 appliances via more than 20,000 channel partners to more than 190,000 end-customers worldwide, including a majority of the 2013 Fortune Global 100.

Our core product line, comprised of FortiGate physical and virtual appliances, ships with a set of broad security and networking capabilities, including firewall, virtual private network (VPN), application control, antivirus, intrusion prevention,


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Web filtering, vulnerability management, anti-spam, wireless controller, wide area network (WAN) acceleration and native internet protocol version 6 (IPv6) support functionality. Customers select the functions or combination of functions that best meet their specific security requirements -- whether that be a high-speed data center firewall (DCFW) at the network core, a next-generation firewall (NGFW) at the edge, or a broad unified threat management (UTM) solution at branch sites. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20 to -100 series, designed for small businesses, FortiGate-200 to -800 series for mid-sized enterprises, to the FortiGate-1000 to -5000 series for large enterprises, telecommunications carriers, and service providers. Our network security platform 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, and anti-spam functionality. 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 protection from advanced persistent threats (APTs), messaging, Web application firewalls, databases, protection against distributed denial of service attacks (DDoS) and endpoint security for employee computers and mobile devices. Sales of these complementary products and related services represent less than 10% of our total revenue.

Financial Highlights

We recorded total revenue of $168.9 million during the three months ended March 31, 2014. This represents an increase of 24% during the three months ended March 31, 2014, compared to the same period last year. Product revenue was $76.8 million, an increase of 32% during the three months ended March 31, 2014, compared to the same period last year. Services and other revenue was $92.2 million during the three months ended March 31, 2014, an increase of 18%, compared to the same period last year.

Cash, cash equivalents and investments were $888.3 million as of March 31, 2014, an increase of $45.3 million from December 31, 2013.

Deferred revenue was $451.3 million as of March 31, 2014, an increase of $18.7 million from December 31, 2013.

We generated cash flows from operating activities of $60.9 million during the three months ended March 31, 2014, an increase of 60% compared to the same period last year.

We received $20.0 million pursuant to a six year mutual covenant-not-to-sue and release agreement with Palo Alto Networks, Inc. during the three months ended March 31, 2014.

We repurchased 0.3 million shares of common stock under our previously-announced Share Repurchase Program for an aggregate purchase price of $7.5 million during the three months ended March 31, 2014.

During the three months ended March 31, 2014, revenue grew as a result of our focused execution and increased investment in sales and marketing, as well as continued commitment to product development, which strengthened our technology advantage. We also continued to gain traction with several recently introduced FortiGate products, including demand for certain of our high speed, low latency next-generation enterprise data center security product.

We continue to invest in research and development to strengthen our technology leadership position, sales and marketing to expand brand awareness, and our global sales team and distribution channels to expand our global reach and sales capacity and meet increasing customer expectations about the quality and functionality of our products. We continue to focus on selling to large customers, such as enterprise and service providers. 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 financial and telecommunication sectors.

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.

During the three months ended March 31, 2014, operating expenses increased by 30% compared to the same period last year. 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. Headcount increased to 2,389 as of March 31, 2014 from 2,077 as of March 31, 2013.


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Key Financial 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. The following table summarizes revenue, deferred revenue, billings (non-GAAP), cash, cash equivalents and investments, net cash provided by operating activities, and free cash flow (non-GAAP). We discuss revenue below under "- Results of Operations," and we discuss our cash, cash equivalents, and investments, and net cash provided by operating activities below under "-Liquidity and Capital Resources." Deferred revenue, billings (non-GAAP), and free cash flow (non-GAAP) are discussed immediately below the following table.

                                                Three Months Ended Or As Of
                                                  March 31,             March 31,
                                                     2014                 2013
                                                       (in thousands)
Revenue                                   $       168,949              $  135,820
Deferred revenue                          $       451,303              $  376,414
Increase in deferred revenue              $        18,675              $   13,229
Billings (non-GAAP)                       $       187,624              $  148,499
Cash, cash equivalents and investments    $       888,314              $  782,538
Net cash provided by operating activities $        60,902              $   38,111
Free cash flow (non-GAAP)                 $        49,584              $   36,577

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.

Billings (Non-GAAP). 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. We consider billings to be a useful metric for management and investors because billings 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. There are a number of limitations related to the use of billings versus revenue calculated in accordance with GAAP. First, billings include amounts that have not yet been recognized as revenue. Second, we may calculate billings in a manner that is different from other companies that report similar financial measures. We compensate for these limitations by providing specific information regarding GAAP revenue and evaluating billings together with revenues calculated in accordance with GAAP. A reconciliation of billings to revenue, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

                                                               Three Months Ended
                                                           March 31,        March 31,
                                                             2014              2013
                                                                 (in thousands)
Billings:
Revenue                                                 $     168,949     $    135,820
Add increase in deferred revenue                               18,675           13,229
Less deferred revenue balance acquired in business
combination                                                         -             (550 )
Total billings (Non-GAAP)                               $     187,624     $    148,499

Free cash flow (Non-GAAP). Free cash flow is defined as net cash provided by operating activities less capital expenditures. We consider free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after the acquisition of property and equipment, can be used for strategic opportunities, including investing in our business, making acquisitions, and strengthening the balance sheet. Analysis of free cash flow facilitates comparisons of our operating results to competitors' operating results. A limitation of using free cash flow versus the GAAP measure of net cash provided by operating activities as a means for evaluating liquidity is that free cash flow does not represent the total increase or decrease in the cash balance from operations for the period


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because it excludes cash used for capital expenditures. We compensate for this limitation by providing information about our capital expenditures on the face of the cash flow statement and under "Liquidity and Capital Resources". A reconciliation of free cash flow to net cash provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

                                             Three Months Ended
                                           March 31,     March 31,
                                             2014          2013
                                               (in thousands)
Free Cash Flow:
Net cash provided by operating activities $  60,902     $  38,111
Less purchases of property and equipment    (11,318 )      (1,534 )
Free cash flow (Non-GAAP)                 $  49,584     $  36,577

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 GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, cost of revenue and expenses, cash flow and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, stock-based compensation expense, valuation of inventory, warranty liabilities, goodwill and other long-lived assets 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 material changes to our critical accounting policies for the three months ended March 31, 2014. During the quarter we prospectively modified the expected term calculation used in accounting for stock-based compensation expense and the estimated useful lives of building improvements and furniture and fixtures.

Stock-Based Compensation Expense-Beginning in the first quarter of fiscal 2014, we changed the methodology of calculating the expected term, which is one of the assumptions used in determining the fair value of our employee stock options under the Black Scholes option pricing model. The expected term represents the period that our stock-based awards are estimated to be outstanding. We believe that we have sufficient historical experience for determining the expected term of the stock option award, and therefore, we calculated our expected term based on historical experience instead of using the simplified method.

Property and Equipment-Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets as follows:

                                                Estimated Useful Lives
Building and building improvements                                   20 years
Evaluation units                                                       1 year
Computer equipment, software and tooling                            1-2 years
Furniture and fixtures                                            3 - 5 years
Leasehold improvements                   Shorter of useful life or lease term

Effective March 2014, we moved into our new corporate headquarters. The useful life of building improvements placed into service during the three months ended March 31, 2014, in association with our new corporate headquarters is estimated to be 20 years. The useful life of furniture and fixtures now ranges from 3 to 5 years as we placed new furniture and fixtures into service at the new corporate headquarters.

Reclassification-Beginning in the first quarter of 2014, the amounts previously reported as Ratable and other revenue have been combined with the amounts previously reported as Services revenue in the Condensed Consolidated Statements of Operations. The combined amounts are being presented as Services and other revenue in the Condensed Consolidated Statements of Operations. The related Cost of revenue and Gross profit, including prior period amounts, have also


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been combined to conform to the current period presentation. The Ratable and other revenue amounts, including the related Cost of revenue and Gross profit amounts, are not material.

Results of Operations

Revenue

                                   Three Months Ended
                            March 31,               March 31,
                              2014                    2013
                                     % of                    % of
                        Amount     Revenue      Amount     Revenue     Change      % Change
                                         (in thousands except percentage)
Revenue:
Product               $  76,765        45 %   $  57,950        43 %   $ 18,815        32 %
Services and other       92,184        55        77,870        57       14,314        18
Total revenue         $ 168,949       100 %   $ 135,820       100 %   $ 33,129        24 %
Revenue by geography:
Americas              $  72,432        43 %   $  52,627        39 %   $ 19,805        38 %
EMEA                     56,643        33        47,326        35        9,317        20
APAC                     39,874        24        35,867        26        4,007        11
Total revenue         $ 168,949       100 %   $ 135,820       100 %   $ 33,129        24 %

Total revenue increased by $33.1 million, or 24%, in the three months ended March 31, 2014 compared to the same period last year. All three regions experienced revenue growth compared to the same period last year, with Americas contributing the largest portion of our revenue growth. Product revenue increased by $18.8 million, or 32% in the three months ended March 31, 2014, compared to the same period last year. The increase in product revenue was primarily driven by greater sales volume in our FortiGate product family due to increased demand across all product categories for our entry-level products for smaller enterprises, our mid-range products for mid to large enterprises and branch deployments, and our high-end products for large enterprise and service provider customers. We also experienced strong demand for some of our more recently introduced high-end appliances.

Services and other revenue increased by $14.3 million, or 18%, in the three months ended March 31, 2014 compared to the same period last year due to the recognition of revenue from our growing deferred revenue balance consisting of subscription and support contracts sold to a larger customer base. In addition, we grew our FortiGuard subscription offerings and FortiCare support, as well as increase in our professional services revenues from existing large enterprise customers.


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Cost of revenue and gross margin

                         Three Months Ended
                       March 31,     March 31,
                         2014          2013         Change       % Change
                                (in thousands except percentage)
Cost of revenue:
Product               $  32,139     $  22,958     $  9,181          40 %
Services and other       18,604        16,170        2,434          15
Total cost of revenue $  50,743     $  39,128     $ 11,615          30 %
Gross margin:
Product                    58.1 %        60.4 %       (2.3 )%
Services and other         79.8          79.2          0.6
Total gross margin         70.0 %        71.2 %       (1.2 )%

Total gross margin decreased by 1.2 percentage points in the three months ended March 31, 2014 compared to the same period last year, as product gross margin declined. Product gross margin decreased by 2.3 percentage points in the three months ended March 31, 2014 compared to the same period last year as we experienced the impact from higher costs related to personnel and occupancy-related costs of $0.6 million, warranty-related costs which increased by $0.4 million, and higher excess inventory write-offs of $1.0 million. Services and other gross margin increased by 0.6 percentage points during the three months ended March 31, 2014 as our continued investments in our technical support and global threat research organizations were relatively in line with our rate of growth of services and other revenue. Cost of services and other revenue increased by $2.4 million primarily due to a $1.8 million increase in cash-based personnel costs related to headcount increases and a $0.5 million increase in travel, depreciation and other expenses.

Operating expenses

                                         Three Months Ended
                                 March 31,                March 31,
                                    2014                    2013
                                          % of                    % of
                             Amount      Revenue     Amount      Revenue     Change      % Change
                                              (in thousands except percentage)
Operating expenses:
Research and development   $  29,055       17 %     $ 23,334       17 %     $  5,721        25 %
Sales and marketing           67,326       40         49,976       37         17,350        35
General and administrative     9,010        5          7,991        6          1,019        13
Total operating expenses   $ 105,391       62 %     $ 81,301       60 %     $ 24,090        30 %

Research and development

Research and development expense increased by $5.7 million, or 25%, in the three months ended March 31, 2014 compared to the same period last year primarily due to an increase of $3.1 million in cash-based personnel costs as a result of increased headcount to support the development of new products and continued enhancements of our existing products. In addition, we incurred higher stock-based compensation expense of $1.1 million, higher product development expenses, such as third-party testing and prototypes, of $1.9 million and higher occupancy-related costs of $0.5 million. This increase in expense was partially offset by a $1.1 million reduction in estimated earn-out liabilities. We intend to continue to invest in our research and development organization but expect research and development expense as a percentage of total revenue to remain at comparable levels during the remainder of fiscal 2014.

Sales and marketing

Sales and marketing expense increased by $17.4 million, or 35%, in the three months ended March 31, 2014 compared to the same period last year, primarily due to an increase of $11.8 million in cash-based personnel costs as we continued to increase our sales headcount in order to drive continued market share gains. In addition, we incurred increases in stock-based


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compensation expense of $1.6 million, and increases in travel, tradeshows and other marketing-related expenses of $2.7 million. As a percentage of revenue, sales and marketing expenses increased as we are accelerating the investment in our sales force and marketing campaigns to support future growth. We intend to continue to make investments in sales and marketing, which are critical to support sustainable growth and expect sales and marketing expense as a percentage of total revenue to remain at comparable levels or increase during the remainder of fiscal 2014.

General and administrative

General and administrative expense increased by $1.0 million, or 13%, in the three months ended March 31, 2014 compared to the same period last year. Cash-based personnel costs increased by $1.1 million and stock-based compensation expense increased by $0.6 million as we continued to increase our headcount in order to support our expanding business. The increase in expense was partially offset by decrease of $0.4 million in facilities and other related costs. We expect general and administrative expense as a percentage of total revenue to remain at comparable levels during the remainder of fiscal 2014.

Interest income and other (expense) income-net

                                Three Months Ended
                             March 31,      March 31,
                               2014            2013        Change    % Change
                                    (in thousands except percentage)
Interest income            $    1,333      $     1,369    $  (36 )       (3 )%
Other (expense) income-net       (389 )            215      (604 )     (281 )

Interest income was relatively flat in the three months ended March 31, 2014 compared to the same period last year due to lower interest earned, despite higher invested balances of cash, cash equivalents and investments. The change in other (expense) income-net, for the three months ended March 31, 2014 when compared to the same period last year, was the result of higher foreign exchange losses.

Provision for income taxes

                               Three Months Ended
. . .
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