Continuing its upbeat performance for the seventh straight quarter, Fortinet Inc. FTNT, yesterday, reported strong results for first-quarter 2018, wherein revenues and earnings came ahead of the company’s expectations, and also surpassed the respective Zacks Consensus Estimate. The company’s revenues, margins and earnings per share, all coming ahead of expectations, were the main highlights of the quarter.

Fortinet’s non-GAAP earnings per share of 33 cents beat the Zacks Consensus Estimate of 24 cents. Also, earnings came in higher than management’s guided range of 21-32 cents and marked an improvement over the year-ago quarter’s earnings of 17 cents. This was mainly driven by higher revenues and improved gross profit due to sales mix shift to higher-margin subscription services, which were partially offset by elevated operating expenses, particularly sales and marketing (S&M).

Quarter in Detail

Fortinet reported first-quarter revenues of $399 million, surpassing the Zacks Consensus Estimate of $390 million. The reported figure also came in 17.1% higher than the year-ago tally. Revenues also came ahead of management’s guided range of $387-$393 million. A large number of deal wins and customer additions during the reported quarter proved conducive to top-line growth.

Segment wise, Product revenues increased approximately 6% year over year to $143 million, while Services revenues jumped 25% to $256 million.

During the quarter, the company witnessed 21% year-over-year growth in the number of deals worth more than $100,000, while the number of deals, worth more than $50,000, climbed 20%.

Billings were up 15% on a year-over-year basis to $463.2 million.

Non-GAAP gross profit jumped 20.6% from the year-ago quarter to $301.8 million. Moreover, gross margin expanded 220 basis points (bps) to 76.4%. It also came above management’s expectation of 75–76%. The robust gross margin performance was mainly driven by aforementioned shift in sales mix to higher-margin subscription services.

Furthermore, non-GAAP operating expenses jumped 11.5% year over year to $234 million. The figure includes a benefit of $11.7 million from adoption of new accounting standards which resulted in lower commission. Excluding the same, operating expenses flared up 17% to $247 million.

Management noted that the increase was mainly due to an impact of $7 million from unfavorable currency exchange rates and a 16.8% increase in S&M expenses. Hiring was the main factor that resulted in higher S&M costs. The company revealed that since last September head counts in S&M department has increased 12%.

Non-GAAP operating profit surged 65.6% to $70.7 million from approximately $42.7 million in the year-ago quarter. Non-GAAP operating profit margin expanded 520 bps to 17.7%. The figure includes a 390-bps benefit from the aforementioned accounting standard adoption. Excluding the same, operating income improved 130 bps to 13.8%, which came above management’s guided range of 12-13%. Increase in operating margin mainly attributed to higher gross margin.

Fortinet, Inc. Price, Consensus and EPS Surprise

Balance Sheet & Cash Flow

Fortinet exited the reported quarter with cash and cash equivalents, and short-term investments of approximately $1.30 billion, down from $1.25 billion recorded at the end of the previous quarter. Accounts receivable were $313.1 million compared with $348.2 million recorded at the end of fourth-quarter 2017.

During the first quarter, the company generated operating cash flow of $139.7 million. Free cash flow came in at $128.1 million. Fortinet bought back 2.5 million shares for $115.5 million during the quarter.

Guidance

Buoyed by overwhelming first-quarter results, Fortinet raised guidance for full-year 2018.

For 2018, management now projects revenues at $1.715-$1.735 billion (mid-point: $1.725 billion), up from the previous range of $1.695-$1.715 billion (mid-point: $1.705 billion). The Zacks Consensus Estimate for revenues is currently pegged at $1.71 billion. Billings range has also been raised to $2.040-$2.065 billion from $2.030-$2.050 billion forecasted previously.

However, non-GAAP gross margin remained unchanged at 75-76%. Non-GAAP operating margin projections have been raised to 20.2-20.7% from the previous range of 17.7-18%. Non-GAAP operating margin include a 250-bps benefit related to the adoption of new accounting standards.

Non-GAAP earnings per share are now estimated between $1.51 and $1.55 (mid-point $1.53), up from earlier forecast of $1.30-$1.32 (mid-point $1.31). The Zacks Consensus Estimate is pegged at $1.42 per share. The updated range includes a 19-cent benefit from new accounting rules adoption.

The company initiated outlook for the second quarter.

The company’s forecasts for the second quarter are impressive. Management expects revenues of $420-$430 million (mid point: $425 million), which is higher than the Zacks Consensus Estimate of $415.3 million. Billings are estimated in the range of $485-$495 million.

Non-GAAP earnings per share are anticipated in the band of 34-36 cents (mid point: 35 cents). The guidance range is higher than the Consensus Estimate of 33 cents, but represents a year-over-year increase of 27-33%. Non-GAAP gross margin is expected in the range of 75-76%, whereas non-GAAP operating margin is anticipated between 18.5% 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 started 2018 on a strong note, reporting solid results for the first quarter, and provided an impressive outlook for the upcoming quarter as well as full year.

We believe Fortinet’s initiative to change its business model to subscription-based service provider is paying off as evident from improving margins. Subscription-based service is a high gross margin business (approximately 80%) compared with the hardware-centric model.

Notably, the company generates more than 50% of the total revenues from these services, which helped it generate a 70-bps gross-margin expansion in 2017 and 220 bps in the first quarter of this year. We anticipated this strategy will continue to improve the company’s bottom-line performances as well.

Nonetheless, we are slightly concerned over the company’s slowing revenue growth rate. Notably, over the last seven quarters, the company’s revenue growth rate has been around 20%, significantly lower than its previous rates of over 30%. Additionally, Fortinet’s second-quarter revenue growth rate guidance range of 15.5-18.3% is also under 20%.

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

Currently, Fortinet has a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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