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FTNT > SEC Filings for FTNT > Form 10-Q on 5-Aug-2014All Recent SEC Filings

Show all filings for FORTINET INC

Form 10-Q for FORTINET INC


5-Aug-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 and investments in strategic relationships;

expected impact of sales of certain products;

            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;

            expectations regarding spending related to capital expenditures,
             including improvements and expansion of our new corporate
             headquarters and other offices and the implementation of our
             enterprise resource planning system;

competition in our market segment;

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 June 30, 2014, we had shipped over 1,600,000 appliances via more than 28,000 channel partners to more than 200,000 end-customers worldwide, including a majority of the 2013 Fortune Global 100.


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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, 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 our advanced persistent threats (APTs) sandboxing product, messaging security product, Web application firewalls, databases security product, distributed denial of service attack (DDoS) security product, and endpoint security product 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 $184.1 million and $353.0 million during the three and six months ended June 30, 2014, respectively. This represents an increase of 25% during each of these periods compared to the same periods last year. Product revenue was $85.4 million and $162.1 million, respectively, an increase of 28% and 30% during the three and six months ended June 30, 2014, respectively, compared to the same periods last year. Services and other revenue was $98.7 million and $190.9 million during the three and six months ended June 30, 2014, respectively, an increase of 22% and 20%, respectively, compared to the same periods last year.

Cash, cash equivalents and investments were $910.6 million as of June 30, 2014, an increase of $67.5 million from December 31, 2013.

Deferred revenue was $480.2 million as of June 30, 2014, an increase of $47.6 million from December 31, 2013.

We generated cash flows from operating activities of $104.7 million during the six months ended June 30, 2014, an increase of 39% 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 six months ended June 30, 2014.

We repurchased 1.0 million shares of common stock under our previously-announced Share Repurchase Program for an aggregate purchase price of $22.5 million during the six months ended June 30, 2014.

During the three and six months ended June 30, 2014, revenue grew as a result of our focus on growth and our strategy to invest in our marketing and increase sales capacity. 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 sales and marketing to expand brand awareness, 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, and research and development to strengthen our technology leadership position. 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.

During the three months ended June 30, 2014, our high-end FortiGate products (FortiGate-1000 to -5000 series) accounted for 40% of billings primarily due to an increase in billings from large enterprise and service provider customers. Our mid-range products (FortiGate-200 to -800 series) accounted for 26% of billings, and our entry-level products (FortiGate-20 to -100 series) accounted for 34% of billings. In prior periods, sales of FortiGate products have generally been balanced across product categories, with some degree of variability from year to year and between quarters.


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During the three and six months ended June 30, 2014, operating expenses increased by 28% and 29%, respectively, compared to the same periods last year. The increase was primarily driven by our accelerated pace of hiring and marketing investments to support our growth as we continued to invest in expanding our sales coverage, marketing capabilities, developing new products and scaling our customer support organization to meet the needs of our growing customer base. Headcount increased to 2,532 as of June 30, 2014 from 2,182 as of June 30, 2013.

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
                                                   June 30,             June 30,
                                                     2014                 2013
                                                      (in thousands)
Revenue                                   $       184,098              $ 147,428
Deferred revenue                          $       480,202              $ 389,682
Increase in deferred revenue              $        28,899              $  13,268
Billings (non-GAAP)                       $       212,997              $ 160,696
Cash, cash equivalents and investments    $       910,594              $ 814,410
Net cash provided by operating activities $        43,798              $  37,221
Free cash flow (non-GAAP)                 $        34,094              $  35,186

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 FortiGuard 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 deferred revenue balances acquired from business combinations, if any. 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
                                  June 30,      June 30,
                                    2014          2013
                                      (in thousands)
Billings:
Revenue                          $  184,098    $ 147,428
Add increase in deferred revenue     28,899       13,268
Total billings (Non-GAAP)        $  212,997    $ 160,696

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


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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, repurchasing shares of our outstanding common stock, 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 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
                                           June 30,      June 30,
                                             2014          2013
                                               (in thousands)
Free Cash Flow:
Net cash provided by operating activities $  43,798     $ 37,221
Less purchases of property and equipment     (9,704 )     (2,035 )
Free cash flow (Non-GAAP)                 $  34,094     $ 35,186

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 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 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 and estimates as of and for the three and six months ended June 30, 2014, as compared to the critical accounting policies and estimates described in the Form 10-K.

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 now 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 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, and the reclassification did not have any impact on our gross margin or net income.

Recent Accounting Pronouncement-In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09 (Topic 606) - Revenue from Contracts with Customers ("ASU 2014-09") ") to create a single, joint revenue standard that is consistent across all industries and markets for companies that prepare their financial statements in accordance with U.S. GAAP. Under ASU 2014-09, an entity is required to recognize revenue upon the transfer of promised goods or services to customers, in an amount that reflects the consideration the entity expects to be entitled to in exchange for those goods or services. ASU 2014-09 is effective for us beginning on January 1, 2017. We are currently evaluating the impact of ASU 2014-09 on our consolidated financial statements.


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Results of Operations

Three Months Ended June 30, 2014 and June 30, 2013

Revenue

                                   Three Months Ended
                            June 30,                June 30,
                              2014                    2013
                                     % of                    % of
                        Amount     Revenue      Amount     Revenue     Change      % Change
                                        (in thousands except percentages)
Revenue:
Product               $  85,384        46 %   $  66,525        45 %   $ 18,859        28 %
Services and other       98,714        54        80,903        55       17,811        22
Total revenue         $ 184,098       100 %   $ 147,428       100 %   $ 36,670        25 %
Revenue by geography:
Americas              $  78,385        43 %   $  60,026        41 %   $ 18,359        31 %
EMEA                     62,554        34        50,801        34       11,753        23
APAC                     43,159        23        36,601        25        6,558        18
Total revenue         $ 184,098       100 %   $ 147,428       100 %   $ 36,670        25 %

Total revenue increased by $36.7 million, or 25%, in the three months ended June 30, 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 $18.9 million, or 28%, in the three months ended June 30, 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, particularly in our high-end products including our recently introduced FortiGate 1500D and 3700D enterprise security appliances.

Services and other revenue increased by $17.8 million, or 22%, in the three months ended June 30, 2014 compared to the same period last year due to the recognition of revenue from our growing deferred revenue balance consisting of FortiGuard subscription and support contracts sold to a larger customer base. In addition, we experienced growth in our FortiGuard subscription offerings, FortiCare support, and our professional services revenues from existing large enterprise customers.

Cost of revenue and Gross margin

                         Three Months Ended
                       June 30,      June 30,
                         2014          2013        Change       % Change
                               (in thousands except percentages)
Cost of revenue:
Product               $  37,455     $ 26,948     $ 10,507          39 %
Services and other       20,302       16,760        3,542          21
Total cost of revenue $  57,757     $ 43,708     $ 14,049          32 %
Gross margin:
Product                    56.1 %       59.5 %       (3.4 )%
Services and other         79.4         79.3          0.1
Total gross margin         68.6 %       70.4 %       (1.8 )%

Total gross margin decreased by 1.8 percentage points in the three months ended June 30, 2014 compared to the same period last year, as product gross margin declined. Product gross margin decreased by 3.4 percentage points in the three months ended June 30, 2014 compared to the same period last year primarily due to a $2.4 million impairment charge related to certain intangible assets. We also experienced higher warranty-related costs of $1.0 million and higher excess inventory write-offs of $0.3 million. Services and other gross margin increased by 0.1 percentage points during the three months ended June 30, 2014


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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 $3.5 million primarily due to a $1.7 million increase in personnel costs related to headcount increases and a $1.0 million increase in depreciation and occupancy-related costs.

Operating expenses

                                         Three Months Ended
                                  June 30,                June 30,
                                    2014                    2013
                                          % of                    % of
                             Amount      Revenue     Amount      Revenue     Change      % Change
                                              (in thousands except percentages)
Operating expenses:
Research and development   $  29,938       16 %     $ 25,158       17 %     $  4,780        19 %
Sales and marketing           74,817       41         55,997       38         18,820        34
General and administrative    10,444        6          8,788        6          1,656        19
Total operating expenses   $ 115,199       63 %     $ 89,943       61 %     $ 25,256        28 %

Research and development

Research and development expense increased by $4.8 million, or 19%, in the three months ended June 30, 2014 compared to the same period last year primarily due to an increase of $2.2 million in 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 product development expenses, such as third-party testing, prototypes and supplies, of $1.6 million, higher depreciation and occupancy-related costs of $1.3 million, and higher stock-based compensation expense of $0.9 million. This increase in expense was partially offset by a $0.7 million reversal of estimated contingent consideration. 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 similar levels during the remainder of fiscal 2014.

Sales and marketing

Sales and marketing expense increased by $18.8 million, or 34%, in the three months ended June 30, 2014 compared to the same period last year, primarily due to an increase of $12.3 million in personnel costs as we continued to increase our headcount in order to drive continued market share gains. In addition, we incurred increases in tradeshows, lead generation campaigns and marketing-related expenses of $3.7 million. Our stock-based compensation expense increased by $1.2 million, depreciation expense and occupancy-related costs increased by $0.9 million and marketing supplies expense increased by $0.6 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 drive future growth. We intend to continue to make investments in sales and marketing and expect sales and marketing expense as a percentage of total revenue to remain at similar levels or increase during the remainder of fiscal 2014.

General and administrative

General and administrative expense increased by $1.7 million, or 19%, in the three months ended June 30, 2014 compared to the same period last year. Stock-based compensation expense increased by $1.8 million and personnel costs increased by $0.6 million as we continued to increase our headcount in order to support our expanding business. This increase was partially offset by a decrease in legal fees of $0.5 million. We expect general and administrative expense as a percentage of total revenue to remain at similar levels during the remainder of fiscal 2014.


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Interest income and Other expense-net

Three Months Ended

                    June 30,      June 30,
                      2014          2013       Change     % Change
                          (in thousands except percentages)
Interest income   $   1,319      $  1,337     $  (18 )      (1 )%
Other expense-net      (574 )        (100 )     (474 )     474

Interest income decreased in the three months ended June 30, 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-net, for the three months ended June 30, 2014 when compared to the same period last year, was the result of higher foreign exchange losses, partially offset by gains on forward contracts.

Provision for income taxes

                              Three Months Ended
                             June 30,      June 30,
                               2014          2013       Change    % Change
                                  (in thousands except percentages)
Provision for income taxes $   5,806      $  6,035     $ (229 )     (4 )%
Effective tax rate                49 %          40 %        9 %      -  %

Our effective tax rate was 49% for the three months ended June 30, 2014, compared to 40% for the same period last year. The provision for income taxes for the three months ended June 30, 2014 was comprised primarily of U.S. federal and state taxes, Singapore and other foreign income taxes, and withholding tax, as well as the inclusion of stock compensation benefits and transfer pricing allocations which impact jurisdictional income taxed at various tax rates. The increase in the effective tax rate for the three months ended June 30, 2014 as . . .

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