Fortinet (FTNT) Q3 Earnings Beat, Revenue Growth Rate Dismal

Continuing with its upbeat performance for the fifth straight quarter, Fortinet Inc. (NASDAQ:FTNT) , yesterday, reported better-than-expected results for third-quarter 2017, wherein revenues and earnings came ahead of the company’s expectations, and also surpassed the respective Zacks Consensus Estimate.

Revenues

Fortinet reported third-quarter revenues of $374.2 million, beating the Zacks Consensus Estimate of $371 million and up 18.2% year over year. Segment wise, Product revenues increased 7% year over year to $137.1 million, while Services revenues jumped 26% to $237.1 million.

The year-over-year improvement was primarily aided by growth in sales productivity and success in selling multiple product deployments. A large number of deal wins and customer additions during the reported quarter also proved conducive to top-line growth.

During the third quarter, the company witnessed 18% year-over-year growth in the number of deals worth over $100,000, while the number of deals worth more than $250,000 and $500,000 climbed 26% and 50%, respectively.

Billings were up 24% on a year-over-year basis to $431.7 million.

Operating Results

Non-GAAP (excluding stock-based compensation and amortization of intangible assets) gross profit jumped 20.8% from the year-ago quarter to $283.4 million. Moreover, gross margin expanded 170 basis points (bps) to 75.7%, primarily backed by sales of higher-value subscription bundles. It also came ahead of management’s expectation of 75%.

Furthermore, the company efficiently managed its operating expenses this quarter. As a percentage of revenues, non-GAAP operating expenses contracted 250 bps year over year to 57%. In dollar terms, however, the figure advanced 13.1% to $213.2 million.

Non-GAAP operating profit surged 52.5% to $70 million from approximately $45.9 million in the year-ago quarter. Non-GAAP operating profit margin expanded 420 bps to 18.7%, mainly attributed to improved gross margin and efficient cost management. Operating margin also surpassed the company’s guidance range of 16-17%.

Fortinet’s non-GAAP earnings per share of 28 cents beat the Zacks Consensus Estimate of 23 cents. Also, earnings came in higher than management’s guidance range of 22-23 cents and marked a solid improvement over the year-ago quarter’s earnings of 18 cents, driven mainly by higher revenues and efficient cost management.

Balance Sheet & Cash Flow

Fortinet exited the reported quarter with cash and cash equivalents, and short-term investments of approximately $1.28 billion, up from $1.21 billion recorded at the end of the second quarter. Accounts receivable were $258 million compared with $271.1 million recorded at the end of the previous quarter.

During the first three quarters of 2017, the company generated operating cash flow of $436.9 million. Free cash flow for the first nine months of the year came in at $315.2 million. Fortinet bought back 3.25 million shares for $124 million during the first three quarters of 2017.

This month management also announced an increase of $400 million in share repurchase authorization, bringing the total authorization amount to $1 billion.

Guidance

Despite reporting impressive third-quarter results, Fortinet lowered its revenue and billings guidance for the full year, and provided a disappointing outlook for the current quarter.

For 2017, management now projects revenues in the range of $1.482-$1.490 billion (mid-point: $1.486 billion), down from the earlier guidance of $1.487-$1.495 billion (mid-point: $1.491 billion). The Zacks Consensus Estimate for revenues is currently pegged at $1.49 billion. Billings forecast has also been trimmed to $1.772-$1.787 billion from $1.775-$1.795 billion.

Nevertheless, the company anticipates that its cost-management initiatives to drive its margins and earnings per share. Therefore, it raised its non-GAAP gross and operating margin projections to 75% and 17%, respectively. Earlier guidance ranges for gross and operating margin were 74.5-75% and 16.2%, respectively.

Similarly, non-GAAP earnings per share are now estimated to come between $1.00 and $1.02 (mid-point $1.01), up from the range of 94-96 cents (mid point: 95 cents) predicted earlier.

The company’s forecasts for the fourth quarter are slightly lackluster. Management expects revenues in the range of $404-$412 million (mid point: $408 million), which is lower than the Zacks Consensus Estimate of $416.59 million at mid-point. Billings are estimated in the range of $510-$525 million.

Non-GAAP earnings per share are anticipated to come in the band of 28-30 cents (mid point: 29 cents). Although, it is a penny higher than the Consensus Estimate, but represents a year-over-year decline of 3.3%. Non-GAAP gross margin is expected to be in the range of 75-76%, whereas non-GAAP operating margin is anticipated to be between 18% and 19%.

Our Take

Fortinet’s network security solutions include firewall, VPN, application control, antivirus, intrusion prevention, web filtering, anti-spam and WAN acceleration. The company reported better-than-expected third-quarter results. Despite persistent macro uncertainties, management seems to be optimistic on the back of a healthy network security market, solid product line-up and investment plans.

Despite all these, shares of Fortinet dropped approximately 8% during yesterday’s after-hour trade, as investors seemed concerned over the company’s slowing revenue growth rate. Notably, over the last five quarters, the company’s revenue growth rate has been around 20%, significantly lower than its previous rates of over 30%. Additionally, Fortinet’s third-quarter revenue guidance marks an even lower growth rate of 11.3-13.6%.

In addition to this, competition from key network security players such as Cisco Systems Inc. (NASDAQ:CSCO) , Check Point (NASDAQ:CHKP) , Juniper Networks (NYSE:JNPR) and Palo Alto Networks, remains a concern.

Nonetheless, we believe Fortinet’s initiative to change its business model to subscription-based service provider will continue to drive the company’s bottom-line results. Subscription-based service is a high gross margin business (approximately 80%) compared with the hardware-centric model.

Notably, the company generates over 50% of the total revenues from these services, which helped it generate a 170 bps gross-margin expansion in the third quarter. We anticipated this strategy will continue to improve the company’s bottom-line performances as well.

Fortinet has outperformed the industry to which it belongs to in the year-to-date period. The stock has returned 33.1%, while the industry registered growth of 26.3% during the same time frame.

Currently, Fortinet has a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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