Fortinet, Inc.
FORTINET INC (Form: 10-Q, Received: 05/08/2013 16:33:16)
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
  FORM 10-Q
(Mark One)
T
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2013
or
o
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   o
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   o  
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
o
Non-accelerated filer
o  
(Do not check if smaller reporting company)
 
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   o      No   x
As of April 30, 2013 , there were 162,225,326 shares of the registrant’s common stock outstanding.




FORTINET, INC.
QUARTERLY REPORT ON FORM 10-Q
For the Quarter Ended March 31, 2013
Table of Contents
 
 
 
 
 
 
Page
 
 
 
 
Part I
 
 
 
 
Item 1.
Item 2.
Item 3.
Item 4.
 
 
 
 
Part II
 
 
 
 
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, except per share amounts)
 
 
March 31,
2013
 
December 31,
2012
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
97,384

 
$
122,975

Short-term investments
362,996

 
290,719

Accounts receivable—Net
102,359

 
107,642

Inventory
23,933

 
21,060

Prepaid expenses and other current assets
26,988

 
26,878

Total current assets
613,660

 
569,274

PROPERTY AND EQUIPMENT—Net
25,803

 
25,638

LONG-TERM INVESTMENTS
322,158

 
325,892

GOODWILL AND OTHER INTANGIBLE ASSETS—Net
9,964

 
2,117

OTHER ASSETS
61,144

 
52,576

TOTAL ASSETS
$
1,032,729

 
$
975,497

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
26,369

 
$
20,816

Accrued liabilities
21,677

 
22,263

Accrued payroll and compensation
26,350

 
28,957

Deferred revenue
257,332

 
247,268

Total current liabilities
331,728

 
319,304

DEFERRED REVENUE—Non-current
119,082

 
115,917

OTHER LIABILITIES
34,210

 
29,342

Total liabilities
485,020

 
464,563

COMMITMENTS AND CONTINGENCIES (Note 7)


 


STOCKHOLDERS’ EQUITY:
 
 
 
Common stock, $0.001 par value — 300,000 shares authorized; 163,550 and 161,757 shares issued and 162,141 and 160,348 shares outstanding as of March 31, 2013 and December 31, 2012, respectively
164

 
162

Additional paid-in capital
425,524

 
400,075

Treasury stock
(2,995
)
 
(2,995
)
Accumulated other comprehensive income
2,166

 
3,091

Retained earnings
122,850

 
110,601

Total stockholders’ equity
547,709

 
510,934

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
1,032,729

 
$
975,497

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
March 31,
2013
 
March 31,
2012
REVENUE:
 
 
 
Product
$
57,950

 
$
53,204

Services
75,896

 
62,138

Ratable and other revenue
1,974

 
1,905

Total revenue
135,820

 
117,247

COST OF REVENUE:
 
 
 
Product
22,958

 
19,067

Services
15,574

 
11,213

Ratable and other revenue
596

 
763

Total cost of revenue
39,128

 
31,043

GROSS PROFIT:
 
 
 
Product
34,992

 
34,137

Services
60,322

 
50,925

Ratable and other revenue
1,378

 
1,142

Total gross profit
96,692

 
86,204

OPERATING EXPENSES:
 
 
 
Research and development
23,334

 
19,667

Sales and marketing
49,976

 
42,036

General and administrative
7,991

 
5,786

Total operating expenses
81,301

 
67,489

OPERATING INCOME
15,391

 
18,715

INTEREST INCOME
1,369

 
1,085

OTHER INCOME (EXPENSE)—Net
215

 
(71
)
INCOME BEFORE INCOME TAXES
16,975

 
19,729

PROVISION FOR INCOME TAXES
4,726

 
5,556

NET INCOME
$
12,249

 
$
14,173

Net income per share:
 
 
 
Basic
$
0.08

 
$
0.09

Diluted
$
0.07

 
$
0.09

Weighted-average shares outstanding:
 
 
 
Basic
161,282

 
156,010

Diluted
167,823

 
165,751

See notes to condensed consolidated financial statements.


4


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


 
Three Months Ended
 
March 31,
2013
 
March 31,
2012
Net income
$
12,249

 
$
14,173

Other comprehensive (loss) income, net of reclassification adjustments:
 
 
 
Foreign currency translation (losses) gains
(952
)
 
558

Unrealized gains on investments
42

 
1,799

Tax provision related to items of other comprehensive income or loss
(15
)
 
(629
)
Other comprehensive (loss) income, net of tax
(925
)
 
1,728

Comprehensive income
$
11,324

 
$
15,901


See notes to condensed consolidated financial statements.




5


FORTINET, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
 
Three Months Ended
 
March 31,
2013
 
March 31,
2012
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
12,249

 
$
14,173

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
3,536

 
2,082

Amortization of investment premiums
3,051

 
3,255

Stock-based compensation expense
9,299

 
7,246

Excess tax benefit from employee stock option plans
(1,453
)
 
(2,320
)
Other non-cash items, net
(540
)
 
19

Changes in operating assets and liabilities:
 
 
 
Accounts receivable—Net
5,747

 
10,763

Inventory
(4,520
)
 
(3,409
)
Prepaid expenses and other current assets
(202
)
 
(345
)
Other assets
(8,568
)
 
569

Accounts payable
4,957

 
(6,319
)
Accrued liabilities
(11
)
 
(231
)
Accrued payroll and compensation
(2,416
)
 
(547
)
Deferred revenue
12,677

 
19,696

Income taxes payable
4,305

 
3,886

Net cash provided by operating activities
38,111

 
48,518

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of investments
(171,506
)
 
(192,567
)
Sales of investments
13,823

 
17,416

Maturities of investments
86,018

 
115,026

Purchases of property and equipment
(1,534
)
 
(1,624
)
Payments made in connection with acquisitions, net of cash acquired
(5,979
)
 
(550
)
Net cash used in investing activities
(79,178
)
 
(62,299
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
14,464

 
13,551

Excess tax benefit from employee stock option plans
1,453

 
2,320

Net cash provided by financing activities
15,917

 
15,871

EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS
(441
)
 
703

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
(25,591
)
 
2,793

CASH AND CASH EQUIVALENTS—Beginning of period
122,975

 
71,990

CASH AND CASH EQUIVALENTS—End of period
$
97,384

 
$
74,783

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid for income taxes
$
8,579

 
$
1,010

NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Purchase of property and equipment not yet paid
$
744

 
$
688

Liability incurred in connection with business acquisition
$

 
$
400

See notes to condensed consolidated financial statements.

6


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


1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Preparation

The unaudited condensed consolidated financial statements of Fortinet, Inc. and its wholly owned subsidiaries (collectively, “we,” “us,” or “our”) have been prepared in accordance with U.S. generally accepted accounting principles (“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 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, 2012, contained in our Annual Report on Form 10-K (“Form 10-K”) filed with the SEC on February 27, 2013. 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 months ended March 31, 2013 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 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 material changes in our significant accounting policies as of and for the three months ended March 31, 2013 , as compared to the significant accounting policies described in the Form 10-K.  

Certain prior period amounts have been combined on the condensed consolidated balance sheets.

Recently Adopted Accounting Pronouncement

In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2013-02, Comprehensive Income (Topic 220)—Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income (“ASU 2013-02”). ASU 2013-02 requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under GAAP to be reclassified in its entirety to net income. For other amounts that are not required under GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under GAAP that provide additional detail about those amounts. We adopted ASU 2013-02 in the three months ended March 31, 2013. The amounts reclassified out of accumulated other comprehensive income were immaterial for the three months ended March 31, 2013 and March 31, 2012.


7

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


2. FINANCIAL INSTRUMENTS AND FAIR VALUE

The following table summarizes our investments ($ amounts in 000’s):
 
 
March 31, 2013
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
559,417

 
1,944

 
(251
)
 
561,110

Commercial paper
76,408

 
23

 
(8
)
 
76,423

Municipal bonds
38,939

 
94

 
(6
)
 
39,027

Certificates of deposit and term deposits
8,590

 
5

 
(1
)
 
8,594

Total available-for-sale securities
683,354

 
2,066

 
(266
)
 
685,154

 
 
 
 
 
 
 
 
 
December 31, 2012
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
529,738

 
1,814

 
(161
)
 
531,391

Commercial paper
39,229

 
22

 
(6
)
 
39,245

Municipal bonds
36,787

 
83

 

 
36,870

Certificates of deposit and term deposits
9,099

 
6

 

 
9,105

Total available-for-sale securities
614,853

 
1,925

 
(167
)
 
616,611



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, as of March 31, 2013 ($ 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
168,514

 
(251
)
 

 

 
168,514

 
(251
)
Commercial paper
11,279

 
(8
)
 

 

 
11,279

 
(8
)
Municipal bonds
7,074

 
(6
)
 

 

 
7,074

 
(6
)
Certificates of deposit and term deposits
1,000

 
(1
)
 

 

 
1,000

 
(1
)
Total available-for-sale securities
187,867

 
(266
)
 

 

 
187,867

 
(266
)

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, as of December 31, 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
133,006

 
(156
)
 
5,010

 
(5
)
 
138,016

 
(161
)
Commercial paper
8,464

 
(6
)
 

 

 
8,464

 
(6
)
Total available-for-sale securities
141,470

 
(162
)
 
5,010

 
(5
)
 
146,480

 
(167
)

8

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



The contractual maturities of our investments were as follows ($ amounts in 000’s)
 
 
March 31,
2013
 
December 31,
2012
Due within one year
362,996

 
290,719

Due within one to three years
322,158

 
325,892

Total
685,154

 
616,611



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 March 31, 2013 and December 31, 2012 ($ amounts in 000’s):
 
 
March 31, 2013
 
December 31, 2012
 
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:
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
561,110

 

 
561,110

 
531,391

 

 
531,391

Commercial paper
80,822

 

 
80,822

 
41,994

 

 
41,994

Municipal bonds
39,027

 

 
39,027

 
36,870

 

 
36,870

Certificates of deposit and term deposits
8,594

 

 
8,594

 
9,105

 

 
9,105

Money market funds
12,528

 
12,528

 

 
39,871

 
39,871

 

Total
702,081

 
12,528

 
689,553

 
659,231

 
39,871

 
619,360

Reported as:
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
16,927

 
 
 
 
 
42,620

 
 
 
 
Short-term investments
362,996

 
 
 
 
 
290,719

 
 
 
 
Long-term investments
322,158

 
 
 
 
 
325,892

 
 
 
 
Total
702,081

 
 
 
 
 
659,231

 
 
 
 

We did not hold financial assets or liabilities which were recorded at fair value using inputs in the Level 3 category as of March 31, 2013 or December 31, 2012 . There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the three months ended March 31, 2013 .

9

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



3. INVENTORY

Inventory consisted of the following ($ amounts in 000’s):
 
 
March 31,
2013
 
December 31,
2012
Raw materials
5,226

 
4,958

Finished goods
18,707

 
16,102

Inventory
23,933

 
21,060


 
4. PROPERTY AND EQUIPMENT—Net

Property and equipment consisted of the following ($ amounts in 000’s):
 
 
March 31,
2013
 
December 31,
2012
Land
13,895

 
13,895

Building and building improvements
610

 
610

Evaluation units
19,708

 
18,322

Computer equipment and software
18,483

 
17,176

Furniture and fixtures
1,637

 
1,501

Leasehold improvements and tooling
5,510

 
5,354

Total property and equipment
59,843

 
56,858

Less: accumulated depreciation
(34,040
)
 
(31,220
)
Property and equipment—net
25,803

 
25,638



Depreciation expense was $3.2 million and $2.1 million for the three months ended March 31, 2013 and March 31, 2012, respectively.



10

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


5. NET INCOME PER SHARE

Basic net income per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding, plus the dilutive effects of stock options, restricted stock units (“RSUs”), and the employee stock purchase plan (“ESPP”). Potentially dilutive shares of common stock are determined by applying the treasury stock method.

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
 
March 31,
2013
 
March 31,
2012
Numerator:
 
 
 
Net income
12,249

 
14,173

 
 
 
 
Denominator:
 
 
 
Basic shares:
 
 
 
Weighted-average common stock outstanding-basic
161,282

 
156,010

Diluted shares:
 
 
 
Weighted-average common stock outstanding-basic
161,282

 
156,010

Effect of potentially dilutive securities:
 
 
 
Stock options
6,457

 
9,699

RSUs
72

 

ESPP
12

 
42

Weighted-average shares used to compute diluted net income per share
167,823

 
165,751

Net income per share:
 
 
 
Basic
0.08

 
0.09

Diluted
0.07

 
0.09



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
 
March 31,
2013
 
March 31,
2012
Stock options
6,751

 
6,028

RSUs
1,069

 

ESPP
331

 
262

 
8,151

 
6,290



11

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


6. DEFERRED REVENUE

Deferred revenue consisted of the following ($ amounts in 000’s):
 
 
March 31,
2013
 
December 31,
2012
Product
4,823

 
5,411

Services
363,739

 
348,548

Ratable and other revenue
7,852

 
9,226

Total deferred revenue
376,414

 
363,185

Reported As:
 
 
 
Short-term
257,332

 
247,268

Long-term
119,082

 
115,917

Total deferred revenue
376,414

 
363,185


7. COMMITMENTS AND CONTINGENCIES

Leases —We lease certain facilities under various non-cancelable operating leases, which expire through 2020. In March 2013, we extended the operating lease for one of our existing facilities in Canada through 2020. The total incremental lease payments are $14.3 million . Rent expense was $2.3 million and $2.2 million during the three months ended March 31, 2013 and March 31, 2012, respectively. Rent expense is recognized using the straight-line method over the term of the lease. The aggregate future non-cancelable minimum rental payments on operating leases as of March 31, 2013 are as follows ($ amounts in 000’s):
 
 
Rental
Payment
Fiscal Years:
 
2013 (remainder)
6,481

2014
5,121

2015
3,630

2016
3,230

2017
2,905

Thereafter
7,254

Total
28,621


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 cancellable. As of March 31, 2013 , we had $36.6 million of open purchase orders with our independent contract manufacturers that may not be cancellable.
 
In addition to commitments with contract manufacturers, we have open purchase orders and contractual obligations in the ordinary course of business for which we have not received goods or services. As of March 31, 2013 , we had $9.2 million in other purchase commitments.


12

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


Warranties —We generally provide a 1 -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 Three Months Ended And As Of
 
For The Year Ended And As Of
 
March 31,
2013
 
December 31,
2012
Accrued warranty balance—beginning of the period
2,309

 
2,582

Warranty costs incurred
(759
)
 
(2,669
)
Provision for warranty
674

 
2,639

Changes in prior period estimates
60

 
(243
)
Accrued warranty balance—end of the period
2,284

 
2,309

 

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 in the U.S. Patent and Trademark Office (“PTO”) on both asserted patents. The PTO 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. In October 2012, ESR filed an additional appeal of the BPAI decision with the United States Court of Appeal for the Federal Circuit. That appeal is still pending. We have determined that, as of this time, there is not a reasonable possibility that a loss has been 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. 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. This case is currently scheduled for a jury trial starting in September 2013. 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 not infringed by any of our products or services. The case is proceeding in the United States District Court for the Northern District of California. The case is currently in the 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.

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


8. STOCKHOLDERS’ EQUITY

Employee Stock Options

The following table summarizes the weighted-average assumptions relating to our employee stock options:
 
 
Three Months Ended
 
March 31,
2012
Expected term in years
4.6

Volatility (%)
52

Risk-free interest rate (%)
0.7

Dividend rate (%)


There were no stock options granted during the three months ended March 31, 2013.

The following table summarizes the stock option activity and related information for the periods presented below (in 000’s, except per share amounts, exercise prices and contractual life):
 
 
Options Outstanding
 
Number
of Shares
 
Weighted-
Average
Exercise
Price ($)
 
Weighted-
Average
Remaining
Contractual
Life (Years)
 
Aggregate
Intrinsic
Value ($)
Balance—December 31, 2012
18,571

 
12.40

 
 
 
 
Forfeited
(325
)
 
21.05

 
 
 
 
Exercised
(1,464
)
 
5.41

 
 
 
 
Balance—March 31, 2013
16,782

 
12.84

 
 
 
189,979

Options vested and expected to vest—March 31, 2013
16,751

 
12.82

 
4.0
 
189,932

Options exercisable—March 31, 2013
11,157

 
8.63

 
3.3
 
170,182


The aggregate intrinsic value represents the pre-tax difference between the exercise price of stock options and the quoted market price of our common stock on March 31, 2013, for all in-the-money options. As of March 31, 2013 , total compensation expense related to unvested stock options granted to employees but not yet recognized was $58.1 million , net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average period of 2.4 years.  

Additional information related to our stock options is summarized below ($ amounts in 000’s, except per share amounts):

 
Three Months Ended
 
March 31, 2013
 
March 31, 2012
Weighted-average fair value per share granted

 
11.23

Intrinsic value of options exercised
26,059

 
38,102

Fair value of options vested
11,004

 
8,193



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


Restricted Stock Units

The following table summarizes the activity and related information for RSUs 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, 2012
830

 
23.73

Granted
2,072

 
23.31

Forfeited
(70
)
 
23.64

Balance—March 31, 2013
2,832

 
23.44

RSUs expected to vest—March 31, 2013
2,607

 
23.44


As of March 31, 2013 , total compensation expense related to unvested RSUs that were granted to employees and non-employees, but not yet recognized, was $64.7 million , net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 3.7 years.

Employee Stock Purchase Plan

In determining the fair value of the shares subject to our ESPP, we use the Black-Scholes option pricing model that employs the following weighted-average assumptions:

 
Three Months Ended
 
March 31, 2013
 
March 31, 2012
Expected term in years
0.5

 
0.5

Volatility (%)
48

 
58

Risk-free interest rate (%)
0.1

 
0.2

Dividend rate (%)

 


Additional information related to our ESPP is provided below (in 000’s, except per share amounts):

 
Three Months Ended
 
March 31, 2013
 
March 31, 2012
Weighted-average fair value per share granted ($)
6.83

 
8.08

Shares issued under the ESPP
329

 
288

Weighted-average price per share issued ($)
19.91

 
17.51



15

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


Stock-based Compensation Expense

Stock-based compensation expense is included in costs and expenses as follows ($ amounts in 000’s):
 
Three Months Ended
 
March 31,
2013
 
March 31,
2012
Cost of product revenue
90

 
64

Cost of services revenue
1,020

 
745

Research and development
2,766

 
1,957

Sales and marketing
4,118

 
3,443

General and administrative
1,305

 
1,037

Total stock-based compensation expense
9,299

 
7,246


The following table summarizes stock-based compensation expense by award type ($ amounts in 000’s)
 
Three Months Ended
 
March 31,
2013
 
March 31,
2012
Stock options
5,486

 
6,316

RSUs
2,674

 

ESPP
1,139

 
930

Total stock-based compensation expense
9,299

 
7,246


Total income tax benefit from employee stock option plans that is recognized in the consolidated statements of operations is as follows ($ amounts in 000’s):

 
Three Months Ended
 
March 31,
2013
 
March 31,
2012
Income tax benefit from employee stock option plans
3,587

 
6,674



9. INCOME TAXES

The effective tax rate was 28% for each of the three months ended March 31, 2013 and March 31, 2012. 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 March 31, 2013 and December 31, 2012, unrecognized tax benefits were $30.2 million and $27.8 million , respectively. The total amount of $29.7 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 March 31, 2013 , we had approximately $1.9 million accrued for estimated interest related to uncertain tax provisions. We do not expect any material unrecognized tax benefits to expire within the next twelve months.


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


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 annual contribution limit specified by the Internal Revenue Service (“IRS”). In Canada, we have a Group Registered Retirement Savings Plan program (the “RRSP”) which permits participants to make tax deductible contributions up to the maximum contribution limits under the Income Tax Act. Our matching contributions to the 401(k) Plans and RRSP were $0.5 million for each of the three months ended March 31, 2013 and March 31, 2012.

11. SEGMENT AND SIGNIFICANT CUSTOMER INFORMATION

The following tables set forth revenue and property and equipment by geographic region ($ amounts in 000’s):
 
 
Three Months Ended
Revenue
March 31,
2013
 
March 31,
2012
Americas:
 
 
 
United States
34,788

 
31,119

Other Americas
17,839

 
15,312

Total Americas
52,627

 
46,431

Europe, Middle East and Africa (“EMEA”)
47,326

 
40,886

Asia Pacific and Japan (“APAC”)
35,867

 
29,930

Total revenue
135,820

 
117,247


During the three months ended March 31, 2013 and March 31, 2012, one distributor, Exclusive Networks Group, accounted for 12% and 11% of total revenue, respectively.

Property and Equipment
March 31,
2013
 
December 31,
2012
Americas:
 
 
 
United States
19,281

 
18,764

Canada
3,813

 
4,376

Other Americas
56

 
87

Total Americas
23,150

 
23,227

EMEA
1,652

 
1,213

APAC
1,001

 
1,198

Total property and equipment—net
25,803

 
25,638


12. FOREIGN CURRENCY DERIVATIVES

The notional amount of forward exchange contracts to hedge balance sheet accounts as of March 31, 2013 was ($ amounts in 000’s):

 
Buy/Sell
 
Notional
Balance Sheet Contracts:
 
 
 
Currency
 
 
 
CAD
Buy
 
22,164



17

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


13. BUSINESS COMBINATIONS

On March 21, 2013, we acquired all of the outstanding equity securities of Coyote Point Systems, Inc. ( “Coyote” ), a provider of enterprise-class application delivery, load balancing and acceleration solutions, for $6.0 million in cash. The acquisition also includes a contingent obligation for up to $5.5 million in future earn-out payments to former stockholders of Coyote, if specified future operational objectives, service conditions and financial results are met within two years of the acquisition date. Of the maximum $5.5 million in contingent earn-out payments, up to $3.5 million will be payable after eighteen months from the acquisition date, and up to $2.0 million will be payable after two years from the acquisition date. As the future earn-out payments are also contingent upon one of Coyote’s former stockholders being in continued employment with us during the earn-out period, these contingent obligations will be recorded as compensation expense ratably over the earn-out periods for future services provided to us.

We accounted for this acquisition as a purchase of a business and, accordingly, the total purchase price was allocated to Coyote’s identifiable tangible and intangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date. The fair value assigned to the intangible assets acquired was determined using the income approach which discounts expected cash flows to present value using our estimates and assumptions.

The following table summarizes the fair value of assets acquired and liabilities assumed as of the acquisition date ($ amounts in 000’s):
Cash and cash equivalents
206

Other current assets
501

Finite-lived intangible assets
2,800

Indefinite-lived intangible assets
2,600

Goodwill
2,766

Other assets
88

Total assets acquired
8,961

Current liabilities
1,078

Long-term liabilities
1,898

Total liabilities assumed
2,976

Total purchase price
5,985


Of the total acquired identified intangible assets, we allocated $2.3 million to developed technology, $0.5 million to customer relationships, and $2.6 million to in-process research and development. Identified finite-lived intangible assets consist of developed technology and customer relationships that will be amortized as cost of revenue and sales and marketing expense, respectively, ratably on a straight-line basis, each over an estimated useful life of 6 years. Identified indefinite-lived intangible assets consist of in-process research and development, which will be amortized upon completion of development. The goodwill of $2.8 million represents the premium we paid over the fair value of the net tangible liabilities assumed and identified intangible assets acquired. We paid this premium for a number of reasons, primarily for acquiring developed and in-process technology. None of the goodwill recognized as a result of the acquisition is deductible for income tax purposes. The financial results of this acquisition are considered immaterial for purposes of pro-forma financial disclosures.

On December 7, 2012, we completed the acquisition of XDN, Inc., a provider of cloud-based content delivery solutions, for a total consideration of $0.5 million . We accounted for this acquisition as a purchase of a business and, accordingly, the total purchase price was allocated to identifiable intangible assets acquired based on their estimated fair market value as of the acquisition date. The purchase price allocation resulted in purchased identifiable intangible assets of $0.5 million . Identifiable intangible assets consist of purchased technology. The fair value assigned to identifiable intangible assets acquired was determined using the market approach, which compares the value of the purchased assets to similar assets in similar lines of business. Purchased identifiable intangible assets are being amortized as cost of revenue ratably over three years. The financial results of this acquisition are considered immaterial for purposes of pro forma financial disclosures.

On March 8, 2012, we completed the acquisition of IntruGuard Devices, Inc. (“IntruGuard”), a supplier of Intelligent Availability Protection Systems, for a total consideration of $1.0 million . Of the total consideration, $0.4 million was withheld

18

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


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 was 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 $0.9 million . 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 amortized as cost of revenue ratably over three years. Of the $0.4 million previously withheld in escrow, $0.2 million and $0.2 million were released to the selling stockholders during the three months ended September 30, 2012 and the three months ended March 31, 2013, respectively. The financial results of this acquisition are considered immaterial for purposes of pro forma financial disclosures.


14. GOODWILL AND OTHER INTANGIBLE ASSETS—NET

We acquired $2.8 million of goodwill during the three months ended March 31, 2013, which approximates the carrying value as of March 31, 2013.

The following table presents other intangible assets ($ amounts in 000’s):
 
March 31, 2013
 
Gross
 
Accumulated Amortization
 
Net
Finite-lived other intangible assets:
 
 
 
 
 
Developed technology
5,826

 
1,728

 
4,098

Customer relationships
500

 

 
500

 
6,326

 
1,728

 
4,598

Indefinite-lived other intangible assets:
 
 
 
 
 
In-process research and development
 
 
 
 
2,600

Total other intangible assets
 
 
 
 
7,198


 
December 31, 2012
 
Gross
 
Accumulated Amortization
 
Net
Finite-lived other intangible assets:
 
 
 
 
 
Developed technology
3,541

 
1,424

 
2,117

Total other intangible assets
3,541

 
1,424

 
2,117


Amortization expense was $0.3 million and $0.2 million during the three months ended March 31, 2013 and March 31, 2012, respectively. The following table summarizes estimated future amortization expense of other intangible assets with finite lives for future fiscal years ($ amounts in 000’s):
 
Amount
Fiscal Years:
 
2013 (remainder)
1,287

2014
1,168

2015
737

2016
472

2017
467

2018
467

Total
4,598



19


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, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended ( Exchange Act ). These statements include, among other things, statements concerning our expectations regarding:
 
variability in sales in certain product categories from year to year and between quarters;

expected impact of sales of certain products;
 
continued sales into large enterprises and service providers;

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 services 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, and expectations regarding these expenses as a percentage of revenue;

our effective tax rate;
 
the sufficiency of our existing cash, cash equivalents and investments to meet our cash needs for at least the next 12 months; and

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

Business Overview

We provide 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. Since inception through March 31, 2013 , we shipped over 1,150,000 appliances via more than 15,000 channel partners to more than 160,000 end-customers worldwide, including a majority of the 2012 Fortune Global 100.

Our core Unified Threat Management (“UTM”)/Next Generation Firewall (“NGFW”) product line of FortiGate physical and virtual appliances ships with a set of security and networking capabilities, including firewall, VPN, application control, anti-malware, intrusion prevention, Web filtering, anti-spam and WAN acceleration functionality. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20, designed for small businesses, to the FortiGate-5000 series for large enterprises, telecommunications carriers, and service providers. Our UTM/NGFW solution also includes our FortiGuard security subscription services, which end-customers can subscribe to in order to

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obtain access to dynamic updates to intrusion prevention, application control, anti-malware, Web filtering, vulnerability management and anti-spam 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, protection against denial of service attacks (DDoS), endpoint security for employee computers and mobile devices and wireless access point. Although sales of these complementary products have grown in recent quarters, these products still represent less than 10% of our total revenue.

In March 2013, we completed the acquisition of Coyote Point Systems, Inc., a provider of application delivery controllers, as part of our strategy to expand our product portfolio.

Financial Highlights

We recorded total revenue of $135.8 million during the three months ended March 31, 2013 . This represents an increase of 16% during the three months ended March 31, 2013 , compared to the same period last year. Product revenue was $58.0 million , an increase of 9% during the three months ended March 31, 2013 , compared to the same period last year. Services revenue was $75.9 million during the three months ended March 31, 2013, an increase of 22% during the three months ended March 31, 2013 , compared to the same period last year.

We generated cash flows from operating activities of $38.1 million during the three months ended March 31, 2013 , a decrease of 21% compared to the same period last year.

Cash, cash equivalents and investments were $782.5 million as of March 31, 2013 , an increase of $43.0 million from December 31, 2012.

Deferred revenue was $376.4 million as of March 31, 2013 , an increase of $13.2 million from December 31, 2012.

During the three months ended March 31, 2013 , revenue grew as a result of our sales efforts and product offerings. We also recently introduced several new FortiGate entry-level appliances such as the FG-60D with its WIFI counterparts and the FG-100D; the FG-800C mid-range appliance; and the FG-3240C, FG-3600C and FG-5001C for large enterprises and service providers.

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 believe that, during the three months ended March 31, 2013, our operating results were negatively impacted primarily by macroeconomic and geopolitical challenges in Latin America and EMEA, as well as a shortfall in sales to the U.S. service provider sector due to increased cautionary purchasing behavior, which resulted in fewer than expected large deals in the quarter. Although we experienced a decline in deals valued at greater than $500,000 during the three months ended March 31, 2013 when compared to the same period last year, during the three months ended March 31, 2013, we experienced an increase in the number of deals involving sales greater than $250,000 and deals greater than $100,000 when compared to the same period last year. Specifically, the number of deals involving sales greater than $500,000 was 13 in the three months ended March 31, 2013, compared to 19 in the three months ended March 31, 2012. The number of deals involving sales greater than $250,000 was 55 in the three months ended March 31, 2013, compared to 47 in the three months ended March 31, 2012. The number of deals involving sales greater than $100,000 was 170 in the three months ended March 31, 2013 , compared to 153 in the three months ended March 31, 2012. We expect some variability in this metric, and remain focused on investing in our sales and marketing and research and development resources in order to expand our reach into new high-growth verticals and emerging markets. Moreover, such investments will allow us to meet increasing customer expectations about the quality and functionality of our products, as we continue to sell to large enterprises and service providers. While we have experienced some success selling into the large enterprise segment, across key verticals, including service provider, government, retail, financial services and education, we experienced slower sales in the U.S. service provider sector during the three months ended March 31, 2013, and there can be no assurance we will be successful selling into these vertical customer segments.

During the three months ended March 31, 2013 , operating expenses increased by 20% 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. During the three months ended March 31, 2013 , headcount

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increased to 2,077 from 1,655 as of March 31, 2012. Our accelerated pace of hiring continued during the three months ended March 31, 2013 , particularly in sales and marketing.

Key Metrics

We monitor the key financial metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts, and assess operational efficiencies. Our total deferred revenue increased by $13.2 million from $363.2 million as of December 31, 2012 to $376.4 million as of March 31, 2013 . Revenue recognized plus the change in deferred revenue from the beginning to the end of the period less any deferred revenue balances acquired from business combination(s), 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 revenue that we recognize in a typical quarter. As of March 31, 2013, we had $782.5 million in cash, cash equivalents and investments and have had positive cash flow from operations every fiscal year since 2005. We discuss revenue, gross margin, and the components of operating income and margin below 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.
 
 
Three Months Ended Or As Of
 
March 31,
2013
 
March 31,
2012
 
($ amounts in 000’s)
Revenue
135,820

 
117,247

Gross margin
71
%
 
74
%
Operating income (1)
15,391

 
18,715

Operating margin
11
%
 
16
%
Total deferred revenue
376,414

 
314,572

Increase in total deferred revenue
13,229

 
19,739

Cash, cash equivalents and investments
782,538

 
600,306

Cash provided by operating activities
38,111

 
48,518

Free cash flow (Non-GAAP) (2)
36,577

 
46,894

___________________
 
 
 
(1) Includes:
 
 
 
Stock-based compensation expense
9,299

 
7,246

Patent settlement income
478

 
478

 
 
 
 
(2) See “—Cash flow from operations” below for a definition of free cash flow.
    
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. We define billings as revenue recognized during a period plus the change in deferred revenue from the beginning to the end of the period less any deferred revenue balances acquired from business combination(s) during the period. 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.

 
Three Months Ended
March 31,
2013
 
March 31,
2012
($ amounts in 000’s)
Billings:
 
 
 
Revenue
135,820

 
117,247

Add increase in deferred revenue
13,229

 
19,739

Less deferred revenue balance acquired in business combination
(550
)
 

Total billings (Non-GAAP)
148,499

 
136,986



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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
March 31,
2013
 
March 31,
2012
($ amounts in 000’s)
Free Cash Flow:
 
 
 
Net cash provided by operating activities
38,111

 
48,518

Less purchases of property and equipment
(1,534
)
 
(1,624
)
Free cash flow (Non-GAAP)
36,577

 
46,894


Other Non-GAAP Financial Measures

To supplement our consolidated financial statements presented in accordance with 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 operating income, 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, offset by patent settlement income. Stock-based compensation expense 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 the section entitled “—Results of Operations” below.












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Non-GAAP gross margin is gross margin as reported on our consolidated statements of operations, excluding the impact of stock-based compensation expense, which is a non-cash charge. Non-GAAP operating income is operating income, as reported on our consolidated statements of operations, excluding the impact of stock-based compensation expense and the income we received from a patent settlement. Non-GAAP operating margin is non-GAAP operating income divided by revenue. The following tables reconcile GAAP gross margin, operating income, and operating margin to non-GAAP gross margin, non-GAAP operating income, and non-GAAP operating margin for the three months ended March 31, 2013 and March 31, 2012 .

 
Three Months Ended
March 31,
2013
 
March 31,
2012
Amount ($)
 
% of
Revenue
 
Amount ($)
 
% of
Revenue
($ amounts in 000’s)
Total revenue
135,820

 
 
 
117,247

 
 
GAAP gross profit and margin
96,692

 
71
 
86,204

 
74
Stock-based compensation expense
1,110

 
1
 
809

 
Non-GAAP gross profit and margin
97,802

 
72
 
87,013

 
74
GAAP operating income and margin
15,391

 
11
 
18,715

 
16
Stock-based compensation expense:
 
 
 
 
 
 
 
Cost of revenue
1,110

 
1
 
809

 
Research and development
2,766

 
2
 
1,957

 
2
Sales and marketing
4,118

 
3
 
3,443

 
3
General and administrative
1,305

 
1
 
1,037

 
1
Total stock-based compensation expense
9,299

 
7
 
7,246

 
6
Patent settlement income
(478
)
 
 
(478
)
 
Non-GAAP operating income and margin
24,212

 
18
 
25,483

 
22




























24

Table of Contents

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 March 31, 2013 and March 31, 2012 .

 
Three Months Ended
March 31,
2013
 
March 31,
2012
Amount ($)
 
% of
Revenue
 
Amount ($)
 
% of
Revenue
($ amounts in 000’s)
Operating Expenses:
 
 
 
 
 
 
 
Research and development expenses:
 
 
 
 
 
 
 
GAAP research and development expenses
23,334

 
17

 
19,667

 
17

Stock-based compensation expense
(2,766
)
 
(2
)
 
(1,957
)
 
(2
)
Non-GAAP research and development expenses
20,568

 
15

 
17,710

 
15

Sales and marketing expenses:
 
 
 
 
 
 
 
GAAP sales and marketing expenses
49,976

 
37

 
42,036

 
36

Stock-based compensation expense
(4,118
)
 
(3
)
 
(3,443
)
 
(3
)
Non-GAAP sales and marketing expenses
45,858

 
34

 
38,593

 
33

General and administrative expenses:
 
 
 
 
 
 
 
GAAP general and administrative expenses
7,991

 
6

 
5,786

 
5

Stock-based compensation expense
(1,305
)
 
(1
)
 
(1,037
)
 
(1
)
Patent settlement income
478

 

 
478

 

Non-GAAP general and administrative expenses
7,164

 
5

 
5,227

 
5

Total operating expenses:
 
 
 
 
 
 
 
GAAP operating expenses
81,301

 
60

 
67,489

 
58

Stock-based compensation expense
(8,189
)
 
(6
)
 
(6,437
)
 
(6
)
Patent settlement income
478

 

 
478

 

Non-GAAP operating expenses
73,590

 
54

 
61,530

 
52






















25

Table of Contents

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 consolidated statements of operations to non-GAAP net income for the three months ended March 31, 2013 and March 31, 2012 .
 
Three Months Ended
March 31,
2013
March 31,
2012
($ and share amounts in 000’s, except per share amounts)
Net Income:
 
 
 
GAAP net income
12,249

 
14,173

Stock-based compensation expense (1)
9,299

 
7,246

Patent settlement income (2)
(478
)
 
(478
)
Provision for income taxes (3)
4,726

 
5,556

Non-GAAP income before provision for income taxes
25,796

 
26,497

Non-GAAP provision for income taxes (4)
(8,513
)
 
(9,009
)
Non-GAAP net income
17,283

 
17,488

Non-GAAP net income per share—diluted
0.10

 
0.11

Shares used in per share calculation—diluted
167,823

 
165,751

____________________
(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)
We used non-GAAP effective tax rates of 33% and 34%, which could differ from the GAAP tax rates, to calculate non-GAAP net income for the three months ended March 31, 2013 and March 31, 2012 , respectively.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, cash flow and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, stock-based compensation expense, valuation of inventory, warranty liabilities and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

There have been no material changes in our significant accounting policies as of and for the three months ended March 31, 2013 , as compared to the significant accounting policies described in the Form 10-K.

Recently Adopted Accounting Pronouncement

In February 2013, the FASB issued ASU 2013-02, which requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under GAAP to be reclassified in its entirety to net income. For other amounts that are not required under GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under GAAP that provide additional detail about those amounts. We adopted ASU 2013-02 in the three months ended March 31, 2013. The amounts reclassified out of accumulated other comprehensive income were immaterial for the three months ended March 31, 2013 and March 31, 2012.

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Table of Contents



Results of Operations

Revenue
 
 
Three Months Ended
 
 
 
 
March 31,
2013
 
March 31,
2012
 
 
 
 
Amount ($)
 
% of
Total Revenue
 
Amount ($)
 
% of
Total Revenue
 
Change
 
% Change
($ amounts in 000’s)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Product
57,950

 
43
 
53,204

 
45
 
4,746

 
9
Services
75,896

 
56
 
62,138

 
53
 
13,758

 
22
Ratable and other revenue
1,974

 
1
 
1,905

 
2
 
69

 
4
Total revenue
135,820

 
100
 
117,247

 
100
 
18,573

 
16
Revenue by geography:
 
 
 
 
 
 
 
 
 
 
 
Americas
52,627

 
39
 
46,431

 
40
 
6,196

 
13
EMEA
47,326

 
35
 
40,886

 
35
 
6,440

 
16
APAC
35,867

 
26
 
29,930

 
25
 
5,937

 
20
Total revenue
135,820

 
100
 
117,247

 
100
 
18,573

 
16

Total revenue increased by $18.6 million , or 16% , in three months ended March 31, 2013 compared to the same period last year. All three regions contributed comparable growth on an absolute basis, with APAC contributing the largest percentage growth at 20%. Product revenue increased by $4.7 million , or 9% , compared to the same period last year. The increase in product revenue was primarily driven by greater sales volume in our FortiGate product family due to increased demand across all product categories with our entry-level products and wireless security and access point products contributing the largest portion of the growth. Services revenue increased by $13.8 million , or 22% , in the three months ended March 31, 2013 compared to the same period last year due to the recognition of revenue from our growing deferred revenue balance consisting of subscription and support contracts sold to a larger customer base.

Cost of revenue and gross margin
 
 
Three Months Ended
 
 
 
 
March 31,
2013
 
March 31,
2012
 
Change
 
% Change
($ amounts in 000’s)
Cost of revenue:
 
 
 
 
 
 
 
Product
22,958

 
19,067

 
3,891

 
20

Services
15,574

 
11,213

 
4,361

 
39

Ratable and other revenue
596

 
763

 
(167
)
 
(22
)
Total cost of revenue
39,128

 
31,043

 
8,085

 
26

Gross margin (%):
 
 
 
 
 
 
 
Product
60.4

 
64.2

 
(3.8
)
 
 
Services
79.5

 
82.0

 
(2.5
)
 
 
Ratable and other revenue
69.8

 
59.9

 
9.9

 
 
Total gross margin
71.2

 
73.5

 
(2.3
)
 
 

Total gross margin decreased by 2.3 percentage points in the three months ended March 31, 2013 compared to the same period last year, as both product and services gross margins declined. Product gross margin decreased by 3.8 percentage

27

Table of Contents

points in the three months ended March 31, 2013 compared to the same period last year primarily as a result of the higher mix of entry-level products and higher overhead costs. From time to time, we have experienced sales of previously reserved inventory. During the three months ended March 31, 2013 , we experienced a positive impact to gross margin of 0.3 percentage point due to the sale of fully reserved inventory compared to a positive impact to gross margin of 0.2 percentage point in the prior year. Services gross margin decreased by 2.5 percentage points during the three months ended March 31, 2013 primarily due to our continued investments in our technical support organization to accommodate our expanding customer base and higher service level expectations from our enterprise customers. In addition, we experienced growth in our professional consulting services which have lower gross margins than our support and subscription businesses. Cost of services revenue increased by $4.4 million primarily due to a $3.2 million increase in cash-based personnel costs related to an increase in headcount, a $0.3 million increase in stock-based compensation expense, and a combined $0.9 million increase in professional services, travel, freight and depreciation expenses.

Operating expenses
 
 
Three Months Ended
 
Change
 
% Change
March 31,
2013
 
March 31,
2012
 
Amount ($)
 
% of
Total Revenue
 
Amount ($)
 
% of
Total Revenue
 
($ amounts in 000’s)
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Research and development
23,334

 
17
 
19,667

 
17
 
3,667

 
19
Sales and marketing
49,976

 
37
 
42,036

 
36
 
7,940

 
19
General and administrative
7,991

 
6
 
5,786

 
5
 
2,205

 
38
Total operating expenses
81,301

 
60
 
67,489

 
58
 
13,812

 
20

Research and development expense

Research and development expense increased by $3.7 million , or 19% , in the three months ended March 31, 2013 compared to the same period last year, primarily due to an increase of $2.9 million in cash-based personnel costs and $0.8 million in stock-based compensation expense as a result of increased headcount to support the development of new products and continued enhancements of our existing products. We intend to continue to invest in our research and development organization, but we currently expect research and development expense as a percentage of total revenue to remain at approximately comparable levels during the remainder of fiscal 2013.

Sales and marketing expense

Sales and marketing expense increased by $7.9 million , or 19% , in the three months ended March 31, 2013 compared to the same period last year, primarily due to an increase of $4.9 million in cash-based personnel costs as we continued to increase our sales headcount in order to expand our global footprint. In addition, we incurred increases in travel expenses of $0.9 million, stock-based compensation expense of $0.7 million and, depreciation expenses of $0.6 million. As a percentage of total revenue, sales and marketing expenses increased as we accelerated the investment in our sales force to support future growth. We intend to continue to make investments in our sales resources and infrastructure which are critical to support sustainable growth, but we currently expect sales and marketing expense as a percentage of total revenue to remain at approximately comparable levels during the remainder of fiscal 2013.

General and administrative expense

General and administrative expense increased by $2.2 million , or 38% , in the three months ended March 31, 2013 compared to the same period last year. Cash-based personnel costs increased by $0.7 million and stock-based compensation expense increased by $0.3 million. In addition, we incurred $1.0 million of higher legal and accounting fees. We currently expect general and administrative expense as a percentage of total revenue to remain at approximately comparable levels during the remainder of fiscal 2013.


28

Table of Contents

Interest income and other income (expense), net
 
 
Three Months Ended
 
 
 
 
March 31,
2013
 
March 31,
2012
 
Change
 
% Change
($ amounts in 000’s)
Interest income
1,369

 
1,085

 
284

 
26

Other income (expense), net
215

 
(71
)
 
286

 
(403
)

The $0.3 million increase in interest income in the three months ended March 31, 2013 compared to the same period last year, was primarily due to interest earned on higher invested balances of cash, cash equivalents and investments. The change in other income (expense), net, for the three months ended March 31, 2013 was the result of foreign exchange gains compared to foreign exchange losses in the same period last year.

Provision for income taxes
 
 
Three Months Ended
 
Change
 
% Change
March 31,
2013
 
March 31,
2012
 
($ amounts in 000’s)
Provision for income taxes
4,726

 
5,556

 
(830
)
 
(15
)
Effective tax rate (%)
28

 
28

 

 

 
Our effective tax rate was 28% in the three months ended March 31, 2013 , compared with an effective tax rate of 28% in the same period last year. The provision for income taxes for the three months ended March 31, 2013 was comprised primarily of federal, state and foreign income taxes, as well as the inclusion of stock option benefits which affected the transfer pricing calculations between some of our foreign subsidiaries and the inclusion of the U.S. Federal Research and Development Tax Credit for benefit for 2012 and 2013. During January 2013, the U.S. Federal Research and Development Tax Credit was reinstated retroactively to fiscal 2012. The U.S. Federal Research and Development Tax Credit benefit was recorded in the first quarter of fiscal 2013, which is the period of enactment. The provision for income taxes for the three months ended March 31, 2012 was impacted by the inclusion of stock option benefits which affected the transfer pricing calculations between some of our foreign subsidiaries. The State of California will be conducting an audit of our state income tax returns for fiscal 2010 and fiscal 2011. We do not currently expect a material impact on our results of operations to arise from this audit that would have a detrimental impact on our income tax liability.

Liquidity and Capital Resources
 
 
March 31,
2013
 
December 31,
2012
 
($ amounts in 000’s)
Cash and cash equivalents
97,384

 
122,975

Investments
685,154

 
616,611

Total cash, cash equivalents and investments
782,538

 
739,586

Working capital
281,932

 
249,970



29

Table of Contents

The following table presents a summary of our cash flows:
 
Three Months Ended
 
March 31,
2013
 
March 31,
2012
 
($ amounts in 000’s)
Cash provided by operating activities
38,111

 
48,518

Cash used in investing activities
(79,178
)
 
(62,299
)
Cash provided by financing activities
15,917

 
15,871

Effect of exchange rates on cash and cash equivalents
(441
)
 
703

Net (decrease) increase in cash and cash equivalents
(25,591
)
 
2,793


As of March 31, 2013 , our cash, cash equivalents, and investments of $782.5 million were held for working-capital purposes and were invested primarily in money market funds, commercial paper, corporate debt securities, municipal bonds and certificates of deposit and term deposits. As of March 31, 2013, $50.7 million of our cash was held by our international subsidiaries and is therefore not immediately available to fund domestic operations unless the cash is repatriated. While we do not intend to do so, should this amount be repatriated, it would be subject to U.S. federal income tax which would be partially offset by foreign tax credits. We do not enter into investments for trading or speculative purposes. We believe that our existing cash, cash equivalents and investments will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors including our growth rate, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced products and services offerings, the costs to ensure access to adequate manufacturing capacity and the continuing market acceptance of our products. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition would be adversely affected.

The following table presents our cash flows from operating activities:
 
Three Months Ended
 
March 31,
2013
 
March 31,
2012
 
($ amounts in 000’s)