Fortinet, Inc.
FORTINET INC (Form: 10-Q, Received: 11/04/2011 15:46:30)

Table of Contents


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
   
 
FORM 10-Q
 
 
(Mark One)
[x]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2011
Or
 
[ ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number: 001-34511
 
 
 
 
FORTINET, INC.
(Exact name of registrant as specified in its charter)
 
 
 
 
 
Delaware
 
77-0560389
 
 
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
1090 Kifer Road
 
 
 
 
Sunnyvale, California
 
94086
 
 
(Address principal executive offices)
 
(Zip Code)
 

(408) 235-7700
(Registrant's telephone number, including area code)
 
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  [x]    No   [ ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  [x]    No   [ ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
[ ]
 
Accelerated filer
[x]
 
 
 
 
 
Non-accelerated filer
[ ]
(Do not check if a smaller reporting company)
Smaller reporting company
[ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  [ ]    No   [x]

As of October 28, 2011 , there were 154,027,282 shares of the registrant's common stock outstanding.
 


Table of Contents

FORTINET, INC.
QUARTERLY REPORT ON FORM 10-Q
For the Quarter Ended September 30, 2011
Table of Contents

 
 
Page
 
Item 1.
Item 2.
Item 3.
Item 4.
 
Item 1.
Item 1A.
Item 2.
Item 6.
 



Table of Contents

Part I

ITEM 1.
Financial Statements
FORTINET, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands)  
 
September 30,
2011
 
December 31,
2010
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
66,630

 
$
66,859

Short-term investments
322,536

 
246,651

Accounts receivable, net of allowance for doubtful accounts of $180 and $303 at September 30, 2011 and December 31, 2010, respectively
75,835

 
72,336

Inventory—Net
12,968

 
13,517

Deferred tax asset
14,330

 
8,158

Prepaid expenses and other current assets
9,258

 
8,849

Deferred cost of revenues
2,369

 
3,788

Total current assets
503,926

 
420,158

PROPERTY AND EQUIPMENT—Net
7,485

 
7,056

DEFERRED TAX ASSET—Non-current
37,443

 
37,443

DEFERRED COST OF REVENUES
3,775

 
5,543

LONG-TERM INVESTMENTS
113,801

 
73,950

OTHER ASSETS
4,557

 
1,272

TOTAL ASSETS
$
670,987

 
$
545,422

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
15,342

 
$
12,761

Accrued liabilities
22,286

 
16,303

Accrued payroll and compensation
21,112

 
19,670

Deferred revenue
192,927

 
169,648

Total current liabilities
251,667

 
218,382

DEFERRED REVENUE—Non-current
82,199

 
82,983

OTHER NON-CURRENT LIABILITIES
20,254

 
11,603

Total liabilities
354,120

 
312,968

COMMITMENTS AND CONTINGENCIES (Note 7)


 


STOCKHOLDERS' EQUITY:
 
 
 
Common stock, $0.001 par value - 300,000 shares authorized; 155,006 and 150,172 shares issued and 153,597 and 148,763 shares outstanding at September 30, 2011 and December 31, 2010, respectively
155

 
150

Additional paid-in-capital
292,440

 
251,845

Treasury stock
(2,995
)
 
(2,995
)
Accumulated other comprehensive income (loss)
(4
)
 
2,181

Retained earnings (accumulated deficit)
27,271

 
(18,727
)
Total stockholders' equity
316,867

 
232,454

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
$
670,987

 
$
545,422

See notes to condensed consolidated financial statements.

3


Table of Contents


FORTINET, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share amounts)

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2011
 
September 30,
2010
 
September 30,
2011
 
September 30,
2010
REVENUE:
 
 
 
 
 
 
 
Product
$
53,093

 
$
35,913

 
$
139,945

 
$
94,060

Services
57,835

 
44,527

 
159,192

 
124,116

Ratable and other revenue
5,498

 
4,531

 
13,578

 
12,921

Total revenue
116,426

 
84,971

 
312,715

 
231,097

COST OF REVENUE:
 
 

 
 
 

Product
20,606

 
13,263

 
51,272

 
36,399

Services
9,438

 
6,565

 
25,815

 
19,851

Ratable and other revenue
1,095

 
1,615

 
4,026

 
4,733

Total cost of revenue
31,139

 
21,443

 
81,113

 
60,983

GROSS PROFIT:
 
 

 
 
 

Product
32,487

 
22,650

 
88,673

 
57,661

Services
48,397

 
37,962

 
133,377

 
104,265

Ratable and other revenue
4,403

 
2,916

 
9,552

 
8,188

Total gross profit
85,287

 
63,528

 
231,602

 
170,114

OPERATING EXPENSES:
 
 

 
 
 

Research and development
16,834

 
12,389

 
47,197

 
36,999

Sales and marketing
36,934

 
26,987

 
105,548

 
81,487

General and administrative
5,359

 
5,993

 
16,473

 
16,985

Total operating expenses
59,127

 
45,369

 
169,218

 
135,471

OPERATING INCOME
26,160

 
18,159

 
62,384

 
34,643

INTEREST INCOME
904

 
514

 
2,560

 
1,181

OTHER INCOME (EXPENSE)—Net
60

 
(402
)
 
(242
)
 
(565
)
INCOME BEFORE INCOME TAXES
27,124

 
18,271

 
64,702

 
35,259

 
 
 
 
 
 
 
 
PROVISION FOR INCOME TAXES
9,207

 
4,254

 
18,704

 
10,155

NET INCOME
$
17,917

 
$
14,017

 
$
45,998

 
$
25,104

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.12

  
$
0.10

 
$
0.30

  
$
0.18

Diluted
$
0.11

  
$
0.09

 
$
0.28

  
$
0.16

Weighted-average shares outstanding:
 
 
 
 
 
 
 
Basic
153,265

 
143,672

 
151,958

 
138,376

Diluted
163,869

  
155,842

 
163,554

  
153,290

See notes to condensed consolidated financial statements.


4


Table of Contents

FORTINET, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)

 
Nine Months Ended
 
September 30,
2011
 
September 30,
2010
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
45,998

 
$
25,104

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
5,114

 
4,233

Loss on disposal of fixed assets
22

 
14

Amortization of investment premiums
9,508

 
4,934

Stock-based compensation
12,674

 
6,846

Excess tax benefit from employee stock option plans
(9,264
)
 
(4,191
)
Changes in operating assets and liabilities:
 
 
 
Accounts receivable—net
(3,559
)
 
(5,011
)
Inventory—net
(1,478
)
 
(2,815
)
Deferred tax assets
(5,546
)
 
(8
)
Prepaid expenses and other current assets
(2,429
)
 
(2,905
)
Deferred cost of revenues
3,188

 
(274
)
Other assets
(1,456
)
 
50

Accounts payable
2,514

 
(689
)
Accrued liabilities
4,867

 
1,711

Accrued payroll and compensation
1,582

 
4,312

Deferred settlement and other liabilities
2,664

 

Deferred revenue
22,471

 
33,321

Income taxes payable
23,413

 
7,327

Net cash provided by operating activities
110,283

 
71,959

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of investments
(407,110
)
 
(311,995
)
Maturities and sales of investments
279,681

 
80,097

Purchases of property and equipment
(2,785
)
 
(2,900
)
Payment made in connection with business acquisition, net
(2,623
)
 

Deposits of restricted cash

 
(4
)
Net cash used in investing activities
(132,837
)
 
(234,802
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from exercise of stock options and warrants
14,018

 
23,892

Offering costs paid in connection with Initial Public Offering

 
(872
)
Excess tax benefit from employee stock option plans
9,264

 
4,191

Net cash provided by financing activities
23,282

 
27,211

EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS
(957
)
 
313

NET DECREASE IN CASH AND CASH EQUIVALENTS
(229
)
 
(135,319
)
CASH AND CASH EQUIVALENTS—Beginning of period
66,859

 
212,458

CASH AND CASH EQUIVALENTS—End of period
$
66,630

 
$
77,139

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid (refunded) for income taxes
$
(689
)
 
$
1,536

NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Purchases of property and equipment not yet paid
$
301

 
$
317

See notes to condensed consolidated financial statements.

5


Table of Contents

FORTINET, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Business —Fortinet, Inc. (“Fortinet”) was incorporated in Delaware in November 2000 and is a leading provider of network security appliances and Unified Threat Management (UTM) network security solutions to enterprises, service providers and government entities worldwide. Fortinet's solutions are designed to integrate multiple levels of security protection, including firewall, virtual private networking, antivirus, intrusion prevention, web filtering, antispam and WAN acceleration.

Basis of Presentation and Preparation —The condensed consolidated financial statements include the accounts of Fortinet and its wholly owned subsidiaries (collectively, the “Company,” “we,” “us,” or “our”). All intercompany transactions and balances have been eliminated in consolidation. The accompanying condensed consolidated balance sheet as of September 30, 2011 , the condensed consolidated statements of operations for the three and nine months ended September 30, 2011 and September 30, 2010 , and the condensed consolidated statements of cash flows for the nine months ended September 30, 2011 and September 30, 2010 are unaudited. The condensed consolidated balance sheet data as of December 31, 2010 was derived from the audited consolidated financial statements, which are included in our Annual Report on Form 10-K (“Form 10-K”). The accompanying statements should be read in conjunction with the audited consolidated financial statements and related notes contained in our Form 10-K.

The accompanying unaudited interim condensed consolidated financial statements for the three and nine months ended September 30, 2011 and September 30, 2010 have been prepared on the same basis as the audited consolidated statements and reflect all adjustments, consisting of normal recurring adjustments which are, in the opinion of management, necessary for a fair presentation of our financial position, results of operations, and cash flows for the interim periods presented. The statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP” or “GAAP”) pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations. The results of operations for the three and nine months ended September 30, 2011 are not necessarily indicative of the operating results for any subsequent quarter, for the full year or any future periods.

Effective June 1, 2011, we completed a two-for-one stock split of our outstanding common shares in the form of a stock dividend. In accordance with GAAP, all shares and per share information referenced throughout the condensed consolidated financial statements have been retroactively adjusted to reflect this stock split. We have changed the caption Ratable product and services revenue on our condensed consolidated statement of operations to Ratable and other revenue. We have made this change to reflect a $2.6 million sale of previously-acquired patents during the third quarter.

Use of Estimates —The preparation of condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Such management estimates include implicit service periods for revenue recognition, the best estimate of selling price, litigation and settlement costs and other loss contingencies, sales returns and allowances, reserve for bad debt, inventory write-offs, reserve for warranty costs, stock-based compensation, valuation of deferred tax assets, and tangible and intangible assets. We base our estimates on historical experience and also on assumptions that we believe are reasonable. Actual results could differ from those estimates.

Certain Significant Risks and Uncertainties —We are subject to certain risks and uncertainties that could have a material adverse effect on our future financial position or results of operations, such as the following: changes in level of demand for our products and services, seasonality, the timing of new product introductions, price and sales competition and our ability to adapt to changing market conditions and dynamics, changes in the expenses caused by, for example, fluctuations in foreign currency exchange rates, management of inventory, internal control over financial reporting, market acceptance of our new products and services, demand for UTM products and services in general, failure of our channel partners to perform, the quality of our products and services, general economic conditions, challenges in doing business outside of the United States of America, changes in customer relationships, litigation, or claims against us based on intellectual property, patent, product regulatory or other factors (Note 7), product obsolescence, and our ability to attract and retain qualified employees.
 
We rely on sole suppliers and independent contract manufacturers for certain of our components and one third-party

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Table of Contents

FORTINET, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


logistics company for distribution of some of our products. The inability of any of these parties to fulfill our supply and logistics requirements could negatively impact our future operating results.

Concentration of Credit Risk —Financial instruments that subject us to concentration of credit risk consist primarily of cash, cash equivalents, short-term and long-term investments, and accounts receivable. We maintain our cash and cash equivalents in fixed income securities with major financial institutions, which our management assesses to be of high credit quality, in order to limit the exposure of each investment. Deposits held with banks may exceed the amount of insurance provided on such deposits.

Credit risk with respect to accounts receivable in general is diversified due to the number of different entities comprising our customer base and their location throughout the world. We perform ongoing credit evaluations of our customers and generally do not require collateral on accounts receivable. We maintain reserves for estimated potential credit losses.

During the three and nine months ended September 30, 2011 and September 30, 2010 , no single customer accounted for more than 10.0% of total net revenue.

At September 30, 2011 and December 31, 2010 , no single customer accounted for more than 10.0% of net accounts receivable.

Financial Instruments and Fair Value —We apply fair value accounting for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. Due to their short-term nature, the carrying amounts reported in the consolidated financial statements approximate the fair value for accounts receivable, accounts payable, accrued compensation, and other current liabilities.

Comprehensive Income —Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 220 (formerly referred to as Statement of Financial Accounting Standards ("SFAS") No. 130, Reporting Comprehensive Income ) establishes standards for the reporting and displaying of comprehensive income and its components. Comprehensive income includes certain changes in equity from non-owner sources that are excluded from net income. Specifically, cumulative foreign currency translation adjustments and unrealized gains and losses on available-for-sale investments are included in comprehensive income in stockholders' equity.

Foreign Currency Translation —Assets and liabilities of foreign subsidiaries are translated into U.S. dollars using the exchange rates in effect at the balance sheet dates and revenue and expenses are translated using average exchange rates during the period. The resulting foreign translation adjustments are recorded in accumulated other comprehensive income. Foreign currency transaction gains (losses) of $0.1 million and $(0.4) million , are included in other income (expense), net for the three months ended September 30, 2011 and September 30, 2010 , respectively. Foreign currency transaction losses of $(0.2) million and $(0.6) million are included in other income (expense), net for the nine months ended September 30, 2011 and September 30, 2010 , respectively.

Cash, Cash Equivalents and Investments —We consider all highly liquid investments, purchased with original maturities of three months or less, to be cash equivalents. Cash and cash equivalents consist of cash on-hand, balances with banks, and highly liquid investments in money market funds, commercial paper, government securities, certificates of deposit, municipal bonds and corporate debt securities.
 
Our investments consist of marketable debt securities, which are classified as available-for-sale and are recognized at fair value. We include these investments on our balance sheet as either short-term or long-term investments depending on their maturity at the time of purchase. Investments with original maturities greater than three months that mature less than one year from the consolidated balance sheet date are classified as short-term investments. Investments with maturities greater than one year from the consolidated balance sheet date are classified as long-term investments.
 
Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. We consult with our investment managers and consider available quantitative and qualitative evidence in evaluating potential impairment of our investments on a quarterly basis. If the cost of an individual investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established.

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FORTINET, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


For debt securities in an unrealized loss position which are deemed to be other-than-temporary, the difference between the security's then-current amortized cost basis and fair value is separated into (i) the amount of the impairment related to the credit loss (i.e., the credit loss component) and (ii) the amount of the impairment related to all other factors (i.e., the non-credit loss component). The credit loss component is recognized in earnings. The non-credit loss component is recognized in accumulated other comprehensive loss.

Inventory —Inventory is recorded at the lower of cost (using the first-in, first-out method) or market, after we give appropriate consideration to obsolescence and inventory in excess of anticipated future demand. In assessing the ultimate recoverability of inventory, we are required to make estimates regarding future customer demand, the timing of new product introductions, economic trends and market conditions. If the actual product demand is significantly lower than forecasted, we could be required to record additional inventory write-downs, which could have an adverse impact on our gross margins and profitability.

Deferred Cost of Revenues —Deferred cost of revenues represents the unamortized cost of products associated with ratable and other revenue, which is based upon the actual cost of the hardware sold and is recognized over the service periods of the arrangements. Deferred cost of revenues associated with short-term deferred revenue is classified as short-term and deferred cost of revenues associated with long-term deferred revenue is classified as long-term.

Property and Equipment —Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally one to three years. Evaluation units are transferred from inventory at cost and are amortized over one year from the date of transfer. Leasehold improvements are amortized over the shorter of the estimated useful lives of the improvements or the lease term.

Impairment of Long-Lived Assets —We evaluate events and changes in circumstances that could indicate carrying amounts of long-lived assets, including intangible assets, may not be recoverable. When such events or changes in circumstances occur, we assess the recoverability of long-lived assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the future undiscounted cash flows is less than the carrying amount of those assets, we record an impairment charge in the period in which we make the determination. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

Deferred Revenue —Deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue.

Income Taxes —We record income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences, generally all expected future events other than enactments or changes in the tax law or rates are considered. We assess the likelihood that some portion or all of our deferred tax assets will be recovered from future taxable income within the respective jurisdictions, and to the extent we believe that recovery does not meet the “more-likely-than-not” standard, based solely on its technical merits as of the reporting date, we establish a valuation allowance. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.

We operate in various tax jurisdictions and are subject to audit by various tax authorities. We provide for tax contingencies whenever it is deemed more likely than not that a tax asset has been impaired or a tax liability has been incurred for events such as tax claims or changes in tax laws. Tax contingencies are based upon their technical merits, relevant tax law and the specific facts and circumstances as of each reporting period. Changes in facts and circumstances could result in material changes to the amounts recorded for such tax contingencies.

Stock-Based Compensation —We apply ASC 718 (formerly referred to as SFAS No. 123R) to our stock option grants and stock purchase rights, which requires compensation expense related to share-based transactions, including employee stock options and stock purchase rights under our employee stock purchase plan ("ESPP"), to be measured and recognized in the financial statements based on fair value. Under ASC 718, the fair value of each option award is estimated on the grant date using the Black-Scholes option pricing model.
 
Research and Development Costs —Research and development costs are expensed as incurred.

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FORTINET, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


Software Development Costs —The costs to develop software have not been capitalized as we believe our current software development process is essentially completed concurrent with the establishment of technological feasibility.

Revenue Recognition —In October 2009, the FASB amended the ASC as summarized in Accounting Standards Update ("ASU") No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements , and ASU No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements . ASU 2009-14 amends industry specific revenue accounting guidance for software and software related transactions to exclude from its scope tangible products containing software components and non-software components that function together to deliver the product's essential functionality. ASU 2009-13 amends the accounting for multiple-element arrangements to provide guidance on how the deliverables in an arrangement should be separated and eliminates the use of the residual method. ASU 2009-13 also requires an entity to allocate revenue using the relative selling price method. The standard establishes a hierarchy of evidence to determine the stand-alone selling price of a deliverable based on vendor-specific objective evidence ("VSOE"), third-party evidence ("TPE"), and the best estimate of selling price ("BESP"). If VSOE is available, it would be used to determine the selling price of a deliverable. If VSOE is not available, the entity would determine whether TPE is available. If so, TPE must be used to determine the selling price. If TPE is not available, then the BESP would be used.
 
Effective January 1, 2011, we adopted the provisions of ASU 2009-13 and ASU 2009-14 for new and materially modified arrangements originating after December 31, 2010. The adoption of ASU 2009-13 and ASU 2009-14, increased revenues $5.1 million and $14.1 million for the three and nine months ended September 30, 2011 , respectively. The increase was primarily due to certain product revenue, which can now be recognized upon shipment, but would have been deferred under the previous revenue recognition rules. We expect the adoption of ASU 2009-13 and ASU 2009-14 to have an impact on future periods; however, we cannot reasonably estimate the effect of adopting these standards on future financial periods as the impact will vary depending on the nature and volume of new or materially modified arrangements in any given period.
 
This guidance does not generally change the units of accounting for our revenue transactions. Most non-software products and services qualify as separate units of accounting because they have value to the customer on a standalone basis and our revenue arrangements generally do not include a right of return relative to delivered products.
 
The majority of our products are hardware appliances containing software components that function together to provide the essential functionality of the product, therefore, our hardware appliances are considered non-software deliverables and are no longer within the scope of ASC 985-605 (formerly SOP 97-2, Software Revenue Recognition).
 
Our product revenue also includes software products that may operate on the hardware appliances, but are not considered essential to the functionality of the hardware and continue to be subject to the guidance at ASC 985-605, which remains unchanged. This includes the use of the residual method for multiple element arrangements. Certain of our software, when sold with our appliances, is considered essential to its functionality and as a result is no longer accounted for under ASC 985-605; however, this same software if sold separately is accounted for under the guidance at ASC 985-605.
 
For all transactions originating or materially modified after December 31, 2010, we recognize revenue in accordance with ASU 2009-13. Certain arrangements with multiple deliverables may continue to have software deliverables that are subject to ASC 985-605 along with non-software deliverables that are subject to the ASU 2009-13. When a sales arrangement contains multiple elements, such as hardware appliances, software, customer support services, and/or professional services, we allocate revenue to each element based on the aforementioned selling price hierarchy. In multiple element arrangements where software is more-than-incidental, revenue is allocated to each separate unit of accounting for each of the non-software deliverables and to the software deliverables as a group using the relative selling prices of each of the deliverables in the arrangement based on the selling price hierarchy in ASU 2009-13.
     
VSOE of fair value for elements of an arrangement is based upon the normal pricing and discounting practices for those services when sold separately. In determining VSOE, we require that a substantial majority of the selling prices for a service fall within a reasonably narrow pricing range, generally evidenced by a substantial majority of such historical stand-alone transactions falling within a reasonably narrow range of the median rates. In addition, we consider major segments, geographies, customer classifications, and other variables in determining VSOE.

We are typically not able to determine TPE for our products or services. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, our go-to-market strategy differs from that of our peers and our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality

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FORTINET, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


cannot be obtained. Furthermore, we are unable to reliably determine what similar competitor products' selling prices are on a stand-alone basis.

For our hardware appliances we use BESP as our selling price. For our support and services, we generally use VSOE as our selling price. When we are unable to establish a selling price using VSOE for our support and services, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine BESP for a product or service by considering multiple factors including, but not limited to, cost of products, gross margin objectives, pricing practices, geographies, customer classes and distribution channels. We review our BESP estimates on a quarterly basis to coincide with our VSOE review process.

We recognize revenue for our software sales based on software revenue recognition guidance pursuant to ASC 985-605. Under ASC 985-605, we use the residual method to recognize revenue when a product agreement includes one or more elements to be delivered and VSOE of fair value for all undelivered elements exists. If evidence of the fair value of one or more undelivered elements does not exist, all revenue is generally deferred and recognized when delivery of those elements occurs or when fair value can be established. When the undelivered element for which we do not have VSOE of fair value is support, revenue for the entire arrangement is recognized ratably over the support period.
 
We derive revenue from sales of products, including appliances and software, and services, including subscription, support and other services. Our appliances include operating system software that is integrated into the appliance hardware and is deemed essential to its functionality. As a result, we account for revenue in accordance with ASC 985-605 and all related interpretations.

Revenue is recognized when all of the following criteria have been met:
 
Persuasive evidence of an arrangement exists. Binding contracts or purchase orders are generally used to determine the existence of an arrangement.
 
Delivery has occurred. Delivery occurs when we fulfill an order and title and risk of loss has been transferred or upon delivery of the service contract registration code.
 
The fee is fixed or determinable. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction. In the event payment terms differ from our standard business practices, the fees are deemed to be not fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.
 
Collectability is probable. We assess collectability based primarily on creditworthiness as determined by credit checks and analysis, as well as payment history. Payment terms generally range from 30 to 90 days from invoice date.
 
For arrangements which include end-customer acceptance criteria, no revenue is recognized prior to acceptance. We recognize product revenue on sales to distributors that have no general right of return and end-customers upon shipment, once all other revenue recognition criteria have been met. We also make sales through distributors under agreements that allow for rights of returns that we estimate and reduce revenue for under our sales returns and allowances. We recognize product revenue on sales made through such distributors upon sale by the distributor to the customer. Substantially all of our products have been sold in combination with services, which consist of subscriptions and/or support. Subscription services provide access to our antivirus, intrusion prevention, web filtering, and anti-spam functionality. Support services include rights to unspecified software upgrades, maintenance releases and patches, telephone and Internet access to technical support personnel, and hardware support.
 
The subscription and support services start on the date the customer registers the appliance. The customer is then entitled to service for the stated contractual period beginning on the registration date.
 
We offer certain sales incentives to channel partners. We reduce revenue for estimates of sales returns and allowances. Additionally, in limited circumstances we may permit end-customers, distributors and resellers to return our products, subject to varying limitations, for a refund within a reasonably short period from the date of purchase. We estimate and record reserves for sales incentives and sales returns based on historical experience.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


Accounts Receivable —Trade accounts receivable are recorded at the invoiced amount, net of allowances for doubtful accounts and reserves for sales returns and allowances. The allowance for doubtful accounts is based on our assessment of the collectability of customer accounts. We regularly review the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances and current economic conditions that may affect a customer's ability to pay. The reserve for sales returns and allowances is based on specific criteria including agreements to provide rebates and other factors known at the time, as well as estimates of the amount of goods shipped that will be returned. To determine the adequacy of the reserves for sales returns and allowances, we analyze historical experience of actual rebates and returns as well as current product return information.

Warranties —We generally provide a one-year warranty on hardware products and a 90-day warranty on software. A provision for estimated future costs related to warranty activities is recorded as a component of cost of product revenues when the product revenues are recognized, based upon historical product failure rates and historical costs incurred in correcting product failures. In the event we change our warranty reserve estimates, the resulting charge against future cost of sales or reversal of previously recorded charges may materially affect our gross margins and operating results.

Accrued warranty activities are summarized as follows ($ amounts in 000's):
 
 
For The Nine Months
Ended And As Of
 
For The Year
Ended And As Of
 
September 30, 2011
 
December 31, 2010
Accrued warranty balance - beginning of the period
1,878

 
2,257

Warranty costs incurred
(1,329
)
 
(1,337
)
Provision for warranty
1,530

 
1,069

Adjustments to previous estimates
195

 
(111
)
Accrued warranty balance - end of the period
2,274

 
1,878


Foreign Currency Derivatives —Our sales contracts are primarily denominated in U.S. dollars and therefore substantially all of our revenue is not subject to foreign currency translation risk. However, a substantial portion of our operating expenses incurred outside the U.S. are denominated in foreign currencies and are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Canadian Dollar (CAD), Euro (EUR), British Pound (GBP), and Japanese Yen (JPY). To help protect against significant fluctuations in the value and volatility of future cash flows caused by changes in currency exchange rates, we engage in foreign currency risk management activities to hedge balance sheet items denominated in EUR, GBP, and CAD and occasionally to hedge future forecasted cash outflows denominated in CAD. We do not use these contracts for speculative or trading purposes. All of the derivative instruments involved are with high quality financial institutions and we monitor the creditworthiness of these parties. These contracts typically have maturities between one and three months. We account for our hedges under ASC 815, Derivatives and Hedging . We record changes in the fair value of forward exchange contracts related to balance sheet accounts as other income (expense), net in the condensed consolidated statements of operations. Gains or losses resulting from settled forward exchange contracts related to future forecasted cash outflows are recorded in operating expenses in the consolidated statement of operations, in the same period the hedged item occurs. Gains or losses resulting from unsettled forward exchange contracts related to future forecasted cash outflows are recorded in other comprehensive income in the consolidated balance sheet.
 
Additionally, independent of any hedging activities, fluctuations in foreign currency exchange rates may cause us to recognize transaction gains and losses in our consolidated statements of operations. Our hedging activities are intended to reduce, but not eliminate, the impact of currency exchange rate movements. As our hedging activities are relatively short-term in nature, long-term material changes in the value of the U.S. dollar versus the EUR, GBP, CAD or JPY could adversely impact our operating expenses in the future.









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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


The notional amount of forward exchange contracts to hedge balance sheet accounts and cash flows as of September 30, 2011 was (amounts in 000's):

 
Buy/Sell
 
Notional
To hedge operation cash outflows:
 
 
 
Currency
 
 
 
CAD
Buy
 
7,500

 
 
 
 
To hedge balance sheet accounts:
 
 
 
Currency
 
 
 
EUR
Buy
 
5,393

GBP
Buy
 
1,390

CAD
Buy
 
12,800


Recent Accounting Pronouncements

In June 2011, the FASB issued Accounting Standards Update No. 2011-05, Comprehensive Income (Topic 220) - Presentation of Comprehensive Income (ASU 2011-05) , to require an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of equity. This accounting update will be applicable to the Company beginning in the first quarter of fiscal year 2012. The Company does not believe the adoption of this guidance will have a material impact on its condensed consolidated financial statements, as it only requires a change in the format of presentation.

In May 2011, the FASB issued Accounting Standards Update No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (Topic 820) – Fair Value Measurement (ASU 2011-04) , to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and International Financial Reporting Standards. ASU 2011-04 changes certain fair value measurement principles and enhances the disclosure requirements particularly for Level 3 fair value measurements. This accounting update will be applicable to the Company beginning in the first quarter of fiscal year 2012 and should be applied prospectively. The Company does not believe the adoption of this guidance will have a material impact on its condensed consolidated financial statements.


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


2. INVESTMENTS AND FAIR VALUE MEASUREMENTS

The following table summarizes our investments in available-for-sale securities ($ amounts in 000's):
 
 
September 30, 2011
 
Amortized Cost
  
Unrealized Gains
  
Unrealized Losses
 
Estimated Fair Value
Available-for-sale securities:
 
  
 
  
 
 
 
U.S. government and agency securities
21,894

  
1

  

 
21,895

Corporate debt securities
327,919

  

  
(1,766
)
 
326,153

Commercial paper
60,774

  
5

  

 
60,779

Municipal bonds
13,410

 
21

 

 
13,431

Term deposits
14,079

 

 

 
14,079

Total available-for-sale securities
438,076

  
27

  
(1,766
)
 
436,337


 
December 31, 2010
 
Amortized Cost
  
Unrealized Gains
  
Unrealized Losses
 
Estimated Fair Value
Available-for-sale securities:
 
  
 
  
 
 
 
U.S. government and agency securities
51,989

 

 
(46
)
 
51,943

Corporate debt securities
213,237

 
159

 

 
213,396

Commercial paper
38,914

 
5

 

 
38,919

Municipal bonds
11,069

 
11

 

 
11,080

Term deposits
5,263

 

 

 
5,263

Total available-for-sale securities
320,472

  
175

  
(46
)
 
320,601


The contractual maturities of our investments are as follows ($ amounts in 000's):
 
 
September 30,
2011
  
December 31,
2010
Due within one year
322,536

 
246,651

Due within one to three years
113,801

 
73,950

Total
436,337

  
320,601


Available-for-sale securities are reported at fair value, with unrealized gains and losses, net of tax, included as a separate component of stockholders' equity and in total comprehensive income. Realized gains and losses on available-for-sale securities are included in other income (expense), net in our consolidated statements of operations.

Realized gains or losses from the sale of available-for-sale securities were not significant for any period presented.
 
Fair Value Accounting —We apply ASC 820 which establishes a valuation hierarchy for disclosure of the inputs to fair value measurement. This hierarchy prioritizes the inputs into three broad levels as follows:

Level 1—Inputs are unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2—Inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the assets or liabilities, either directly or indirectly through market corroboration, for substantially the full term of the financial instruments.

Level 3—Inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. The inputs require significant management judgment or estimation.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)



The valuation techniques we use to measure the fair value of money market funds and term deposits were derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to measure the fair value of all other financial instruments, all of which have counterparties with high credit ratings, were valued based on quoted market prices or model driven valuations using significant inputs derived from or corroborated by observable market data.

We classify investments within Level 1 if quoted prices are available in active markets.

We classify items in Level 2 if the investments are valued using quoted prices for identical assets in markets that are not active, using quoted prices for similar assets in an active market, or using model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets.

The following table presents the fair value of our financial assets as of September 30, 2011 and December 31, 2010 using the ASC 820 input categories ($ amounts in 000's):

 
September 30, 2011
  
December 31, 2010
 
Aggregate
Fair
Value
  
Quoted
Prices in
Active
Markets For
Identical
Assets
  
Significant
Other
Observable
Remaining
Inputs
  
Aggregate
Fair
Value
  
Quoted
Prices in
Active
Markets For
Identical
Assets
  
Significant
Other
Observable
Remaining
Inputs
 
 
  
(Level 1)
  
(Level 2)
  
 
  
(Level 1)
  
(Level 2)
Assets:
 
  
 
  
 
  
 
  
 
  
 
U.S. government and agency securities
21,895

 

 
21,895

 
51,943

 

 
51,943

Corporate debt securities
326,153

 

 
326,153

 
213,396

 

 
213,396

Commercial paper
75,277

 

 
75,277

 
52,415

 

 
52,415

Municipal bonds
13,431

 

 
13,431

 
11,080

 

 
11,080

Term deposits
14,079

 
14,079

 

 
5,263

 
5,263

 

Money market funds
22,833

 
22,833

 

 
7,078

 
7,078

 

Foreign currency contracts
119

 

 
119

 
74

 

 
74

Total
473,787

 
36,912

 
436,875

 
341,249

 
12,341

 
328,908

Reported as:
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
37,331

 
 
 
 
 
20,574

 
 
 
 
Short-term investments
322,536

 
 
 
 
 
246,651

 
 
 
 
Prepaid expenses and other current assets
119

 
 
 
 
 
74

 
 
 
 
Long-term investments
113,801

 
 
 
 
 
73,950

 
 
 
 
Total
473,787

 
 
 
 
 
341,249

 
 
 
 

We did not hold financial assets or liabilities which were recorded at fair value using inputs in the Level 3 category as of September 30, 2011 or December 31, 2010 . There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the three or nine months ended September 30, 2011 .

3. INVENTORY—Net

Inventory, net, consisted of the following ($ amounts in 000's):

14


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September 30,
2011
  
December 31,
2010
Raw materials
3,257

 
2,593

Finished goods
9,711

 
10,924

Inventory—net
12,968

  
13,517


4. PROPERTY AND EQUIPMENT—Net

Property and equipment consisted of the following ($ amounts in 000's):
 
September 30,
2011
 
December 31,
2010
Evaluation units
12,834

 
10,607

Computer equipment and software
11,364

 
9,561

Furniture and fixtures
1,219

 
1,087

Leasehold improvements and tooling
4,294

 
4,548

Total property and equipment
29,711

 
25,803

Less: accumulated depreciation
(22,226
)
 
(18,747
)
Property and equipment—net
7,485

 
7,056


Depreciation expense was $1.8 million and $1.4 million for the three months ended September 30, 2011 and September 30, 2010 , respectively. Depreciation expense was $5.1 million and $4.2 million for the nine months ended and September 30, 2011 and September 30, 2010 , respectively.

5. INCOME PER SHARE

Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted-average number of common shares outstanding, plus the dilutive effects of stock options and warrants.

Potentially dilutive common shares are determined by applying the treasury stock method to the assumed exercise of outstanding stock options.

A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per share is as follows ($ and share amounts in 000's, except per share amounts):
 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


 
Three Months Ended
 
Nine Months Ended
 
September 30,
2011
  
September 30,
2010
 
September 30,
2011
  
September 30,
2010
Numerator:
 
  
 
 
 
  
 
Net income
17,917

 
14,017

 
45,998

 
25,104

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Basic shares:
 
 
 
 
 
 
 
Weighted-average common shares outstanding - basic
153,265

 
143,672

 
151,958

 
138,376

 
 
 
 
 
 
 
 
Diluted shares:
 
 
 
 
 
 
 
Weighted-average common shares outstanding - basic
153,265

 
143,672

 
151,958

 
138,376

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Employee stock options
10,590

 
11,984

 
11,582

 
14,736

Employee stock purchase rights
14

 

 
14

 

Warrants to purchase common stock

 
186

 

 
178

Weighted-average shares used to compute diluted net income per share
163,869

 
155,842

 
163,554

 
153,290

Net income per share:
 
 
 
 
 
 
 
Basic
0.12

 
0.10

 
0.30

 
0.18

Diluted
0.11

 
0.09

 
0.28

 
0.16


The following outstanding options and employee stock purchase rights were excluded from the computation of diluted net income per common share applicable to common stockholders for the periods presented as their effect would have been antidilutive (in 000's):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2011
  
September 30,
2010
 
September 30,
2011
  
September 30,
2010
Options to purchase common stock
5,058

  
3,512

 
3,375

  
2,590

Employee stock purchase rights
186

 

 
186

 

 
5,244

 
3,512

 
3,561

 
2,590


6. DEFERRED REVENUE

Deferred revenue consisted of the following ($ amounts in 000's):
 
 
September 30,
2011
  
December 31,
2010
Product
6,195

  
4,466

Services
250,437

  
219,022

Ratable and other revenue
18,494

  
29,143

Total deferred revenue
275,126

  
252,631

Reported As:
 
  
 
Current
192,927

  
169,648

Non-current
82,199

  
82,983

Total deferred revenue
275,126

  
252,631


7. COMMITMENTS AND CONTINGENCIES

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)



Leases and Minimum Royalties— We lease our facilities under various noncancelable operating leases, which expire through 2015. Rent expense was $2.1 million and $1.7 million for the three months ended September 30, 2011 and  September 30, 2010 , respectively and $6.1 million and $5.2 million for the nine months ended September 30, 2011 and  September 30, 2010 , respectively. Rent expense is recognized using the straight-line method over the term of the lease.

We entered into a Settlement and Patent License Agreement with Trend Micro Incorporated ("Trend Micro") in January 2006 (see "Litigation" below). The aggregate future noncancelable minimum rental payments on operating leases and minimum royalties payable if we continued paying under the Trend Micro Settlement and License Agreement as of September 30, 2011 are as follows ($ amounts in 000's):
 
 
Rental
Payment
 
Royalty (1)
Fiscal Years:
 
 
 
2011 (remainder)
2,056

 
250

2012
6,235

 
1,000

2013
4,111

 
1,000

2014
2,248

 
500

2015
1,299

 
500

Total
15,949

 
3,250

-----------
(1) Consists of minimum royalties claimed by Trend Micro pursuant to the January 2006 settlement and license agreement between Trend Micro and Fortinet, which are subject to dispute (see "Litigation" below). The  $250 ,000 listed in the chart above as the "2011 (remainder)" represents the minimum royalties, pursuant to the settlement and license agreement, for the fourth quarter of fiscal 2011. We have accrued a total payment including interest of $6.3 million as of September 30, 2011 , related to amounts under the settlement and license agreement with Trend Micro which have not been paid pursuant to the dispute.

Contract Manufacturer Commitments— Our independent contract manufacturers procure components and build our products based on our forecasts. These forecasts are based on estimates of future demand for our products, which are in turn based on historical trends and an analysis from our sales and marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate component supply, we may issue purchase orders to some of our independent contract manufacturers which may not be cancelable. As of September 30, 2011 , we had $32.5 million of open purchase orders with our independent contract manufacturers that may not be cancelable compared to $18.3 million as of June 30, 2011. The increase from prior quarter is required to replenish current inventories and to ensure adequate future inventories due to new product releases and product lead-times for certain sole source products.

Litigation —In August 2009, Trend Micro filed a complaint against us in the Superior Court of the State of California for Santa Clara County alleging breach of contract and seeking a declaratory judgment that we are obligated to make certain royalty payments to Trend Micro pursuant to a settlement and license agreement entered into in January 2006. We maintain that the patents that are the basis for the royalty payments are invalid, and, as a result of the patents' invalidity along with other defenses, we believe we have no contractual obligation to pay the royalties. We filed an action in the U.S. District Court for the Northern District of California that is stayed pending the resolution of the state court action. We have continued to accrue expense based on the quarterly royalties provided for in the settlement and license agreement. In May 2011, in response to petitions for re-examination we filed with the U.S. Patent and Trademark Office (“PTO”) on two Trend Micro patents, the PTO issued final office actions rejecting a number of the Trend Micro patent claims allegedly forming the basis for the royalty payments. Trend Micro has responded disputing one of the final office actions. We have determined that, as of this time, there is not a reasonable possibility that a loss exceeding amounts already recognized may be incurred.   
 
In August 2009, Enhanced Security Research, LLC and Security Research Holdings LLC (collectively “ESR”), a non-practicing entity, filed a complaint against us in the United States District Court for the District of Delaware alleging infringement by us and other defendants of two patents. The plaintiffs are claiming unspecified damages and requesting an injunction against the alleged infringement. In June 2010, the Court granted our motion to stay pending the outcome of reexamination proceedings on both asserted patents. The PTO has finally rejected all of the claims of the patents in the suit and ESR has appealed this result to the Board of Patent Appeals and Interferences (“BPAI”). There was a related action that was

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


dismissed by the District Court and appealed by ESR to the Federal Circuit. The Federal Circuit in June 2011 rejected ESR's appeal and confirmed the dismissal. We have determined that, as of this time, there is not a reasonable possibility that a loss may be incurred. 

In July 2010, Network Protection Sciences, LLC ("NPS"), a non-practicing entity, filed a complaint in the United States District Court for the Eastern District of Texas alleging patent infringement by us and other defendants. NPS is claiming unspecified damages, including treble damages for willful infringement, and requests an injunction against such alleged infringement. Currently the case is in the early stages, and we have determined that, as of this time, there is not a reasonable possibility that a loss may be incurred.
 
In April 2010, an individual, a former stockholder of Fortinet, filed a class action lawsuit against us in the Superior Court of the State of California for the County of Los Angeles alleging violation of various California Corporations' Code sections and related tort claims alleging misrepresentation and breach of fiduciary duty regarding the 2009 repurchase by Fortinet of shares of its stock while we were a privately-held company. The plaintiff is claiming unspecified damages. In September 2010, the Court granted our motion to transfer the case to the California Superior Court for Santa Clara County and the plaintiff has filed an amended complaint in the Superior Court to add individual defendants, among other amendments. Currently the case is in the early stages, and we have determined that, as of this time, there is not a reasonable possibility that a loss may be incurred.
 
Indemnification —Under the indemnification provisions of our standard sales contracts, we agree to defend our customers against third-party claims asserting infringement of certain intellectual property rights, which may include patents, copyrights, trademarks, or trade secrets, and to pay judgments entered on such claims. Our exposure under these indemnification provisions is generally limited to the total amount paid by our customer under the agreement. However, certain agreements include indemnification provisions that could potentially expose us to losses in excess of the amount received under the agreement. To date, there have been no claims under such indemnification provisions.

8. STOCKHOLDERS' EQUITY

Stock Plans —We issue shares under three plans and we grant equity compensation awards to acquire our common shares from one plan, and which collectively are referred to as our stock plans below. For further discussion of these Plans, refer to Note 11, "Stock Plans," of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2010.

Common Shares Reserved for Issuance —At September 30, 2011 , we had reserved 40.2 million common shares for issuance.

Stock-based compensation under ASC 718 —Stock-based compensation is accounted for in accordance with ASC 718, which requires compensation costs related to share-based transactions, including employee stock options, to be recognized in the financial statements based on fair value. Under ASC 718, the fair value of each option award is estimated on the grant date using the Black-Scholes option pricing model. We determined weighted-average valuation assumptions as follows:

Expected Term —The expected term represents the period that our stock-based awards are expected to be outstanding. As we do not have sufficient historical experience for determining the expected term of the stock option awards granted, we have based our expected term on the simplified method available under ASC 718-10 (formerly referred to as Staff Accounting Bulletin 110).

Expected Volatility —The computation of expected volatility for the periods presented includes the historical and implied stock volatility of comparable companies from a representative peer group selected based on industry and market capitalization data and to a lesser extent, our weighted historical and implied volatility following our IPO in November 2009.

Fair Value of Common Stock —The fair value of our common stock is the closing sales price of the Common Stock (or the closing bid, if no sales were reported) on the effective grant date.

Risk-Free Interest Rate —We base the risk-free interest rate used in the Black-Scholes valuation model on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term.

Expected Dividend —The expected dividend weighted-average assumption is based on our current expectations about

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


our anticipated dividend policy.

The following table summarizes the weighted-average assumptions relating to our stock options as follows:
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2011
 
September 30,
2010
 
September 30,
2011
 
September 30,
2010
Expected term in years
4.6

 
4.6

 
4.6

 
4.6

Volatility (%)
46.2

 
41.8

 
40.4 - 46.2

 
37.6 - 41.8

Risk-free interest rate (%)
1.5

 
1.6

 
1.5 - 2.0

 
1.6 - 2.4

Dividend rate (%)

 

 

 


Stock-based compensation expense is included in costs and expenses as follows ($ amounts in 000's):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2011
 
September 30,
2010
 
September 30,
2011
 
September 30,
2010
Cost of product revenue
64

  
26

 
129

  
76

Cost of services revenue
564

  
242

 
1,124

  
684

Research and development
1,516

  
600

 
2,954

  
1,741

Sales and marketing
2,708

  
1,017

 
6,289

  
2,780

General and administrative
882

  
549

 
2,178

  
1,565

 
5,734

  
2,434

 
12,674

  
6,846


A summary of the option activity under our stock plans and changes during the reporting periods are presented below (in 000's, except per share amounts):
 
 
 
 
Options Outstanding
 
Shares
Available
For Grant
 
Number
Of Shares
 
Weighted-
Average
Exercise
Price ($)
  
Weighted-
Average
Remaining
Contractual
Life (Years)
  
Aggregate
Intrinsic
Value ($)
Balance-December 31, 2010
15,091

 
22,490

 
4.21

  
 
  
 
Authorized
7,438

 

 

 
 
 
 
Granted
(5,920
)
 
5,920

 
20.75

  
 
  
 
Forfeited
1,027

 
(1,027
)
 
10.61

  
 
  
 
Exercised (aggregate intrinsic value of $86,961)

 
(4,834
)
 
2.90

  
 
  
 
Balance—September 30, 2011
17,636

 
22,549

 
8.54

  
 
  
 
Options vested and expected to vest—September 30, 2011
 
 
21,569

 
8.40

  
4.78

  
201,785

Options vested and exercisable—September 30, 2011
 
 
11,282

 
3.34

  
3.87

  
151,886


At September 30, 2011 , total compensation cost related to unvested stock-based awards granted to employees under our stock plans but not yet recognized was $53.3 million , net of estimated forfeitures. This cost is expected to be amortized on a straight-line basis over a weighted-average period of 3.15 years. Future option grants will increase the amount of compensation expense to be recorded in these periods.

The total fair value of awards vested under our stock plans was $2.5 million and $1.8 million for the three months ended September 30, 2011 and September 30, 2010 , respectively. The total fair value of awards vested under our stock plans was $8.3 million and $6.7 million for the nine months ended September 30, 2011 and September 30, 2010 , respectively. The weighted-average fair value of options granted during the three and nine months ended September 30, 2011 was $8.04 and $7.80 per

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FORTINET, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


share, respectively.

Employee Stock Purchase Plan —The ESPP was originally adopted by our Board of Directors (the “Board”) in April 2011 and subsequently approved by our stockholders in June 2011. Under the ESPP, we can grant stock purchase rights to all eligible employees during a six months offering period with purchase dates at the end of each offering period. The first offering period under the ESPP began on August 15, 2011 and ends on February 14, 2012. Shares are purchased through employees' payroll deductions, up to a maximum of 15.0% of employees' compensation for each purchase period, at purchase prices equal to 85.0% of the lesser of the fair market value of our common stock at the first trading date of the applicable offering period or the purchase date. No participant may purchase more than 4,000 shares of common stock in any one calendar year period. The ESPP is compensatory and results in compensation expense. During the three months ended September 30, 2011, compensation expense recognized in connection with the ESPP was $0.5 million .

The following table summarizes the weighted-average assumptions relating to our ESPP during the three and nine months ended September 30, 2011 as follows:

Expected term in years
0.5

Volatility (%)
59.9

Risk-free interest rate (%)
0.07

Dividend rate (%)

Estimated fair value ($)
6.56


Non-employees —During the three months ended September 30, 2011 , we issued options to purchase 5,760 shares of common stock, at an exercise price of $20.13 per share, to non-employees in exchange for services. During the three months ended September 30, 2010 , no options were granted to non-employees in exchange for services. During the nine months ended September 30, 2011 and September 30, 2010 , we granted to non-employees in exchange for services, options to purchase 34,144 and 22,860 shares of Common Stock, respectively, at a range of exercise prices of $8.43 to $23.04 per share. These options vest over periods of up to 48 months, and in accordance with ASC 505-50 (formerly referred to as Emerging Issues Task Force (EITF) Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services ), we accounted for these options as variable awards. The options were valued using the Black-Scholes option pricing model with the following weighted-average assumptions:
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2011
 
September 30,
2010
 
September 30,
2011
 
September 30,
2010
Expected term in years
3.6 - 6.1
 
4.6 - 6.3
 
3.6 - 6.3

 
4.6 - 6.8
Volatility (%)
46.2
 
41.8
 
40.4 - 46.2

 
37.6 - 41.8
Risk-free interest rate (%)
1.5
 
1.6
 
1.5 - 2.0

 
1.6 - 2.4
Dividend rate (%)
 
 

 

9. INCOME TAXES

The effective tax rate was 33.9% for the three months ended September 30, 2011 , compared to an effective tax rate of 23.3% for the three months ended September 30, 2010 . The effective tax rate was 28.9% for the nine months ended September 30, 2011 , compared to an effective tax rate of 28.8% for the nine months ended September 30, 2010 . The provision for income taxes for the three months and nine months ended September 30, 2011 is comprised of foreign income taxes, U.S. federal and state taxes, and withholding tax. The provision for income taxes for the three months and nine months ended September 30, 2010 is comprised of foreign income taxes, U.S. federal and state taxes, and withholding tax.

As of September 30, 2011 and December 31, 2010 , unrecognized tax benefits determined in accordance with authoritative guidance on accounting for uncertainty in income taxes, approximated $17.2 million and $11.2 million, respectively. The total amount of unrecognized tax benefits, if recognized, would favorably impact the effective tax rate.

It is our policy to classify accrued interest and penalties related to unrecognized tax benefits in the provision for income

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FORTINET, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


taxes. As of September 30, 2011 , we had approximately $0.3 million accrued for estimated interest related to uncertain tax positions. For the nine months ended September 30, 2011 , we recorded estimated interest of $0.1 million. Penalties were immaterial at September 30, 2011 .

10. EMPLOYEE BENEFIT PLAN

We have established a 401(k) tax-deferred savings plan (the “401(k) Plan”) which permits participants to make contributions by salary deduction pursuant to Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ($16,500 for the calendar year 2011). In Canada, we have established a Group Registered Retirement Savings Plan program (the "RRSP Plan") which permits participants to make tax deductible contributions up to the maximum RRSP contribution limits under the Income Tax Act. As of January 1, 2011, our board of directors approved 50.0% matching contributions on employee contributions, up to 4.0% of the employee's eligible earnings. Our matching contributions to the RRSP and 401(k) Plans for the three and nine months ended September 30, 2011 were $0.4 million and $1.2 million , respectively.

11. SEGMENT INFORMATION

ASC 280 (formerly referred to as SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information) establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our chief executive officer. Our chief executive officer reviews financial information presented on a consolidated basis, accompanied by information about revenue by geographic region for purposes of allocating resources and evaluating financial performance. We have one business activity, and there are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Accordingly, we are considered to be in a single reportable segment and operating unit structure.

Revenue by geographic region is based on the billing address of the customer. The following tables set forth revenue, interest income and property and equipment by geographic region ($ amounts in 000's):
 
 
Three Months Ended
 
Nine Months Ended
Revenue
September 30,
2011
  
September 30,
2010
 
September 30,
2011
  
September 30,
2010
Americas:
 
 
 
 
 
 
 
United States
36,565

  
27,494

 
88,838

 
66,661

Other Americas
13,463

 
7,902

 
37,376

 
21,442

 
50,028

 
35,396

 
126,214

 
88,103

Europe, Middle East and Africa (EMEA)
37,942

  
28,926

 
108,216

  
85,482

Asia Pacific and Japan (APAC)
28,456

  
20,649

 
78,285

  
57,512

Total revenue
116,426

  
84,971

 
312,715

  
231,097


Property and Equipment—Net
September 30,
2011
  
December 31,
2010
Americas:
 
 
 
United States
2,269

 
1,639

Canada
3,734

 
3,933

Other Americas
28

 
13

 
6,031

 
5,585

Europe, Middle East and Africa (EMEA)
664

  
616

Asia Pacific and Japan (APAC)
790

  
855

Total property and equipment—net
7,485

  
7,056


12. ACQUISITIONS

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FORTINET, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)



On April 6, 2011, we completed the acquisition of TalkSwitch Corp. (TalkSwitch), a privately held company that provides voice over IP phones and phone systems, for a cash payment of $2.6 million. We accounted for this acquisition as a purchase of a business and, accordingly, the total purchase price has been allocated to TalkSwitch tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair market values as of the acquisition date. The purchase price allocation resulted in purchased tangible assets of approximately $0.9 million and liabilities of $0.1 million and purchased identifiable intangible assets of approximately $1.8 million. Identifiable intangible assets consist of purchased technology. The fair value assigned to identifiable intangible assets acquired is determined using the income approach, which discounts expected future cash flows to present value using estimates and assumptions determined by us. Purchased identifiable intangible assets are being amortized on a straight-line basis over three years.

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 of 1933 and Section 21E of the Securities Exchange Act of 1934. 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;

the continued realization of efficiency gains in our sales and marketing organization as well as efficiency gains in our overall headcount measured by revenue per employee;
 
continued sales into large customers;

mix of billings between product and services, as well as, increases in sales of multi-year support and subscription contracts;
 
the significance of stock compensation as an expense;
 
the proportion of our revenue that consists of our product and service revenues and future trends with respect to service revenue as we renew existing services contracts and expand our customer base;
 
our royalty payments to Trend Micro;
 
the impact of our product innovation strategy and comprehensive product portfolio;

impact of the newly-adopted revenue recognition rules;
 
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;
 
investments in research and development and sales and marketing staff to address market opportunities and to position ourselves for future growth;

our effective tax rate;
 
the impact of seasonality on our business; and
 
the sufficiency of our existing cash 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” included elsewhere in this Quarterly Report on Form 10-Q and in our other Securities and Exchange Commission filings, including our Annual Report on Form 10-K for the year ended December 31, 2010, which was filed on February 25, 2011. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking

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statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Business Overview

We provide 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 government entities worldwide. As of September 30, 2011 , we had shipped over 800,000 appliances to more than 10,000 channel partners and to more than 125,000 end-customers worldwide, including a majority of the 2011 Fortune Global 100.

Our core UTM product line of FortiGate appliances ships with a set of security and networking capabilities, including firewall, VPN, antivirus, intrusion prevention, application control, Web filtering, antispam and WAN acceleration functionality. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-30, designed for small businesses, to the FortiGate-5000 series for large enterprises, telecommunications carriers, and service providers. Our UTM solution also includes our FortiGuard security subscription services, which end-customers can subscribe to in order to obtain access to dynamic updates to the antivirus, intrusion prevention/application control, Web filtering and antispam 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, employee computers and mobile devices. Sales of these complementary products have grown in recent quarters, although these products still represent less than 10.0% of our total revenue. During the past several quarters, we have also expanded and enhanced our FortiGate UTM and FortiAP secure wireless access product lines, as well as introduced software-based virtual appliances for many of our appliance-based product lines, including 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.

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 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 5 years. Sales of new and renewal services increase our deferred revenue balance, which contributes significantly to our positive cash flow from operations. 
During the third quarter of 2011, billings (a non-GAAP financial measure that we define as total revenue plus the change in deferred revenue) and revenues grew as a result of the leverage achieved on our investments in research and development and the successful execution of our global sales strategy. Sales of FortiGate products continued to be generally balanced across entry-level (FortiGate-30 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. We expect some degree of variability from year to year and between quarters, although we do not consider small percentage changes meaningful in terms of business trends. The percentage of our FortiGate related billings from the mid-range category increased to 31.0% in the third quarter of 2011 from 27.0% in the third quarter of 2010, while the high-end category decreased slightly from 39.0% to 37.0%, and the entry-level category decreased from 34.0% to 32.0%. 

We also believe continued product innovation, as evidenced by the increased demand for our recently introduced FortiGate models such as the FortiGate-5001B and FortiGate-3140B in the high-end, as well as continued acceptance by small businesses of our mid-range FortiGate-200B model and FortiWifi-60C devices are reinforcing our competitive edge and driving market share gains. During the third quarter, we experienced inventory shortages due primarily to demand for specific products exceeding our forecasts.

During the third quarter of 2011, we also continued to invest in research and development as well as sales and marketing to expand brand awareness, strengthen our value proposition, and expand our distribution channel. We experienced healthy deal volumes driven by traction in enterprise data center deployments, core enterprise deals, and continued strength in the retail and telecommunications sectors. We also experienced a sizable increase in the number of deals involving sales greater than

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$100,000, although the number of deals greater than $250,000 and $500,000 were relatively flat compared to the third quarter of 2010. We expect some variability in this metric, and 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 in an effort to ensure the quality and functionality of our products meet increasing customer expectations as we continue to sell to large customers, such as enterprise and service providers.
 
Billings (as further described under "Non-GAAP Financial Measures") were $118.4 million in the third quarter of 2011, an increase of 25.0% compared to the third quarter of 2010. Total revenue was $116.4 million for the third quarter of 2011, an increase of 37.0% compared to the third quarter of 2010. Both metrics were positively impacted by a $2.6 million sale of previously-acquired patents during the quarter. Revenue for the third quarter of 2011 includes a $5.1 million , or 4.4% , positive impact related to the adoption of the new revenue recognition rules, as described in our "Summary of Significant Accounting Policies" included in - Footnote 1 to our Condensed Consolidated Financial Statements. The increase was attributable to both using BESP in our allocation of arrangement consideration when we do not have VSOE, and being able to recognize upon shipment certain product revenue, which would have been deferred under the previous revenue recognition rules. Product revenue was $53.1 million , an increase of 47.8% compared to the third quarter of 2010, and a greater percentage of total revenue ( 45.6% in the third quarter of 2011, compared to 42.3% in the third quarter of 2010). The higher product revenue can be attributed to an increase of higher-end product billings relative to services billings compared to last year, and upfront recognition of revenue related to sales in China previously amortized ratably. Services revenue in the third quarter of 2011 was $57.8 million , an increase of 29.9% compared to the third quarter of 2010. Services revenue is important to our future revenue and profitability as it provides a source of recurring revenue for us, representing 49.7% and 52.4% of total revenue for the third quarter of 2011 and 2010, respectively. Ratable and other revenue in the third quarter of 2011 was $5.5 million , an increase of 21.3% compared to the third quarter of 2010, due to a $2.6 million sale of previously-acquired patents, partially offset by $1.6 million of declining ratable revenue amortization due to the new revenue recognition rules.
 
We are a global, geographically diversified business, with 57.0% of our total revenue generated outside of the Americas region in the third quarter of 2011. Our strong operating results were driven by strong performance across all geographies, especially in the Americas and EMEA. During the quarter, $50.0 million , or 43.0% , of our total revenue was generated from the Americas, representing an increase of 41.3% from the third quarter of 2010. EMEA generated $37.9 million , or 32.6% , of our total revenue during the third quarter of 2011, representing an increase of 31.2% from the third quarter of 2010. APAC generated $28.5 million , or 24.4% , of our total revenue during the third quarter of 2011, representing an increase of 37.8% from the third quarter of 2010.
 
Our total operating expenses were $59.1 million for the third quarter of 2011, an increase of 30.3% compared to the same period in the prior year. The 37.0% increase in revenues compared to the 30.3% increase in operating expenses from the third quarter of 2010 (as discussed under "Results of Operations" below) demonstrates the leverage that we are achieving from the efficiencies in our business operations during the past year. Despite the negative impact of foreign currency fluctuations experienced during the quarter, operating expenses as a percentage of revenue decreased to 50.7% from 53.5% during the third quarter last year. We are also seeing improvements in productivity and efficiencies in our overall headcount as our annualized third quarter 2011 revenue per employee, defined as quarterly revenue, annualized and divided by average headcount, reached a record $310,000 , up from $263,000 for the third quarter of 2010. Headcount increased during the third quarter of 2011 from 1,475 at the end of the second quarter of 2011 to 1,527 , as our pace of hiring picked up this quarter (particularly in research and development and sales and marketing), following a ramp up in our recruiting efforts over the past few quarters.
Key Metrics

We monitor the key financial metrics set forth below on a quarterly basis 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 $1.9 million from $273.2 million at June 30, 2011 to $275.1 million at September 30, 2011 . Revenue recognized plus the change in deferred revenue from the beginning to the end of the period 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 quarterly revenue that we recognize. We also ended the third quarter of 2011 with $503.0 million in cash, cash equivalents and investments and have had positive cash flow from operations for 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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Table of Contents

 
For The Three Months Ended Or As Of
 
September 30, 2011
 
September 30, 2010
 
($ amounts in 000's)
Revenue
116,426

 
84,971

Gross margin
73.3
%
 
74.8
%
Operating income (1)
26,160

 
18,159

Operating margin
22.0
%
 
21.0
%
Total deferred revenue
275,126

 
235,250

Increase in total deferred revenue over prior quarter
1,927

 
9,729

Cash, cash equivalents and investments
502,967

 
352,344

Cash flows from operating activities
36,039

 
32,193

Free cash flow (2)
34,704

 
31,522

-----------
 
 
 
(1)    Includes:
 
 
 
 Stock-based compensation expense
5,734

 
2,434

 Patent settlement income
478

 

(2)    Free cash flow is a non-GAAP financial measure, which we define as cash flow from operations minus capital
    expenditures, as further described below.
 
 
 

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. The following table reflects the calculation of billings as discussed in the paragraph above.

 
Three Months Ended
 
September 30,
2011
 
September 30,
2010
 
($ amounts in 000's)
Billings:
 
 
 
Revenue
116,426

 
84,971

Increase in deferred revenue
1,927

 
9,729

Total Billings (Non-GAAP)
118,353

 
94,700


Cash flow from operations. 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 advance payments for both new and renewal contracts for subscription and support services, consistent with our billings for the period. Monitoring cash flow from operations 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.


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Table of Contents

 
Three Months Ended
 
September 30,
2011
 
September 30,
2010
 
($ amounts in 000's)
Cash Flow:
 
 
 
Net cash provided by operating activities
36,039

 
32,193

Less purchases of property and equipment
(1,335
)
 
(671
)
Free cash flow (Non-GAAP)
34,704

 
31,522

Net cash used in investing activities*
(52,950
)
 
(84,943
)
Net cash provided by financing activities
7,572

 
11,890

-----------
 
 
 
*
Includes purchases of property and equipment

Non-GAAP Financial Measures

To supplement our condensed consolidated financial statements presented in accordance with U.S. GAAP, we consider certain financial measures that are not prepared in accordance with GAAP, including non-GAAP gross margin, non-GAAP income from operations and non-GAAP operating margin, non-GAAP operating expenses, non-GAAP net income and non-GAAP free cash flow. 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 and the patent settlement. Stock-based compensation 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 our Results of Operations below.

Non-GAAP gross margin is gross margin as reported on our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense, which is a non-cash charge. Non-GAAP income from operations is operating income, as reported on our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense and the income from the patent settlement. Non-GAAP operating margin is non-GAAP income from operations divided by revenue. The following tables reconcile GAAP gross margin, income from operations, and operating margin to non-GAAP gross margin, non-GAAP income from operations, and non-GAAP operating margin for the third quarters of 2011 and 2010 .

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Table of Contents

 
Three Months Ended
 
September 30, 2011
 
September 30, 2010
 
Amount
  
% of
Revenue
 
Amount
  
% of
Revenue
 
($ amounts in 000's)
Total revenue
116,426

  
 
 
84,971

  
 
 
 
 
 
 
 
 
 
GAAP gross profit and margin
85,287

  
73.3

 
63,528

  
74.8
Stock-based compensation expense
628

 
0.5

 
268

 
0.3
Non-GAAP gross profit and margin
85,915

  
73.8

 
63,796

  
75.1
 
 
 
 
 
 
 
 
GAAP income from operations and margin
26,160

  
22.0

 
18,159

  
21.4
Stock-based compensation expense:
 
  
 
 
 
  
 
Cost of revenue
628

  
0.5

 
268

  
0.3
Research and development
1,516

  
1.3

 
600

  
0.7
Sales and marketing
2,708

  
2.3

 
1,017

  
1.2
General and administrative
882

  
0.8

 
549

  
0.6
Total stock-based compensation
5,734

  
4.9

 
2,434

  
2.8
Patent settlement
(478
)
 
(0.4
)
 

 
Non-GAAP income from operations and margin
31,416

  
26.5

 
20,593

  
24.2

Non-GAAP operating expenses exclude the impact of stock-based compensation expense and the income from the patent settlement. The following tables reconcile GAAP operating expenses to non-GAAP operating expenses for the third quarters of 2011 and 2010 .

 
Three Months Ended
 
September 30, 2011
 
September 30, 2010
 
Amount
  
% of
Revenue
 
Amount
  
% of
Revenue
 
($ amounts in 000's)
Operating Expenses:
 
 
 
 
 
  
 
Research and development expenses:
 
 
 
 
 
  
 
GAAP research and development expenses
16,834

 
14.4

 
12,389

  
14.6

Stock-based compensation
(1,516
)
 
(1.3
)
 
(600
)
  
(0.7
)
Non-GAAP research and development expenses
15,318

 
13.1

 
11,789

  
13.9

 
 
 
 
 
 
 
 
Sales and marketing expenses:
 
 
 
 
 
  
 
GAAP sales and marketing expenses
36,934

 
31.7

 
26,987

  
31.8

Stock-based compensation
(2,708
)
 
(2.3
)
 
(1,017
)
  
(1.2
)
Non-GAAP sales and marketing expenses
34,226

 
29.4

 
25,970

  
30.6

 
 
 
 
 
 
 
 
General and administrative expenses:
 
 
 
 
 
  
 
GAAP general and administrative expenses
5,359

 
4.6

 
5,993

  
7.1

Stock-based compensation
(882
)
 
(0.8
)
 
(549
)
  
(0.6
)
Patent settlement
478

 
0.4

 

 

Non-GAAP general and administrative expenses
4,955

 
4.2

 
5,444

  
6.5

 
 
 
 
 
 
 
 
Total operating expenses:
 
 
 
 
 
  
 
GAAP operating expenses
59,127

 
50.7

 
45,369

  
53.4

Stock-based compensation
(5,106
)
 
(4.4
)
 
(2,166
)
  
(2.5
)
Patent settlement
478

 
0.4

 

 

Non-GAAP operating expenses
54,499

 
46.7

 
43,203

  
50.9


Non-GAAP net income is net income, as reported in our condensed consolidated statements of operations, excluding the

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impact of stock-based compensation expense and income from the patent settlement. The following tables reconcile GAAP net income as reported on our condensed consolidated statements of operations to non-GAAP net income for the third quarters of 2011 and 2010 .

 
Three Months Ended
 
September 30, 2011
 
September 30, 2010
 
($ amounts in 000's)
Net Income:
 
 
 
GAAP net income
17,917

  
14,017

Stock-based compensation expense (1)
5,734

  
2,434

Patent settlement (2)
(478
)
 

Provision for income taxes (3)
9,207

  
4,254

Non-GAAP income before provision for income taxes
32,380

  
20,705

Tax effects related to non-GAAP adjustments (4)
(10,685
)
 
(7,247
)
Non-GAAP net income
21,695

  
13,458

 
 
 
 
Non-GAAP net income per share - diluted
0.13

 
0.09

 
 
 
 
Shares used in per share calculation - diluted
163,869

 
155,842

---------
(1)
Stock-based compensation expense is added back to GAAP net income to reconcile to non-GAAP income before taxes.
(2)
The patent settlement income is removed from GAAP net income to reconcile to non-GAAP income before taxes.
(3)
Provision for income taxes is our GAAP provision that must be added to GAAP net income to reconcile to non-GAAP income before taxes.
(4)
Tax provision related to non-GAAP income before tax reflects 33.0% and 35.0% effective tax rates in the third quarter of 2011 and 2010 , respectively. Based on the annual estimate for geographic split of income, as well as various tax credits we expect to achieve in various locations, we currently plan to use a 33.0% tax rate for the year, subject to discrete items that may occur in a particular quarter.

Components of Operating Results

Revenue

We derive our revenue from sales of our products and subscription and support services. We recognize our revenue in accordance with the guidance in ASC 985-605 and all related interpretations , which is discussed in further detail in Footnote 1 to our Condensed Consolidated Financial Statements, “Summary of Significant Accounting Policies - Revenue Recognition.” Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable and collectability is probable.

Our total revenue is comprised of the following:

Product revenue . Product revenue is generated from sales of our appliances and software. The substantial majority of our product revenue has been generated by our FortiGate line of appliances, and we do not expect this to change in the foreseeable future. Product revenue also includes revenue derived from sales of FortiManager, FortiAnalyzer, FortiSwitch, FortiMail, FortiDB, FortiWeb, FortiAP, FortiScan, FortiCarrier, FortiBalancer, FortiCache, FortiBridge, and FortiAuthenticator appliances, and our FortiClient and virtual domain, or VDOM, software. Additionally, we generate revenue from the TalkSwitch line of telephony products. We recognize product revenue on sales to distributors that have no general right of return and end-customers upon shipment, once all other revenue recognition criteria have been met. As a percentage of total revenue, we expect our product revenue may vary from quarter-to-quarter based on seasonal and cyclical factors, but generally may remain at comparable levels or decline modestly over time, as services revenue becomes a larger portion of our business as our customers renew existing services contracts and we expand our customer base.
 
Services revenue . Services revenue is generated primarily from FortiCare technical support services for software updates, maintenance releases and patches, Internet access to technical content, telephone and Internet access to technical support personnel and hardware support, and FortiGuard security subscription services related to antivirus, intrusion prevention, Web filtering, antispam and vulnerability management updates. We recognize revenue from

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subscription and support services over the service performance period. Our typical contractual support and subscription term is one year from the date of registration, although, we do offer multi-year support and subscription contracts. We also generate a small portion of our revenue from professional services and training services, and we recognize this revenue as the services are provided. As a percentage of total revenue, we expect our services revenue to remain at comparable levels or increase as our customers renew existing service contracts, as our services revenue growth rate depends significantly on the growth of our customer base.

Ratable and other revenue . Ratable and other revenue is generated from sales of our products and services in cases where the fair value of the services being provided cannot be separated from the value of the entire sale. In these cases, the value of the entire sale is deferred and recognized ratably over the service performance period. See Footnote 1 to our Condensed Consolidated Financial Statements - “Summary of Significant Accounting Policies - Revenue Recognition” for more details. Ratable and other revenue was formerly referred to as Ratable product and services revenue. We have made this change to reflect a $2.6 million sale of previously-acquired patents during the third quarter. In the third quarters of 2011 and 2010, ratable and other revenue represented approximately 4.7% and 5.3% of total revenue, respectively. Over time we expect this category to continue to decline due to the new revenue recognition rules, which allow us to use BESP in our allocation of arrangement consideration when we do not have VSOE.

Cost of revenue

Our total cost of revenue is comprised of the following:

Cost of product revenue. A substantial majority of the cost of product revenue consists of third-party manufacturing costs. Our cost of product revenue also includes product testing costs, write-offs for excess and obsolete inventory, royalty payments, amortization and any impairment of applicable acquired intangible assets, warranty costs, shipping and allocated facilities costs, stock-based compensation costs, and personnel costs associated with logistics and quality control. Personnel costs include cash-based personnel costs such as salaries, benefits and bonuses. Royalties reflect amounts related to Trend Micro since 2006, which Trend Micro claims are owed through 2015, as discussed in “Item 1 - Legal Proceedings.” For fiscal 2009, 2010 and the first three quarters of 2011, this royalty represented approximately one percent of total revenue, and we do not expect this percentage to increase substantially in the foreseeable future.

Cost of services revenue. Cost of services revenue is primarily comprised of cash-based personnel costs associated with our FortiGuard Labs team and our technical support, professional services and training teams, as well as depreciation, supplies, data center, data communications, facility-related costs and stock-based compensation costs. We expect our cost of services revenue will increase as we continue to invest in subscription and support services to meet the needs of our growing customer base.

Cost of ratable and other revenue . Cost of ratable and other revenue is comprised primarily of deferred product costs and services-related costs.

Gross profit . Gross profit as a percentage of revenue, or gross margin, has been and will continue to be affected by a variety of factors, including the average sales price of our products, any excess inventory write-offs, manufacturing costs, services headcount, the mix of products sold and the mix of revenue between products and services. We believe our overall gross margin for the near term will remain comparable (or decrease slightly) to that achieved through the first three quarters of 2011.

Operating expenses . Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel costs are the most significant component of operating expenses and consist of cash-based personnel costs such as salaries, benefits, bonuses and, with regard to the sales and marketing expense, sales commissions. They also include non-cash charges, specifically, stock-based compensation. We expect personnel costs to continue to increase in absolute dollars as we hire new employees.

Research and development. Research and development expense consists primarily of cash-based personnel costs. Additional research and development expenses include ASIC and system prototypes and certification-related expenses, depreciation of capital equipment, facility-related expenses and stock-based compensation expenses. The majority of our research and development is focused on both software development and the ongoing development of our hardware platform. We record all research and development expenses as incurred, except for capital equipment which is depreciated over time. Our development teams are primarily located in Canada, China, and California. We

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expect our spending for research and development to increase in absolute dollars but remain comparable to recent periods as a percentage of total revenue.

Sales and marketing . Sales and marketing expense is the largest component of our operating expenses and primarily consists of cash-based personnel costs. Additional sales and marketing expenses include stock-based compensation, promotional and other marketing expenses, travel, depreciation of capital equipment and located facility-related expenses. We intend to hire additional personnel focused on sales and marketing and expand our sales and marketing efforts worldwide in order to increase our presence in new geographic markets and enterprise verticals, add new customers and increase penetration within our existing customer base. Accordingly, we expect sales and marketing expenses to increase in absolute dollars and to continue to be our largest operating expense.

General and administrative . General and administrative expense consists of cash-based personnel costs as well as professional fees, stock-based compensation, depreciation of capital equipment and software, and facility-related expenses. General and administrative personnel include our executive, finance, human resources, information technology and legal organizations. Our professional fees principally consist of outside legal, auditing, accounting, information technology and other consulting costs. We expect that general and administrative expense will increase in absolute dollars as we hire additional personnel, make improvements to our information technology infrastructure, and defend our intellectual property, but remain comparable to recent periods as a percentage of total revenue.

Interest income. Interest income consists of income earned on our cash, cash equivalents and investments. We have historically invested our cash in money market funds, commercial paper, corporate debt securities, municipal bonds, term deposits, and U.S. government and agency debt securities.

Other income (expense), net . Other income (expense), net consists primarily of foreign exchange and related hedging gains and losses. Foreign exchange gains and losses relate to foreign currency exchange re-measurement. The hedging gains and losses are related to our settled balance sheet hedges.

Provision for income taxes. Our income tax provision is based on our worldwide estimated annualized effective tax rate. We are subject to tax in the United States as well as other tax jurisdictions or countries in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to current U.S. income tax. Our effective tax rates differ from the statutory rate primarily due to foreign income subject to different tax rates than the U.S., research and development tax credits (when applicable), withholding tax, nondeductible compensation and adjustments related to our intercompany transfer pricing.

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 U.S. 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, 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.
 
We believe the accounting policies and estimates discussed under Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010 , reflect our more significant judgments and estimates used in the preparation of the consolidated financial statements. Effective January 1, 2011, we prospectively adopted the new accounting standards related to software revenue recognition for applicable transactions originating or materially modified after December 31, 2010, which is discussed in further detail in Footnote 1 to our Condensed Consolidated Financial Statements, “Summary of Significant Accounting Policies - Revenue Recognition.”


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Results of Operations

Three Months Ended