Fortinet, Inc.
FORTINET INC (Form: 10-Q, Received: 10/30/2012 17:13:13)

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, 2012
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 of 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
[x]
 
Accelerated filer
[ ]
 
 
 
 
 
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 23, 2012 , there were 159,938,847 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, 2012
Table of Contents

 
 
Page
 
Item 1.
Item 2.
Item 3.
Item 4.
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 




Table of Contents

Part I

ITEM 1.
Financial Statements
FORTINET, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands)  
 
September 30,
2012
 
December 31,
2011
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
75,466

 
$
71,990

Short-term investments
299,180

 
318,283

Accounts receivable, net of allowance for doubtful accounts of $234 and $336 at September 30, 2012 and December 31, 2011, respectively
89,843

 
95,522

Inventory
26,182

 
16,249

Deferred tax assets
7,088

 
7,578

Prepaid expenses and other current assets
16,893

 
13,948

Total current assets
514,652

 
523,570

PROPERTY AND EQUIPMENT—Net
26,020

 
7,966

DEFERRED TAX ASSETS—Non-current
50,393

 
46,523

LONG-TERM INVESTMENTS
315,657

 
148,414

OTHER ASSETS
6,546

 
8,274

TOTAL ASSETS
$
913,268

 
$
734,747

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
23,160

 
$
19,768

Accrued liabilities
19,032

 
15,971

Accrued payroll and compensation
25,940

 
24,197

Deferred revenue
230,562

 
206,928

Total current liabilities
298,694

 
266,864

DEFERRED REVENUE—Non-current
109,516

 
87,905

OTHER LIABILITIES
26,589

 
21,624

Total liabilities
434,799

 
376,393

COMMITMENTS AND CONTINGENCIES (Note 7)


 


STOCKHOLDERS' EQUITY:
 
 
 
Common stock, $0.001 par value - 300,000 shares authorized; 161,217 and 156,401 shares issued and 159,808 and 154,992 shares outstanding at September 30, 2012 and December 31, 2011, respectively
161

 
156

Additional paid-in-capital
388,632

 
317,026

Treasury stock
(2,995
)
 
(2,995
)
Accumulated other comprehensive income
3,577

 
402

Retained earnings
89,094

 
43,765

Total stockholders' equity
478,469

 
358,354

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
$
913,268

 
$
734,747

See notes to condensed consolidated financial statements.


3




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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
REVENUE:
 
 
 
 
 
 
 
Product
$
63,027

 
$
53,093

 
$
177,923

 
$
139,945

Services
69,782

 
57,835

 
197,332

 
159,192

Ratable and other revenue
3,459

 
5,498

 
7,222

 
13,578

Total revenue
136,268

 
116,426

 
382,477

 
312,715

COST OF REVENUE:
 
 
 
 
 
 
 
Product
23,995

 
20,606

 
66,997

 
51,272

Services
13,166

 
9,438

 
36,846

 
25,815

Ratable and other revenue
647

 
1,095

 
2,135

 
4,026

Total cost of revenue
37,808

 
31,139

 
105,978

 
81,113

GROSS PROFIT:
 
 
 
 
 
 
 
Product
39,032

 
32,487

 
110,926

 
88,673

Services
56,616

 
48,397

 
160,486

 
133,377

Ratable and other revenue
2,812

 
4,403

 
5,087

 
9,552

Total gross profit
98,460

 
85,287

 
276,499

 
231,602

OPERATING EXPENSES:
 
 
 
 
 
 
 
Research and development
20,498

 
16,834

 
60,553

 
47,197

Sales and marketing
44,743

 
36,934

 
131,038

 
105,548

General and administrative
7,449

 
5,359

 
19,473

 
16,473

Total operating expenses
72,690

 
59,127

 
211,064

 
169,218

OPERATING INCOME
25,770

 
26,160

 
65,435

 
62,384

INTEREST INCOME
1,318

 
904

 
3,606

 
2,560

OTHER (EXPENSE) INCOME—Net
(317
)
 
60

 
(315
)
 
(242
)
INCOME BEFORE INCOME TAXES
26,771

 
27,124

 
68,726

 
64,702

PROVISION FOR INCOME TAXES
9,565

 
9,207

 
23,397

 
18,704

NET INCOME
$
17,206

 
$
17,917

 
$
45,329

 
$
45,998

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.11

  
$
0.12

 
$
0.29

 
$
0.30

Diluted
$
0.10

  
$
0.11

 
$
0.27

 
$
0.28

Weighted-average shares outstanding:
 
 
 
 
 
 
 
Basic
158,751

 
153,265

 
157,416

 
151,958

Diluted
166,791

  
163,869

 
166,127

 
163,554

See notes to condensed consolidated financial statements.


4



FORTINET, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited, in thousands)

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
Net income
$
17,206

 
$
17,917

 
$
45,329

 
$
45,998

Other comprehensive income:
 
 
 
 
 
 
 
Foreign currency translation gains (losses)
1,092

 
(1,722
)
 
867

 
(797
)
Unrealized gains (losses) on investments
1,968

 
(1,347
)
 
3,441

 
(1,194
)
Unrealized losses on cash flow hedges
(19
)
 
(119
)
 

 
(194
)
Tax provision related to items of other comprehensive income
(618
)
 

 
(1,133
)
 

Net change in accumulated other comprehensive income
2,423

 
(3,188
)
 
3,175

 
(2,185
)
Comprehensive income
$
19,629

 
$
14,729

 
$
48,504

 
$
43,813

See notes to condensed consolidated financial statements.



5



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

 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
45,329

 
$
45,998

Adjustments to reconcile net income to net cash provided by operating activities:


 
 
Depreciation and amortization
8,076

 
5,114

Amortization of investment premiums
10,002

 
9,508

Stock-based compensation
23,928

 
12,674

Excess tax benefit from employee stock option plan
(9,611
)
 
(9,264
)
Other non-cash items, net
893

 
22

Changes in operating assets and liabilities:
 
 
 
Accounts receivable—net
5,680

 
(3,559
)
Inventory
(14,977
)
 
(1,478
)
Deferred tax assets
(4,515
)
 
(5,546
)
Prepaid expenses and other current assets
(71
)
 
(1,009
)
Other assets
1,885

 
312

Accounts payable
3,049

 
2,514

Accrued liabilities
2,662

 
4,867

Accrued payroll and compensation
1,563

 
1,582

Other liabilities
(1,361
)
 
2,664

Deferred revenue
45,192

 
22,471

Income taxes payable
15,849

 
23,413

Net cash provided by operating activities
133,573

 
110,283

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of investments
(523,389
)
 
(407,110
)
Sales of investments
25,768

 
75,582

Maturities of investments
343,174

 
204,099

Purchases of property and equipment
(20,283
)
 
(2,785
)
Payment made in connection with business acquisition
(749
)
 
(2,623
)
Net cash used in investing activities
(175,479
)
 
(132,837
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
36,006

 
14,018

Excess tax benefit from employee stock option plan
9,611

 
9,264

Net cash provided by financing activities
45,617

 
23,282

EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS
(235
)
 
(957
)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
3,476

 
(229
)
CASH AND CASH EQUIVALENTS—Beginning of period
71,990

 
66,859

CASH AND CASH EQUIVALENTS—End of period
$
75,466

 
$
66,630

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid (refunded) for income taxes
$
10,335

 
$
(689
)
NON-CASH INVESTING ACTIVITIES:
 
 
 
Purchases of property and equipment not yet paid
$
722

 
$
301

Liability incurred in connection with business acquisition
$
201

 
$

See notes to condensed consolidated financial statements.

6



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

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Preparation

The unaudited condensed consolidated financial statements of Fortinet and its wholly owned subsidiaries (collectively, the “Company,” “we,” “us,” or “our”) have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information as well as the instructions to Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements, and should be read in conjunction with our audited consolidated financial statements as of and for the fiscal year ended December 31, 2011, contained in our Annual Report on Form 10-K (“Form 10-K”) filed with the SEC on February 28, 2012. In the opinion of management, all adjustments, including normal recurring accruals, considered necessary for a fair presentation have been included. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the operating results for any subsequent quarter, for the full year or any future periods.

The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.

There have been no substantial changes in our significant accounting policies since the fiscal year ended December 31, 2011.

Revenue Recognition —In October 2009, the Financial Accounting Standards Board (“FASB”) amended the Accounting Standards Codification (“ASC”) as summarized in Accounting Standards Update (“ASU”) No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements ( “ASU 2009-13” ), and ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements ( “ASU 2009-14” ) . ASU 2009-13 amended 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 estimated 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. ASU 2009-14 amended 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.
 
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 Software Revenue Recognition (“ASC 985-605”).
 
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. 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 ASU 2009-13. When a sales arrangement contains multiple elements, such as hardware appliances, software, customer support services, and/or professional services, we allocate

7


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


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 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 other services, we generally use VSOE as our selling price. When we are unable to establish a selling price using VSOE for our support and other 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 ASU 2009-13 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, revenue is recognized upon acceptance. We recognize product revenue on sales to distributors that have no general right of return and direct sales to end-customers upon

8


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


shipment, once all other revenue recognition criteria have been met. We also recognize revenue upon sell-through for distributor agreements that allow for rights of return. Such returns are estimated and recorded as a reduction to revenue. 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.

Recently Adopted Accounting Pronouncements

In May 2011, the FASB issued ASU 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. We adopted ASU 2011-04 in the first quarter of 2012. The measurement provisions of this guidance did not impact our condensed consolidated financial statements.

In June 2011, the FASB issued ASU 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 stockholders' equity. We adopted ASU 2011-05 in the first quarter of 2012 and applied it retrospectively. We elected to present the comprehensive income in two separate but consecutive statements within our condensed consolidated financial statements.




9


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


2. INVESTMENTS AND FAIR VALUE MEASUREMENTS

The following table summarizes our investments ($ amounts in 000's):
 
 
September 30,
2012
 
Amortized Cost
  
Unrealized Gains
  
Unrealized Losses
 
Estimated Fair Value
U.S. government and agency securities
7,600

  
1

  

 
7,601

Corporate debt securities
521,502

  
1,856

  
(102
)
 
523,256

Commercial paper
33,814

  
15

  

 
33,829

Municipal bonds
40,210

 
94

 
(4
)
 
40,300

Certificates of deposit and term deposits
9,844

 
7

 

 
9,851

Total available-for-sale securities
612,970

  
1,973

  
(106
)
 
614,837


 
December 31,
2011
 
Amortized Cost
  
Unrealized Gains
  
Unrealized Losses
 
Estimated Fair Value
U.S. government and agency securities
38,900

 
10

 
(2
)
 
38,908

Corporate debt securities
339,110

 
219

 
(1,832
)
 
337,497

Commercial paper
51,025

 
7

 
(5
)
 
51,027

Municipal bonds
20,473

 
36

 
(5
)
 
20,504

Certificates of deposit and term deposits
18,762

 
1

 
(2
)
 
18,761

Total available-for-sale securities
468,270

  
273

  
(1,846
)
 
466,697


The following table shows the gross unrealized losses and the related fair values of our investments that have been in a continuous unrealized loss position, at September 30, 2012 ($ amounts in 000's):

 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
  
Unrealized Losses
  
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
Corporate debt securities
84,190

 
(98
)
 
2,001

 
(4
)
 
86,191

 
(102
)
Municipal bonds
5,382

 
(4
)
 

 

 
5,382

 
(4
)
Total available-for-sale securities
89,572

 
(102
)
 
2,001

 
(4
)
 
91,573

 
(106
)

The following table shows the gross unrealized losses and the related fair values of our investments that have been in a continuous unrealized loss position, at December 31, 2011 ($ amounts in 000's):

 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
  
Unrealized Losses
  
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
U.S. government and agency securities
10,996

 
(2
)
 

 

 
10,996

 
(2
)
Corporate debt securities
258,159

 
(1,832
)
 

 

 
258,159

 
(1,832
)
Commercial paper
9,279

 
(5
)
 

 

 
9,279

 
(5
)
Municipal bonds
8,067

 
(5
)
 

 

 
8,067

 
(5
)
Certificates of deposit and term deposits
7,499

 
(2
)
 

 

 
7,499

 
(2
)
Total available-for-sale securities
294,000

 
(1,846
)
 

 


294,000

 
(1,846
)


10


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


The contractual maturities of our investments are as follows ($ amounts in 000's):
 
 
September 30,
2012
  
December 31,
2011
Due within one year
299,180

 
318,283

Due within one to three years
315,657

 
148,414

Total
614,837

  
466,697


Realized gains or losses from the sale of available-for-sale securities were not significant for any of the periods presented.
 
The following table presents the fair value of our financial assets measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011 ($ amounts in 000's):

 
September 30,
2012
  
December 31,
2011
 
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
7,601

 

 
7,601

 
38,908

 

 
38,908

Corporate debt securities
523,256

 

 
523,256

 
337,497

 

 
337,497

Commercial paper
44,428

 

 
44,428

 
64,890

 

 
64,890

Municipal bonds
40,300

 

 
40,300

 
20,504

 

 
20,504

Certificates of deposit and term deposits
9,851

 

 
9,851

 
18,761

 

 
18,761

Money market funds
33,000

 
33,000

 

 
31,438

 
31,438

 

Total
658,436

 
33,000

 
625,436

 
511,998

 
31,438

 
480,560

Reported as:
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
43,599

 
 
 
 
 
45,301

 
 
 
 
Short-term investments
299,180

 
 
 
 
 
318,283

 
 
 
 
Long-term investments
315,657

 
 
 
 
 
148,414

 
 
 
 
Total
658,436

 
 
 
 
 
511,998

 
 
 
 

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, 2012 or December 31, 2011 . There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the three and nine months ended September 30, 2012.


11


3. INVENTORY

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

 
September 30,
2012
  
December 31,
2011
Raw materials
4,927

 
3,447

Finished goods
21,255

 
12,802

Inventory
26,182

  
16,249



4. PROPERTY AND EQUIPMENT—Net

Property and equipment consisted of the following ($ amounts in 000's):
 
September 30,
2012
 
December 31,
2011
Land
13,895

 

Building and building improvements
610

 

Evaluation units
17,388

 
13,912

Computer equipment and software
17,449

 
12,219

Furniture and fixtures
1,400

 
1,307

Leasehold improvements and tooling
5,047

 
4,381

Total property and equipment
55,789

 
31,819

Less: accumulated depreciation
(29,769
)
 
(23,853
)
Property and equipment—net
26,020

 
7,966


In August 2012, we purchased certain real property including land and a building in Sunnyvale, California, for cash of $14.5 million , to support the growth in our business operations. Of the total cost, we allocated $13.9 million to land and $0.6 million to building and building improvements.

Depreciation expense was $2.7 million and $1.8 million during the three months ended September 30, 2012 and September 30, 2011, respectively. Depreciation expense was $7.2 million and $5.1 million during the nine months ended September 30, 2012 and September 30, 2011, respectively.


12


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


5. NET 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, restricted stock units (“RSUs”), and the employee stock purchase plan ("ESPP"). Potentially dilutive common shares are determined by applying the treasury stock method to the assumed exercise of outstanding stock options, RSUs, and ESPP.

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):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
  
September 30,
2011
 
September 30,
2012
  
September 30,
2011
Numerator:
 
 
 
 
 
  
 
Net income
17,206

 
17,917

 
45,329

 
45,998

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Basic shares:
 
 
 
 
 
 
 
Weighted-average common shares outstanding - basic
158,751

 
153,265

 
157,416

 
151,958

 
 
 
 
 
 
 
 
Diluted shares:
 
 
 
 
 
 
 
Weighted-average common shares outstanding - basic
158,751

 
153,265

 
157,416

 
151,958

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Employee stock options, restricted stock units, and employee stock purchase plan
8,040

 
10,604

 
8,711

 
11,596

Weighted-average shares used to compute diluted net income per share
166,791

 
163,869

 
166,127

 
163,554

Net income per share:
 
 
 
 
 
 
 
Basic
0.11

 
0.12

 
0.29

 
0.30

Diluted
0.10

 
0.11

 
0.27

 
0.28


The following weighted-average shares of common stock were excluded from the computation of diluted net income per share for the periods presented as their effect would have been antidilutive (in 000's):

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
  
September 30,
2011
Options to purchase common stock
5,686

 
5,058

 
6,847

  
3,375

RSUs
388

 

 
130

 

ESPP
303

 
186

 
300

 
186

 
6,377

 
5,244

 
7,277

 
3,561



13


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


6. DEFERRED REVENUE

Deferred revenue consisted of the following ($ amounts in 000's):
 
 
September 30,
2012
  
December 31,
2011
Product
6,391

  
5,817

Services
322,936

  
272,843

Ratable and other revenue
10,751

  
16,173

Total deferred revenue
340,078

  
294,833

Reported as:
 
  
 
Current
230,562

  
206,928

Non-current
109,516

  
87,905

Total deferred revenue
340,078

  
294,833


7. COMMITMENTS AND CONTINGENCIES

Leases— We lease certain of our facilities under various non-cancelable operating leases, which expire through 2017. Rent expense was $2.1 million for each of the three-month periods ended September 30, 2012 and September 30, 2011. Rent expense was $6.5 million and $6.1 million for the nine months ended September 30, 2012 and September 30, 2011, respectively.

The aggregate future non-cancelable minimum rental payments on operating leases as of September 30, 2012 are as follows ($ amounts in 000's):
 
 
Rental
Payment
Fiscal years:
 
2012 (remainder)
2,425

2013
7,799

2014
5,024

2015
2,291

Thereafter
579

Total
18,118


Contract Manufacturer and Other 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, 2012 , we had $23.8 million of open purchase orders with our independent contract manufacturers that are not cancelable.

In addition to commitments with contract manufacturers, we have open purchase orders and contractual obligations associated with our ordinary course of business for which we have not received goods or services. As of September 30, 2012 , we had $3.9 million in other purchase commitments.


14


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


Warranties— We generally provide a one -year warranty on hardware products and a 90 -day warranty on software. 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,
2012
 
December 31,
2011
Accrued warranty balance - beginning of the period
2,582

 
1,878

Warranty costs incurred
(1,843
)
 
(1,778
)
Provision for warranty
1,604

 
2,103

Adjustments to previous estimates
(307
)
 
379

Accrued warranty balance - end of the period
2,036

 
2,582


Litigation —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 U.S. Patent and Trademark Office (“PTO”) has rejected all of the claims of the patents in the suit and ESR appealed this result to the Board of Patent Appeals and Interferences (“BPAI”). In August 2012, the BPAI completed its review of both reexamination proceedings, and, after the BPAI's review, all claims of the asserted ESR patents remain rejected. We have determined that, as of this time, there is not a reasonable possibility that a loss has been incurred. 
 
In April 2010, an individual, a former stockholder of Fortinet, filed a class action lawsuit against us claiming unspecified damages in the California Superior Court 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. 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 several amended complaints in the Superior Court to add individual defendants, among other amendments. The Superior Court set a trial date for December 2012, but subsequently we have made progress in settlement discussions for this matter. We have determined that, as of this time, it is reasonably likely that to settle this matter, Fortinet will pay approximately $1.0 million , which has been accrued as of September 30, 2012.

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. In December 2011, the United States District Court for the Eastern District of Texas ordered the case to be transferred to the Northern District of California. In June 2012, the United States District Court for the Northern District of California dismissed the other defendants for misjoinder, and the case is proceeding with Fortinet as the sole defendant. We have determined that, as of this time, there is not a reasonable possibility that a loss has been incurred.

In June 2012, we received a letter from SRI International (“SRI”) claiming that we infringed certain SRI patents. Subsequently, we filed a complaint in the United States District Court for the Northern District of California seeking declaratory relief and a judgment that the SRI patents were invalid, unenforceable and/or not infringed by any of our products or services. The case is currently in the very early stages, and we have determined that, as of this time, there is not a reasonable possibility that a loss has been 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 by the terms of our contracts 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.


15


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


8. STOCKHOLDERS' EQUITY

Restricted Stock Units

Our 2009 Equity Incentive Plan (the “2009 Plan”) permits us to grant awards of stock options, stock appreciation rights, restricted stock, restricted stock units, and performance units or performance shares. In August 2012, we began to grant RSUs instead of stock options to employees, non-employees, and members of the board of directors. RSUs are payable in shares of our common stock as the periodic vesting requirements are satisfied. RSUs will vest over a four-year period from the date of grant if the employees, non-employees, or directors, as applicable, remain with us for the duration of the vesting period. The value of RSUs is determined based on the number of shares granted and the quoted price of our common stock on the date of grant.

The following table summarizes the RSU activity and related information for the period presented below (in 000's, except per share amounts):

 
Restricted Stock Units Outstanding
 
Number
Of Shares
 
Weighted-
Average
Grant-Date Fair Value per Share ($)
Balance—December 31, 2011

 

Granted
667

 
24.89

Forfeited
(14
)
 
24.89

Vested

 

Balance—September 30, 2012
653

 
24.89

RSUs expected to vest—September 30, 2012
602

 
24.89


As of September 30, 2012 , total compensation cost related to unvested RSUs that were granted to employees and non-employees under the 2009 Plan but not yet recognized was $16.0 million , net of estimated forfeitures. This cost is expected to be amortized on a straight-line basis over a weighted-average vesting period of 3.8 years.

Stock Options

The following table summarizes the weighted-average assumptions relating to our employee stock options:
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
Expected term in years

 
4.6

 
4.6

 
4.6

Volatility (%)

 
46.2

 
46.4 - 51.9

 
40.4 - 46.2

Risk-free interest rate (%)

 
1.5

 
0.7 - 0.9

 
1.5 - 2.0

Dividend rate (%)

 

 

 

Estimated fair value ($)

 
8.07

 
11.13

 
7.85



16


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


The following table summarizes the stock option activity and related information for the period presented below (in 000's, except per share amounts and contractual life):
 
 
Options Outstanding
 
Number
Of Shares
 
Weighted-
Average
Exercise
Price ($)
  
Weighted-
Average
Remaining
Contractual
Life (Years)
  
Aggregate
Intrinsic
Value ($)
Balance—December 31, 2011
21,389

 
9.10

  
 
  
 
Granted
3,401

 
26.38

  
 
  
 
Forfeited
(1,024
)
 
19.10

  
 
  
 
Exercised (aggregate intrinsic value of $83,313)
(4,238
)
 
5.92

  
 
  
 
Balance—September 30, 2012
19,528

 
12.32

  
 
  
 
Options vested and expected to vest—September 30, 2012
18,876

 
12.07

  
4.36

  
234,005

Options vested and exercisable—September 30, 2012
10,894

 
6.17

  
3.44

  
195,582


As of September 30, 2012 , total compensation cost related to unvested stock options granted to employees under the 2009 plan but not yet recognized was $75.5 million , net of estimated forfeitures. This cost is expected to be amortized on a straight-line basis over a weighted-average period of 2.7 years.

Shares Available for Grant

The following table presents the equity based awards (including stock options and RSUs) available for future issuance (in 000's)
 
 
 
Shares
Available
For Grant
Balance—December 31, 2011
17,399

Authorized
7,750

Options granted
(3,401
)
Options forfeited
1,024

Options exercised

RSUs granted
(667
)
RSUs forfeited
14

RSUs exercised

Balance—September 30, 2012
22,119



17


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


Employee Stock Purchase Plan

The following table summarizes the weighted-average assumptions relating to our ESPP:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
Expected term in years
0.5

 
0.5

 
0.5

 
0.5

Volatility (%)
43.1

 
59.9

 
53.7

 
59.9

Risk-free interest rate (%)
0.2

 
0.1

 
0.1

 
0.1

Dividend rate (%)

 

 

 

Estimated fair value ($)
6.63

 
6.56

 
7.06

 
6.56


Stock-based Compensation Expense

Stock-based compensation expense is included in costs and expenses as follows ($ amounts in 000's):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
Cost of product revenue
85

  
64

 
237

 
129

Cost of services revenue
1,018

  
564

 
2,704

 
1,124

Research and development
2,525

  
1,516

 
6,774

 
2,954

Sales and marketing
3,879

  
2,708

 
10,797

 
6,289

General and administrative
1,323

  
882

 
3,416

 
2,178

 
8,830

  
5,734

 
23,928

 
12,674


The following table summarizes stock-based compensation expense by award type ($ amounts in 000's):

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
Options—employee
6,825

 
5,193

 
19,507

 
11,877

Options—non-employee
160

 
6

 
475

 
262

RSUs
576

 

 
576

 

ESPP
1,269

 
535

 
3,370

 
535

 
8,830

 
5,734

 
23,928

 
12,674



18


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


9. INCOME TAXES

The effective tax rate was 36% for the three months ended September 30, 2012, compared to an effective tax rate of 34% for the three months ended September 30, 2011. The effective tax rate was 34% for the nine months ended September 30, 2012, compared to an effective tax rate of 29% for the nine months ended September 30, 2011. The provision for income taxes for the periods presented is comprised of foreign income taxes, U.S. federal and state taxes, and withholding tax.

As of September 30, 2012 and December 31, 2011 , unrecognized tax benefits were $25.2 million and $19.3 million , respectively. The total amount of $25.2 million in 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 taxes. As of September 30, 2012 , we had approximately $1.5 million accrued for estimated interest related to uncertain tax positions. We do not expect any material unrecognized tax benefits to expire within the next twelve months.

10. EMPLOYEE BENEFIT PLAN

The 401(k) tax-deferred savings plan (the “401(k) Plan”) permits participants to make contributions by salary deduction pursuant to Section 401(k) of the Internal Revenue Code of 1986, as amended. Under the 401(k) Plan, participating employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit. In Canada, we have a Group Registered Retirement Savings Plan program (the “RRSP Plan”) which permits participants to make tax deductible contributions up to the maximum contribution limits under the Income Tax Act. Our aggregate matching contributions to the 401(k) Plan and RRSP Plan for the three and nine months ended September 30, 2012 were $0.4 million and $1.4 million , respectively. Our aggregate matching contributions to the 401(k) Plan and RRSP Plan for the three and nine months ended September 30, 2011 were $0.4 million and $1.2 million , respectively.


11. SEGMENT AND SIGNIFICANT CUSTOMER INFORMATION

The following tables set forth revenue, and property and equipment—net, by geographic region ($ amounts in 000's):
 
 
Three Months Ended
 
Nine Months Ended
Revenue
September 30,
2012
  
September 30,
2011
 
September 30,
2012
  
September 30,
2011
Americas:
 
 
 
 
 
 
 
United States
38,674

  
36,565

 
103,983

 
88,838

Other Americas
18,543

 
13,463

 
51,587

 
37,376

Total Americas
57,217

 
50,028

 
155,570

 
126,214

Europe, Middle East and Africa (“EMEA”)
45,566

  
37,942

 
130,116

 
108,216

Asia Pacific and Japan (“APAC”)
33,485

  
28,456

 
96,791

 
78,285

Total revenue
136,268

  
116,426

 
382,477

 
312,715


During the three and nine months ended September 30, 2012, one distributor, Exclusive Networks, accounted for 10% and 11% of revenue, respectively. During the three and nine months ended September 30, 2011, no single customer or distributor accounted for 10% or more of total revenue.


19


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


Property and Equipment—Net
September 30,
2012
  
December 31,
2011
Americas:
 
 
 
United States
18,499

 
2,225

Canada
4,888

 
4,062

Other Americas
78

 
33

Total Americas
23,465

 
6,320

EMEA
1,348

  
805

APAC
1,207

  
841

Total property and equipment—net
26,020

  
7,966


12. FOREIGN CURRENCY DERIVATIVES

The notional value of our outstanding forward exchange contracts that were entered into in order to hedge balance sheet accounts as of September 30, 2012 consisted of the following ($ amounts in 000's):

 
Buy/Sell
 
Notional
Balance Sheet Contracts:
 
 
 
Currency
 
 
 
CAD
Buy
 
16,812

EUR
Buy
 
5,908

GBP
Buy
 
3,083

 
 
 
 

13. ACQUISITION

On March 8, 2012, we completed the acquisition of IntruGuard Devices (“IntruGuard”), a leading supplier of Intelligent Availability Protection Systems, for a total consideration of $950,000 . Of the total consideration, $400,000 is being withheld in escrow as security for IntruGuard's indemnification obligations. We accounted for this acquisition as a purchase of a business and, accordingly, the total purchase price has been allocated to 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 $53,000 and liabilities of $43,000 , and purchased identifiable intangible assets of $940,000 . Identifiable intangible assets consist of purchased technology. The fair value assigned to identifiable intangible assets acquired was 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 expensed as Cost of revenue on a straight-line basis over three years. Of the $400,000 previously withheld in escrow, $199,000 was released to the selling shareholders during the three months ended September 30, 2012.


20


FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


14. INTANGIBLE ASSETS

The following table presents the detail of our intangible assets with definite lives included in other assets ($ amounts in 000's):

 
September 30,
2012
 
December 31,
2011
 
Gross
 
Accumulated Amortization
 
Net
 
Gross
 
Accumulated Amortization
 
Net
Existing technology
3,041

 
1,145

 
1,896

 
1,772

 
394

 
1,378


Amortization expense was $0.3 million and $0.2 million for the three months ended September 30, 2012 and September 30, 2011, respectively, and $0.7 million and $0.3 million for the nine months ended September 30, 2012 and September 30, 2011, respectively. The following table summarizes estimated future amortization expense of intangible assets with definite lives as of September 30, 2012 ($ amounts in 000's):

 
Amount
Fiscal Years:
 
2012 (remainder)
279

2013
964

2014
540

2015
108

2016
5

Total
1,896





21


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;

expected impact of sales of certain products;
 
continued sales into large enterprises;

mix of billings between products and services;

mix of service sales containing multi-year support and subscription contracts;

the significance of stock-based 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;
 
the impact of our product innovation strategy;
 
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;

our effective tax rate; 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 SEC filings, including our Form 10-K. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Business Overview

We provide 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 governmental entities worldwide. As of September 30, 2012 , we had shipped over 1,000,000 appliances to more than 10,000 channel partners and to more than 140,000 end-customers worldwide, including a majority of the Fortune Global 100.

Our core Unified Threat Management (“UTM”) product line of FortiGate physical and virtual appliances ships with a set of security and networking capabilities, including firewall, VPN, application control, antivirus, intrusion prevention, Web filtering, antispam and WAN acceleration functionality. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20 series, designed for small businesses, to the FortiGate-5000 series for large enterprises, telecommunications carriers, and service providers. Sales of FortiGate products are generally balanced across entry-level (FortiGate-20 to -100 series), mid-range (FortiGate-200 to -800 series) and high-end (FortiGate-1000 to -5000 series) models with each product category representing approximately one-third of FortiGate sales. 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 intrusion prevention, application control, antivirus, Web filtering, vulnerability management 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

22


Table of Contents

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, protection against denial of service attacks (DDoS) and endpoint security for employee computers and mobile devices. Sales of these complementary products have grown in recent quarters, although these products still represent less than 10% of our revenue.

In October 2012, we announced our new FortiOS 5.0 operating system.  FortiOS 5.0 is our fifth generation security operating system, and this release brings more than 150 new features to our FortiGate product line. In addition, we announced version 5.0 operating systems for our FortiManager, FortiAnalyzer, and FortiClient products, to address the need for increasingly sophisticated management and analysis of the network infrastructure and endpoint devices in various environments.

In October 2012, we also announced our new FortiASIC-SoC2 processor. FortiASIC-SoC2 is our second-generation processor that combines general purpose processing power with Fortinet's custom technology to provide hardware-accelerated network security performance for our FortiGate appliances. It provides more than double the general processing capacity than its predecessor.

Financial Highlights

We recorded revenue of $136.3 million and $382.5 million during the three and nine months ended September 30, 2012, respectively. This represents an increase of 17% and 22% during the three and nine months ended September 30, 2012, respectively, compared to the same periods last year. Revenue included $1.8 million and $2.6 million from the sales of previously-acquired patents during the three months ended September 30, 2012 and September 30, 2011, respectively. Product revenue was $63.0 million and $177.9 million during the three and nine months ended September 30, 2012, respectively, an increase of 19% and 27% during the three and nine months ended September 30, 2012, respectively, compared to the same periods last year. Services revenue was $69.8 million and $197.3 million during the three and nine months ended September 30, 2012, respectively, an increase of 21% and 24% during the three and nine months ended September 30, 2012, respectively, compared to the same periods last year.

We generated cash flows from operating activities of $133.6 million during the nine months ended September 30, 2012, an increase of 21% compared to the same period last year.

Cash, cash equivalents and investments were $690.3 million as of September 30, 2012, an increase of $151.6 million from December 31, 2011.

Deferred revenue was $340.1 million as of September 30, 2012, an increase of $45.2 million from December 31, 2011.

During the three months ended September 30, 2012, revenues grew as a result of the successful execution of our global sales strategy and the continued product innovation that has strengthened our technology advantages and resulted in market share gains. The recent introduction of several new FortiGate entry-level appliances such as the FortiGate-20C and -40C with their WIFI counterparts and the FortiGate-100D; the FortiGate-600C and FortiGate-800C mid-range appliances; and the FortiGate-1000C, FortiGate-3240C and FortiGate-5101C for large enterprises and service providers continued to gain traction and contributed to the revenue growth.

We continue to invest in research and development to strengthen our technology leadership position, as well as sales and marketing to expand brand awareness, strengthen our value proposition, and expand our global sales team and distribution channels. We experienced healthy deal volumes driven by traction in enterprise data center deployments, large enterprise deals, with particular strength in the retail, financial and telecommunications sectors. The number of deals involving sales greater than $100,000 was 168 in the three months ended September 30, 2012, compared to 130 in the three months ended September 30, 2011. The number of deals involving sales greater than $250,000 was 61 in the three months ended September 30, 2012, compared to 39 in the three months ended September 30, 2011. The number of deals involving sales greater than $500,000 was 16 in the three months ended September 30, 2012, compared to 13 in the three months ended September 30, 2011. 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 meet increasing customer expectations about the quality and functionality of our products, as we continue to sell to large customers, such as enterprise and service providers. While we have experienced some success selling into certain vertical customer segments, such as service providers and enterprise, we have experienced less traction selling into other verticals such as the U.S. federal government and there can be

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no assurance we will be successful selling into certain vertical customer segments.
 
During the three months ended September 30, 2012, operating expenses increased by 23% compared to the same period last year. The increase was primarily driven by additional headcount to support our growth as we continued to invest in the development of new products and expand our sales coverage. We also incurred $1.3 million of litigation settlement expense in the three months ended September 30, 2012. These increases were partially offset by favorable foreign currency exchange rates compared to the same period last year. Headcount increased to 1,854 at September 30, 2012 from 1,527 at September 30, 2011. Our accelerated pace of hiring continued this quarter, particularly in support, sales and marketing and research and development as we increased headcount by 92 from June 30, 2012.
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 $8.7 million from $331.4 million at June 30, 2012 to $340.1 million at September 30, 2012 . 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 three months ended September 30, 2012 with $690.3 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 under “Results of Operations,” 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.
 
 
For The Three Months Ended Or As Of
 
September 30,
2012
 
September 30,
2011
 
($ amounts in 000's)
Revenue
136,268

 
116,426

Gross margin
72
%
 
73
%
Operating income (1)
25,770

 
26,160

Operating margin
19
%
 
22
%
Total deferred revenue
340,078

 
275,126

Increase in total deferred revenue over prior quarter
8,710

 
1,927

Cash, cash equivalents and investments
690,303

 
502,967

Cash flows from operating activities
40,770

 
36,039

Free cash flow (2)
24,342

 
34,704

----------
 
 
 
(1)    Includes:
 
 
 
 Stock-based compensation expense
8,830

 
5,734

 Patent settlement income
478

 
478

(2)    Free cash flow is a non-GAAP financial measure, which is defined as net cash provided by operating activities less 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. For a discussion of the limitations of non-GAAP financial measures, see “—Other Non-GAAP Financial Measures” below.


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Three Months Ended
 
September 30,
2012
 
September 30,
2011
 
($ amounts in 000's)
Billings:
 
 
 
Revenue
136,268

 
116,426

Increase in deferred revenue
8,710

 
1,927

Total billings (Non-GAAP)
144,978

 
118,353


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 and free cash flow 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. For a discussion of the limitations of non-GAAP financial measures, see “—Other Non-GAAP Financial Measures” below.

 
Three Months Ended
 
September 30,
2012
 
September 30,
2011
 
($ amounts in 000's)
Free Cash Flow:
 
 
 
Net cash provided by operating activities
40,770

 
36,039

Less purchases of property and equipment
(16,428
)
 
(1,335
)
Free cash flow (Non-GAAP)
24,342

 
34,704


Other 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 billings and free cash flow discussed above as well as non-GAAP gross margin, non-GAAP income from operations and non-GAAP operating margin, non-GAAP operating expenses and non-GAAP net income. 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 a 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

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income, as reported on our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense and the income from a 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 three months ended September 30, 2012 and September 30, 2011.
 
Three Months Ended
 
September 30,
2012
 
September 30,
2011
 
Amount
  
% of
Revenue
 
Amount
  
% of
Revenue
 
($ amounts in 000's)
Total revenue
136,268

  
 
 
116,426

  
 
 
 
 
 
 
 
 
 
GAAP gross profit and margin
98,460

  
72

 
85,287

  
73

Stock-based compensation expense
1,103

 
1

 
628

 
1

Non-GAAP gross profit and margin
99,563

  
73

 
85,915

  
74

 
 
 
 
 
 
 
 
GAAP income from operations and margin
25,770

  
19

 
26,160

  
22

Stock-based compensation expense:
 
  
 
 
 
  
 
Cost of revenue
1,103

  
1

 
628

  
1

Research and development
2,525

  
1

 
1,516

  
1

Sales and marketing
3,879

  
3

 
2,708

  
2

General and administrative
1,323

  
1

 
882

  
1

Total stock-based compensation
8,830

  
6

 
5,734

  
5

Patent settlement
(478
)
 

 
(478
)
 

Non-GAAP income from operations and margin
34,122

  
25

 
31,416

  
27


Non-GAAP operating expenses exclude the impact of stock-based compensation expense and the income from a patent settlement. The following tables reconcile GAAP operating expenses to non-GAAP operating expenses for the three months ended September 30, 2012 and September 30, 2011.


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Three Months Ended
 
September 30,
2012
 
September 30,
2011
 
Amount
  
% of
Revenue
 
Amount
  
% of
Revenue
 
($ amounts in 000's)
Operating Expenses:
 
 
 
 
 
  
 
Research and development expenses:
 
 
 
 
 
  
 
GAAP research and development expenses
20,498

 
15

 
16,834

  
14

Stock-based compensation
(2,525
)
 
(1
)
 
(1,516
)
  
(1
)
Non-GAAP research and development expenses
17,973

 
14

 
15,318

  
13

 
 
 
 
 
 
 
 
Sales and marketing expenses:
 
 
 
 
 
  
 
GAAP sales and marketing expenses
44,743

 
33

 
36,934

  
32

Stock-based compensation
(3,879
)
 
(3
)
 
(2,708
)
  
(2
)
Non-GAAP sales and marketing expenses
40,864

 
30

 
34,226

  
30

 
 
 
 
 
 
 
 
General and administrative expenses:
 
 
 
 
 
  
 
GAAP general and administrative expenses
7,449

 
5

 
5,359

  
5

Stock-based compensation
(1,323
)
 
(1
)
 
(882
)
  
(1
)
Patent settlement
478

 

 
478

 

Non-GAAP general and administrative expenses
6,604

 
4

 
4,955

  
4

 
 
 
 
 
 
 
 
Total operating expenses:
 
 
 
 
 
  
 
GAAP operating expenses
72,690

 
53

 
59,127

  
51

Stock-based compensation
(7,727
)
 
(5
)
 
(5,106
)
  
(4
)
Patent settlement
478

 

 
478

 

Non-GAAP operating expenses
65,441

 
48

 
54,499

  
47


Non-GAAP net income is net income, as reported in our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense and income from a 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 three months ended September 30, 2012 and September 30, 2011.

 
Three Months Ended
 
September 30,
2012
 
September 30,
2011
 
($ amounts in 000's)
Net Income:
 
 
 
GAAP net income
17,206

  
17,917

Stock-based compensation expense (1)
8,830

  
5,734

Patent settlement (2)
(478
)
 
(478
)
Provision for income taxes (3)
9,565

  
9,207

Non-GAAP income before provision for income taxes
35,123