Fortinet, Inc.
FORTINET INC (Form: 10-Q, Received: 05/07/2014 06:02:23)
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, 2014
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.)
899 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 (“Exchange Act”) 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 Act).    Yes   o      No   x
As of April 30, 2014 , there were 163,069,548 shares of the registrant’s common stock outstanding.


Table of Contents




FORTINET, INC.
QUARTERLY REPORT ON FORM 10-Q
For the Quarter Ended March 31, 2014
Table of Contents
 
 
 
 
 
 
Page
 
 
 
 
Part I
 
 
 
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
 
Part II
 
 
 
 
Item 1.
Item 1A.
Item 2.
Item 6.
 


 


Table of Contents

Part I


Item 1. Financial Statements
FORTINET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except per share amounts)
 
 
March 31,
2014
 
December 31,
2013
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
172,968

 
$
115,873

Short-term investments
388,083

 
375,497

Accounts receivable—net of allowance for doubtful accounts and sales returns of $4,467 and $4,605 as of March 31, 2014 and December 31, 2013, respectively
111,489

 
130,471

Inventory
43,294

 
48,672

Deferred tax assets
50,956

 
50,980

Prepaid expenses and other current assets
14,670

 
14,053

Total current assets
781,460

 
735,546

PROPERTY AND EQUIPMENT—Net
47,474

 
36,652

DEFERRED TAX ASSETS—Non-current
30,058

 
30,058

LONG-TERM INVESTMENTS
327,263

 
351,675

GOODWILL
2,824

 
2,872

OTHER INTANGIBLE ASSETS—Net
6,218

 
6,841

OTHER ASSETS
4,734

 
4,820

TOTAL ASSETS
$
1,200,031

 
$
1,168,464

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
27,603

 
$
35,599

Accrued liabilities
25,716

 
27,380

Accrued payroll and compensation
35,845

 
34,997

Income taxes payable

 
21,421

Deferred revenue
305,702

 
293,664

Total current liabilities
394,866

 
413,061

DEFERRED REVENUE—Non-current
145,601

 
138,964

INCOME TAXES PAYABLE—Non-current
32,860

 
30,208

OTHER LIABILITIES
16,610

 
471

Total liabilities
589,937

 
582,704

COMMITMENTS AND CONTINGENCIES (Note 9)


 
 
STOCKHOLDERS’ EQUITY:
 
 
 
Common stock, $0.001 par value — 300,000 shares authorized; 162,981 and 161,535 shares issued and outstanding as of March 31, 2014 and December 31, 2013, respectively
163

 
161

Additional paid-in capital
486,174

 
462,644

Accumulated other comprehensive income
77

 
1,092

Retained earnings
123,680

 
121,863

Total stockholders’ equity
610,094

 
585,760

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
1,200,031

 
$
1,168,464

See notes to condensed consolidated financial statements.


3


FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share amounts)
 
 
Three Months Ended
March 31,
2014
 
March 31,
2013
REVENUE:
 
 
 
Product
$
76,765

 
$
57,950

Services and other
92,184

 
77,870

Total revenue
168,949

 
135,820

COST OF REVENUE:
 
 
 
Product
32,139

 
22,958

Services and other
18,604

 
16,170

Total cost of revenue
50,743

 
39,128

GROSS PROFIT:
 
 
 
Product
44,626

 
34,992

Services and other
73,580

 
61,700

Total gross profit
118,206

 
96,692

OPERATING EXPENSES:
 
 
 
Research and development
29,055

 
23,334

Sales and marketing
67,326

 
49,976

General and administrative
9,010

 
7,991

Total operating expenses
105,391

 
81,301

OPERATING INCOME
12,815

 
15,391

INTEREST INCOME
1,333

 
1,369

OTHER (EXPENSE) INCOME—Net
(389
)
 
215

INCOME BEFORE INCOME TAXES
13,759

 
16,975

PROVISION FOR INCOME TAXES
5,366

 
4,726

NET INCOME
$
8,393

 
$
12,249

Net income per share attributable to common stockholders (Note 7):
 
 
 
Basic
$
0.05

 
$
0.08

Diluted
$
0.05

 
$
0.07

Weighted-average shares outstanding:
 
 
 
Basic
162,391

 
161,282

Diluted
168,114

 
167,823

See notes to condensed consolidated financial statements.


4


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

 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Net income
$
8,393

 
$
12,249

Other comprehensive loss—net of taxes:
 
 
 
Foreign currency translation losses
(1,017
)
 
(952
)
Unrealized gains on investments
2

 
42

Tax provision related to items of other comprehensive income or loss

 
(15
)
Other comprehensive loss—net of taxes
(1,015
)
 
(925
)
Comprehensive income
$
7,378

 
$
11,324


See notes to condensed consolidated financial statements.




5


FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
8,393

 
$
12,249

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
4,422

 
3,536

Amortization of investment premiums
2,513

 
3,051

Stock-based compensation
12,930

 
9,299

Excess tax benefit from stock-based compensation
(579
)
 
(1,453
)
Other non-cash items—net
(67
)
 
(540
)
Changes in operating assets and liabilities:
 
 
 
Accounts receivable—net
19,119

 
5,747

Inventory
3,326

 
(4,520
)
Deferred tax assets
24

 
(8,970
)
Prepaid expenses and other current assets
(287
)
 
(217
)
Other assets
45

 
417

Accounts payable
(6,042
)
 
4,957

Accrued liabilities
(170
)
 
2

Other liabilities
16,155

 
(13
)
Accrued payroll and compensation
1,071

 
(2,416
)
Deferred revenue
18,469

 
12,677

Income taxes payable
(18,420
)
 
4,305

Net cash provided by operating activities
60,902

 
38,111

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchase of investments
(120,590
)
 
(171,506
)
Sales of investments
10,920

 
13,823

Maturities of investments
118,641

 
86,018

Purchase of property and equipment
(11,318
)
 
(1,534
)
Payments made in connection with acquisitions—net of cash acquired
(17
)
 
(5,979
)
Net cash used in investing activities
(2,364
)
 
(79,178
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
14,471

 
14,464

Taxes paid related to net share settlement of equity awards
(3,633
)
 

Excess tax benefit from stock-based compensation
579

 
1,453

Repurchase and retirement of common stock
(12,305
)
 

Net cash (used in) provided by financing activities
(888
)
 
15,917

EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS
(555
)
 
(441
)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
57,095

 
(25,591
)
CASH AND CASH EQUIVALENTS—Beginning of period
115,873

 
122,975

CASH AND CASH EQUIVALENTS—End of period
$
172,968

 
$
97,384

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid for income taxes—net
$
22,136

 
$
8,579

NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Purchase of property and equipment not yet paid
$
5,844

 
$
744

Liability incurred for repurchase of common stock
$
657

 
$

See notes to condensed consolidated financial statements.

6


FORTINET, INC.
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 generally accepted accounting principles (“GAAP”) in the United States (“U.S.”) for interim financial information as well as the instructions to Form 10-Q pursuant to 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, 2013, contained in our Annual Report on Form 10-K (“Form 10-K”) filed with the SEC on March 3, 2014. In the opinion of management, all adjustments, which includes normal recurring adjustments, except as otherwise noted, considered necessary for a fair presentation have been included. All intercompany balances, transactions and cash flows have been eliminated. The results of operations for the three months ended March 31, 2014 are not necessarily indicative of the operating results for any subsequent quarter, for the full year or for any future periods. The condensed consolidated balance sheets as of December 31, 2013 are derived from the audited consolidated financial statements for the year ended December 31, 2013.

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 to our significant accounting policies for the three months ended March 31, 2014 . During the quarter we prospectively modified the expected term calculation used in accounting for stock-based compensation expense and the estimated useful lives of building improvements and furniture and fixtures.

Stock-Based Compensation Expense —Beginning in the first quarter of fiscal 2014, we changed the methodology of calculating the expected term, which is one of the assumptions used in determining the fair value of our employee stock options under the Black Scholes option pricing model. The expected term represents the period that our stock-based awards are estimated to be outstanding. We believe that we have sufficient historical experience for determining the expected term of the stock option award, and therefore, we calculated our expected term based on historical experience instead of using the simplified method.

Property and Equipment —Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets as follows:

 
Estimated Useful Lives
Building and building improvements
20 years
Evaluation units
1 year
Computer equipment, software and tooling
1-2 years
Furniture and fixtures
3 - 5 years
Leasehold improvements
Shorter of useful life or lease term

Effective March 2014, we moved into our new corporate headquarters. The useful life of building improvements placed into service during the three months ended March 31, 2014, in association with our new corporate headquarters is estimated to be 20 years. The useful life of furniture and fixtures now ranges from 3 to 5 years as we placed new furniture and fixtures into service at the new corporate headquarters.

Reclassification —Beginning in the first quarter of 2014, the amounts previously reported as Ratable and other revenue have been combined with the amounts previously reported as Services revenue in the Condensed Consolidated Statements of Operations. The combined amounts are being presented as Services and other revenue in the Condensed Consolidated Statements of Operations. The related Cost of revenue and Gross profit, including prior period amounts, have also been combined to conform to the current period presentation. The Ratable and other revenue amounts, including the related Cost of revenue and Gross profit amounts, are not material.


7


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




2. FINANCIAL INSTRUMENTS AND FAIR VALUE

The following table summarizes our investments as of March 31, 2014 and December 31, 2013 (in thousands):
 
 
March 31, 2014
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
583,341

 
$
1,406

 
$
(280
)
 
$
584,467

Commercial paper
74,547

 
4

 
(2
)
 
74,549

Municipal bonds
38,207

 
50

 
(9
)
 
38,248

Certificates of deposit and term deposits
12,331

 
2

 

 
12,333

U.S. government and agency securities
5,748

 
3

 
(2
)
 
5,749

Total available-for-sale securities
$
714,174

 
$
1,465

 
$
(293
)
 
$
715,346


 
December 31, 2013
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
603,185

 
$
1,506

 
$
(374
)
 
$
604,317

Commercial paper
69,356

 
7

 

 
69,363

Municipal bonds
38,815

 
48

 
(20
)
 
38,843

Certificates of deposit and term deposits
12,645

 
3

 

 
12,648

U.S. government and agency securities
2,000

 
1

 

 
2,001

Total available-for-sale securities
$
726,001

 
$
1,565

 
$
(394
)
 
$
727,172



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, 2014 and December 31, 2013 (in thousands):

 
March 31, 2014
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
Corporate debt securities
$
148,132

 
$
(257
)
 
$
13,176

 
$
(23
)
 
$
161,308

 
$
(280
)
Commercial paper
12,094

 
(2
)
 

 

 
12,094

 
(2
)
Municipal bonds
4,776

 
(5
)
 
4,028

 
(4
)
 
8,804

 
(9
)
U.S. government and agency securities
2,748

 
(2
)
 

 

 
2,748

 
(2
)
Total available-for-sale securities
$
167,750

 
$
(266
)
 
$
17,204

 
$
(27
)
 
$
184,954

 
$
(293
)


8


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




 
December 31, 2013
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
Corporate debt securities
$
182,795

 
$
(374
)
 
$
500

 
$

 
$
183,295

 
$
(374
)
Commercial paper
7,897

 

 

 

 
7,897

 

Municipal bonds
14,736

 
(20
)
 

 

 
14,736

 
(20
)
Total available-for-sale securities
$
205,428

 
$
(394
)
 
$
500

 
$

 
$
205,928

 
$
(394
)

The contractual maturities of our investments are as follows (in thousands):
 
 
March 31,
2014
 
December 31,
2013
Due within one year
$
388,083

 
$
375,497

Due within one to three years
327,263

 
351,675

Total
$
715,346

 
$
727,172


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

The unrealized losses on our available-for-sale securities were caused by fluctuations in market value and interest rates as a result of the economic environment. As the decline in market value are attributable to changes in market conditions and not credit quality, and because we have concluded currently that we neither intend to sell nor it is more likely than not that we will be required to sell these investments prior to a recovery of par value, we do not consider these investments to be other-than temporarily impaired as of March 31, 2014 .

Realized gains and losses from the sale of available-for-sale securities were not significant in any of the periods presented.
 
The following table presents the fair value of our financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2014 and December 31, 2013 (in thousands):
 

9


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




 
March 31, 2014
 
 
 
December 31, 2013
 
 
 
Aggregate
Fair
Value
 
Quoted
Prices in
Active
Markets For
Identical
Assets
 
Significant
Other
Observable
Remaining
Inputs
 
Significant
Other
Unobservable
Remaining
Inputs
 
Aggregate
Fair
Value
 
Quoted
Prices in
Active
Markets For
Identical
Assets
 
Significant
Other
Observable
Remaining
Inputs
 
Significant
Other
Unobservable
Remaining
Inputs
 
 
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
 
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
$
584,467

 
$

 
$
584,467

 
$

 
$
604,317

 
$

 
$
604,317

 
$

Commercial paper
74,549

 

 
74,549

 

 
71,363

 

 
71,363

 

Municipal bonds
38,248

 

 
38,248

 

 
38,843

 

 
38,843

 

Certificates of deposit and term deposits
12,333

 

 
12,333

 

 
12,648

 

 
12,648

 

Money market funds
20,298

 
20,298

 

 

 
5,724

 
5,724

 

 

U.S. government and agency securities
5,749

 

 
5,749

 

 
2,001

 

 
2,001

 

Total
$
735,644

 
$
20,298

 
$
715,346

 
$

 
$
734,896

 
$
5,724

 
$
729,172

 
$

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Contingent consideration
$
707

 
$

 
$

 
$
707

 
$
1,850

 
$

 
$

 
$
1,850

Total
$
707

 
$

 
$

 
$
707

 
$
1,850

 
$

 
$

 
$
1,850

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reported as:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
$
20,298

 
 
 
 
 
 
 
$
7,724

 
 
 
 
 
 
Short-term investments
388,083

 
 
 
 
 
 
 
375,497

 
 
 
 
 
 
Long-term investments
327,263

 
 
 
 
 
 
 
351,675

 
 
 
 
 
 
Total
$
735,644

 
 
 
 
 
 
 
$
734,896

 
 
 
 
 
 

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

We classify items within Level 2 if the investments are valued using model driven valuations using observable inputs such as quoted market prices, benchmark yields, reported trades, broker/dealer quotes or alternative pricing sources with reasonable levels of price transparency. Investments are held by custodians who obtain investment prices from a third-party pricing provider that incorporates standard inputs in various asset price models.

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the three months ended March 31, 2014 .

The fair value of contingent consideration arising from the acquisition of Coyote Point Systems (see Note 5), is classified within Level 3 of the fair value hierarchy since it is based on a probability-based approach that includes significant unobservable inputs. The significant unobservable inputs include projected revenues and the percentage probability of occurrence to value the payment. A significant increase (decrease) in the projected revenue in isolation could result in a significantly higher (lower) fair value measurement and significant increase (decrease) in the probability of occurrence between the outcomes in isolation could result in a significantly higher (lower) fair value measurement. The fair value of the contingent consideration is calculated on a quarterly basis by management based on a collaborative effort of our operations and finance and accounting groups. Potential valuation adjustments are made as additional information becomes available, including the progress toward achieving revenue targets as compared to initial projections, the impact of market competition, and changes in actual and projected product mix and average selling price. Any adjustments to the fair value of the contingent consideration are included in research and development expense in the condensed consolidated statements of operations.

The following table presents quantitative information about the inputs and valuation methodologies used for our fair value measurements classified in Level 3 of the fair value hierarchy as of March 31, 2014 (in thousands except for percentage):


10


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




 
March 31, 2014
 
Fair
Value
 
Valuation Technique
 
Significant Unobservable Input
 
 Range
Contingent consideration
$707
 
Probability Weighted Income Approach
 
Revenue
 
$7,000 - $7,639
 
 
 
 
 
 
 
 
 
 
 
 
 
Probability of occurrence (%)
 
20%-70%

The change in the fair value of our contingent consideration liability is as follows (in thousands):

As of December 31, 2013
$1,850
Less adjustment to fair value of contingent consideration
(1,143)
As of March 31, 2014
$707


3. INVENTORY

Inventory consisted of the following (in thousands):
 
 
March 31,
2014
 
December 31,
2013
Raw materials
$
5,089

 
$
4,319

Finished goods
34,555

 
40,093

Consigned inventory
3,650

 
4,260

Inventory
$
43,294

 
$
48,672


 
4. PROPERTY AND EQUIPMENT—Net
Property and equipment—net consisted of the following (in thousands):
 
 
March 31,
2014
 
December 31,
2013
Land
$
13,895

 
$
13,895

Building and building improvements
19,121

 
610

Evaluation units
24,951

 
23,442

Computer equipment, software and tooling
25,151

 
23,556

Furniture and fixtures
3,185

 
1,697

Construction-in-progress
634

 
10,947

Leasehold improvements
4,520

 
4,303

Total property and equipment
91,457

 
78,450

Less: accumulated depreciation
(43,983
)
 
(41,798
)
Property and equipment—net
$
47,474

 
$
36,652


Beginning in the first quarter of 2014, we reclassified certain fixed assets between categories in the table above to better reflect the nature of these fixed assets. Prior period amounts have also been reclassified to conform to the current period presentation. We believe the impact of the reclassification is not material.


11


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




Depreciation expense was $3.9 million and $3.2 million during the three months ended March 31, 2014 and March 31, 2013 , respectively.


5. BUSINESS COMBINATIONS

Coyote Point Systems

On March 21, 2013, we acquired all of the outstanding equity securities of Coyote Point Systems, Inc. ( Coyote ), a provider of application delivery, load balancing and acceleration solutions, for $6.0 million in cash. The acquisition also included 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 stockholder's employment during the earn-out period, the estimated fair value of these contingent obligations is being recorded as compensation expense ratably over the earn-out periods. This acquisition complemented our network security strategy and allowed us and our channel partners to accelerate and further deliver on our vision of providing broad security and networking functionality to customers.

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 (in thousands):

Cash and cash equivalents
$
206

Other current assets
501

Finite-lived intangible assets
2,800

Indefinite-lived intangible assets
2,600

Goodwill
2,824

Other assets
88

Total assets acquired
9,019

Current liabilities
1,030

Long-term liabilities
2,004

Total liabilities assumed
3,034

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 ( IPR&D ) as of the acquisition date. Identified finite-lived intangible assets consist of developed technology and customer relationships that are being amortized as cost of revenue and sales and marketing expense, respectively, ratably on a straight-line basis, each over an estimated useful life of six years. Identified indefinite-lived intangible assets consisted of acquired IPR&D relating to existing research and development projects at the time of acquisition. 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, due primarily to acquire 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 were considered immaterial for purposes of pro-forma financial disclosures. During the three months ended September 30, 2013, we completed the development of technology associated with the IPR&D projects, and started amortizing this developed technology as cost of revenue ratably on a straight-line basis over an estimated useful life of 6 years.



12


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




6. GOODWILL AND OTHER INTANGIBLE ASSETS—Net

We recorded $2.8 million of goodwill from the acquisition of Coyote. There were no impairments to goodwill during the three months ended March 31, 2014 .

The following tables present other intangible assets (in thousands):

 
March 31, 2014
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
Developed technology
$
8,887

 
$
3,086

 
$
5,801

Customer relationships
500

 
83

 
417

Total other intangible assets—net
$
9,387

 
$
3,169

 
$
6,218


 
December 31, 2013
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
Developed technology
$
8,971

 
$
2,568

 
$
6,403

Customer relationships
500

 
62

 
438

Total other intangible assets—net
$
9,471

 
$
2,630

 
$
6,841


Amortization expense was $0.5 million and $0.3 million during the three months ended March 31, 2014 and March 31, 2013 , respectively. The following table summarizes estimated future amortization expense of Other intangible assets—net (in thousands):

 
Amount
Years Ending December 31:
 
2014 (remainder)
$
1,220

2015
1,567

2016
1,261

2017
900

2018
900

Thereafter
370

Total
$
6,218



13


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





7. 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 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 (in thousands, except per share amounts):
 
 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Numerator:
 
 
 
Net income
$
8,393

 
$
12,249

 
 
 
 
Denominator:
 
 
 
Basic shares:
 
 
 
Weighted-average common stock outstanding-basic
162,391

 
161,282

Diluted shares:
 
 
 
Weighted-average common stock outstanding-basic
162,391

 
161,282

Effect of potentially dilutive securities:
 
 
 
Stock options
5,196

 
6,457

RSUs
484

 
72

ESPP
43

 
12

Weighted-average shares used to compute diluted net income per share
168,114

 
167,823

Net income per share:
 
 
 
Basic
$
0.05

 
$
0.08

Diluted
$
0.05

 
$
0.07


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 thousands):
 
 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Stock options
5,079

 
6,751

RSUs
1,348

 
1,069

ESPP
358

 
331

 
6,785

 
8,151



14


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




8. DEFERRED REVENUE

Deferred revenue consisted of the following (in thousands):
 
 
March 31,
2014
 
December 31,
2013
Product
$
3,527

 
$
2,915

Services and other
447,776

 
429,713

Total deferred revenue
$
451,303

 
$
432,628

Reported As:
 
 
 
Current
$
305,702

 
$
293,664

Non-current
145,601

 
138,964

Total deferred revenue
$
451,303

 
$
432,628


9. COMMITMENTS AND CONTINGENCIES

The following table summarizes our future principal contractual obligations as of March 31, 2014 (in thousands):

 
Total
 
2014 (remainder)
 
2015
 
2016
 
2017
 
2018
 
Thereafter
Operating lease commitments
$
31,592

 
$
6,543

 
$
6,547

 
$
5,385

 
$
4,639

 
$
3,649

 
$
4,829

Less: Sublease rental income
1,040

 
585

 
455

 

 

 

 

Operating lease commitments—net
30,552

 
5,958

 
6,092

 
5,385

 
4,639

 
3,649

 
4,829

Purchase commitments
38,880

 
38,880

 

 

 

 

 

Other contract commitments
24,182

 
18,502

 
3,914

 
889

 
877

 

 

Total
$
93,614

 
$
63,340

 
$
10,006

 
$
6,274

 
$
5,516

 
$
3,649

 
$
4,829


Operating Leases —We lease certain facilities under various non-cancelable operating leases, which expire through 2020. The terms of certain operating leases provide for renewal options. Future minimum payments under the non-cancelable operating leases totaled $31.6 million as of March 31, 2014 . Rent expense is recognized using the straight-line method over the term of the lease. Rent expense was $2.7 million and $2.3 million during the three months ended March 31, 2014 and March 31, 2013 , respectively.
    
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 March 31, 2014 , we had $38.9 million of open purchase orders with our independent contract manufacturers that may not be cancelable.
 
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, 2014 , we had $24.2 million in other purchase commitments.

Warranties —Accrued warranty activities are summarized as follows (in thousands):


15


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




 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Accrued warranty balance—beginning of the period
$
3,037

 
$
2,309

Warranty costs incurred
(756
)
 
(759
)
Provision for warranty for the period, including warranty liabilities assumed in connection with an acquisition
837

 
674

Changes in prior period estimates
(313
)
 
60

Accrued warranty balance—end of the period
$
2,805

 
$
2,284


Litigation —We are involved in disputes, litigation, and other legal actions. We are defending these litigation matters, and while there can be no assurances and the outcome of these matters is currently not determinable, we currently believe that there are no existing claims or proceedings that are likely to have a material adverse effect on our financial position. There are many uncertainties associated with any litigation and these actions or other third-party claims against us may cause us to incur costly litigation or substantial settlement charges. In addition, the resolution of any intellectual property litigation may require us to make royalty payments, which could adversely affect our gross margins in future periods. If any of those events were to occur, our business, financial condition, results of operations, and cash flows could be adversely affected. The actual liability in any such matters may be materially different from our estimates, if any, which could result in the need to adjust the liability and record additional expenses. We have not recorded any material accrual for loss contingencies associated with such legal proceedings; determined that an unfavorable outcome is probable or reasonably possible; or determined that the amount or range of any possible loss is reasonably estimable.

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 beyond indemnification for third party claims of intellectual property infringement and that could potentially expose us to losses in excess of the amount received under the agreement. To date, there have been no awards under such indemnification provisions.


10. STOCKHOLDERS’ EQUITY

Our 2009 Equity Incentive Plan (the “Plan”) permits us to grant awards of stock options, stock appreciation rights, restricted stock, restricted stock units, and performance units or performance shares.

Employee Stock Options

The following table summarizes the weighted-average assumptions relating to our employee stock options:
 
 
Three Months Ended
 
March 31,
2014
Expected term in years
4.88

Volatility
44.5
%
Risk-free interest rate
1.7
%
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 thousands, except exercise prices and contractual life):
 

16


 
Options Outstanding
 
Number
of Shares
 
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Life (Years)
 
Aggregate
Intrinsic
Value
Balance—December 31, 2013
15,521

 
$
13.18

 
 
 


Granted
187

 
21.46

 
 
 
 
Forfeited
(148
)
 
23.16

 
 
 
 
Exercised
(1,015
)
 
7.09

 
 
 
 
Balance—March 31, 2014
14,545

 
13.61

 
 
 
 
Options vested and expected to vest—March 31, 2014
14,509

 
$
13.59

 
3.14
 
$
135,393

Options exercisable—March 31, 2014
11,567

 
$
11.20

 
2.72
 
$
132,401


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, 2014 , for all in-the-money options. As of March 31, 2014 , total compensation expense related to unvested stock options granted to employees but not yet recognized was $34.2 million , net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average period of 1.70 years.  

Additional information related to our stock options is summarized below (in thousands, except per share amounts):

 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Weighted-average fair value per share granted
$
8.65

 
$

Intrinsic value of options exercised
$
15,321

 
$
26,059

Fair value of options vested
$
4,562

 
$
11,004


Restricted Stock Units

The following table summarizes the activity and related information for RSUs for the periods presented below (in thousands, except per share amounts):

 
Restricted Stock Units Outstanding
 
Number of Shares
 
Weighted-Average Grant-Date-Fair Value per Share
Balance—December 31, 2013
4,199

 
$
22.00

Granted
1,852

 
21.48

Forfeited
(100
)
 
21.74

Vested
(516
)
 
23.25

Balance—March 31, 2014
5,435

 
$
21.74

RSUs expected to vest—March 31, 2014
5,120

 
$
21.78


As of March 31, 2014 , total compensation expense related to unvested RSUs that were granted to employees and non-employees under the 2009 Plan, but not yet recognized, was $116.1 million , net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 3.25 years.




The following summarizes the number and value of the shares withheld for employee taxes for the three months ended March 31, 2014 (in thousands):

 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Shares withheld for taxes
171

 

Amount withheld for taxes
$
3,633

 
$


Employee Stock Purchase Plan

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

 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Expected term in years
0.49

 
0.50

Volatility
36.9
%
 
48
%
Risk-free interest rate
0.08
%
 
0.10
%
Dividend rate

 


Additional information related to the ESPP is provided below (in thousands, except per share amounts):

 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Weighted-average fair value per share granted
$
5.76

 
$
6.83

Shares issued under the ESPP
424

 
329

Weighted-average price per share issued
$
17.18

 
$
19.91


Stock-based Compensation Expense

Stock-based compensation expense is included in costs and expenses as follows (in thousands):
 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Cost of product revenue
$
113

 
$
90

Cost of services and other revenue
1,329

 
1,020

Research and development
3,882

 
2,766

Sales and marketing
5,746

 
4,118

General and administrative
1,860

 
1,305

Total stock-based compensation expense
$
12,930

 
$
9,299


The following table summarizes stock-based compensation expense by award type (in thousands):



 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Stock options
$
4,692

 
$
5,486

RSUs
7,363

 
2,674

ESPP
875

 
1,139

Total stock-based compensation expense
$
12,930

 
$
9,299


Total income tax benefit associated with stock-based compensation that is recognized in the consolidated statements of operations is as follows (in thousands):

 
Three Months Ended
 
March 31,
2014
 
March 31,
2013
Income tax benefit associated with stock-based compensation
$
3,349

 
$
3,587


Share Repurchase Program

On December 6, 2013, our Board of Directors authorized a Share Repurchase Program (“the Program”) to repurchase up to $200.0 million of our outstanding common stock through December 31, 2014. Under the Program, share repurchases may be made by us from time to time in privately negotiated transactions or in open market transactions. The Program does not require us to purchase a minimum number of shares, and may be suspended, modified or discontinued at any time without prior notice. During the three months ended March 31, 2014, we repurchased 0.3 million shares of common stock under the Program in open market transactions for an aggregate purchase price of $7.5 million . The share repurchases were financed by available cash balances and cash flow from operations. As of March 31, 2014, $153.5 million remains authorized for future share repurchases under the Program.


11. INCOME TAXES

The effective tax rate was 39% for the three months ended March 31, 2014 , compared to an effective tax rate of 28% for the three months ended March 31, 2013 . The provision for income taxes for the periods presented is comprised of U.S. federal and state taxes, foreign income taxes, and withholding tax, as well as the inclusion of stock option benefits and cost allocations, which affected the transfer pricing calculations among the U.S. and some of our foreign subsidiaries.

As of March 31, 2014 and December 31, 2013 , unrecognized tax benefits were $33.8 million and $30.2 million , respectively. The total amount of $ 33.2 million in unrecognized tax benefits, 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, 2014 , we had accrued approximately $1.2 million for estimated interest related to uncertain tax positions.

The State of California had been conducting an audit of our state income tax returns for fiscal 2010 and fiscal 2011. The audit was settled during the three months ended March 31, 2014 with no significant impact to our tax position or reserves.


12. EMPLOYEE BENEFIT PLAN

Our tax-deferred savings plan, under the 401(k) Plan, allows participating employees to 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”) which permits participants to make tax deductible contributions up to the maximum contribution limits under the Income Tax Act. Our board of directors approved 50% matching contributions on employee contributions up to 4% of each



employee’s eligible earnings. Our matching contributions to the 401(k) Plans and RRSP for the three months ended March 31, 2014 and March 31, 2013 were $0.6 million and $0.5 million , respectively.


13. SEGMENT INFORMATION

The following table sets forth revenue by geographic region (in thousands):
 
 
Three Months Ended
Revenue
March 31,
2014
 
March 31,
2013
Americas:
 
 
 
United States
$
44,793

 
$
34,788

Other Americas
27,639

 
17,839

Total Americas
72,432

 
52,627

Europe, Middle East, and Africa (“EMEA”)
56,643

 
47,326

Asia Pacific and Japan (“APAC”)
39,874

 
35,867

Total revenue
$
168,949

 
$
135,820


During the three months ended March 31, 2014 , Exclusive Networks Group and Ingram Micro, accounted for 14% and 10% of total revenue, respectively. During the three months ended March 31, 2013, Exclusive Networks Group accounted for 12% of total revenue.

The following table sets forth property and equipment by geographic region (in thousands):

Property and Equipment—Net
March 31,
2014
 
December 31,
2013
Americas:
 
 
 
United States
$
40,146

 
$
29,334

Canada
3,930

 
4,372

Other Americas
30

 
45

Total Americas
44,106

 
33,751

EMEA
1,647

 
1,273

APAC
1,721

 
1,628

Total property and equipment—net
$
47,474

 
$
36,652






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




14. ACCUMULATED OTHER COMPREHENSIVE INCOME

The following table summarizes the changes in accumulated balances of other comprehensive income for the three months ended March 31, 2014 (in thousands):

 
March 31, 2014
 
Foreign Currency Translation Gains And Losses
 
Unrealized Gains And Losses On Investments
 
Tax Benefit Or Provision Related To Items Of Other Comprehensive Income Or Loss
 
Total
Balance as of December 31, 2013
$
333

 
$
1,168

 
$
(409
)
 
$
1,092

Other comprehensive income before reclassifications
(1,019
)
 
6

 

 
(1,013
)
Amounts reclassified from accumulated other comprehensive income

 
(2
)
 

 
(2
)
Net current-period other comprehensive income
(1,019
)
 
4

 

 
(1,015
)
Balance as of March 31, 2014
$
(686
)
 
$
1,172

 
$
(409
)
 
$
77


The following table provides details about the reclassification out of accumulated other comprehensive income for the three months ended March 31, 2014 (in thousands):

March 31, 2014
Details About Accumulated Other Comprehensive Income Components
 
Amount Reclassified From Accumulated Other Comprehensive Income
 
Affected Line Item In The Statement Where Net Income Is Presented
Unrealized gains on investments
 
$
(2
)
 
Other (expense) income—net
Tax provision related to items of other comprehensive income or loss
 

 
Provision for income taxes
Total reclassification for the period
 
$
(2
)
 
 


15. FOREIGN CURRENCY DERIVATIVES

Foreign Currency Derivatives —Our sales contracts are primarily denominated in U.S. dollars and therefore substantially all of our revenue is not subject to foreign currency translation risk. However, a substantial portion of our operating expenses incurred outside the U.S. are denominated in foreign currencies and are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Canadian dollar ( “CAD” ). To help protect against significant fluctuations in value and the volatility of future cash flows caused by changes in currency exchange rates, we engage in foreign currency risk management activities to hedge balance sheet items denominated in CAD. We do not use these contracts for speculative or trading purposes. All of the derivative instruments are with high quality financial institutions and we monitor the creditworthiness of these parties. These contracts typically have maturities between one and three months. We record changes in the fair value of forward exchange contracts related to balance sheet accounts as Other (expense) income—net in the consolidated statement of operations.

Additionally, independent of any hedging activities, fluctuations in foreign currency exchange rates may cause us to recognize transaction gains and losses in our consolidated statements of operations. Our hedging activities are intended to reduce, but not eliminate, the impact of currency exchange rate movements. As our hedging activities are relatively short-term in nature and are focused on CAD, long-term material changes in the value of the U.S. dollar against other foreign currencies, such as the EUR, GBP and JPY could adversely impact our operating expenses in the future.

The notional amount of forward exchange contracts to hedge balance sheet accounts as of March 31, 2014 and December 31, 2013 were (in thousands):


21


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




 
Buy/Sell
 
Notional
Currency—As of March 31, 2014
 
 
 
CAD
Buy
 
$
23,058

 
 
 
 
Currency—As of December 31, 2013
 
 
 
CAD
Buy
 
$
21,867


22


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 and Section 21E of the 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 certain acquisitions, asset purchases and strategic investments;

expected impact of sales of certain products;
 
the significance of stock-based compensation as an expense;
 
the proportion of our revenue that consists of our product and service revenues, and the mix of billings between products and services;
 
the impact of our product innovation strategy;

expanding our reach into new high growth verticals and emerging markets and continuing to sell to large enterprises and service providers;

our ability to meet increasing customer expectations about the quality and functionality of our products;
 
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;

continued investments in research and development to strengthen our technology leadership position and in sales and marketing and the impact of those investments;

expectations regarding uncertain tax benefits and 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;

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” in Part II, Item 1A of 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 high performance network security solutions, which enable broad, integrated and high performance protection against advanced security threats while simplifying the IT security infrastructure for enterprises, service providers and governmental entities worldwide. Since inception through March 31, 2014 , we had shipped over 1,500,000 appliances via more than 20,000 channel partners to more than 190,000 end-customers worldwide, including a majority of the 2013 Fortune Global 100.

Our core product line, comprised of FortiGate physical and virtual appliances, ships with a set of broad security and networking capabilities, including firewall, virtual private network (VPN), application control, antivirus, intrusion prevention,

23

Table of Contents

Web filtering, vulnerability management, anti-spam, wireless controller, wide area network (WAN) acceleration and native internet protocol version 6 (IPv6) support functionality. Customers select the functions or combination of functions that best meet their specific security requirements -- whether that be a high-speed data center firewall (DCFW) at the network core, a next-generation firewall (NGFW) at the edge, or a broad unified threat management (UTM) solution at branch sites. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20 to -100 series, designed for small businesses, FortiGate-200 to -800 series for mid-sized enterprises, to the FortiGate-1000 to -5000 series for large enterprises, telecommunications carriers, and service providers. Our network security platform 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, anti-malware, Web filtering, and anti-spam functionality. 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 protection from advanced persistent threats (APTs), messaging, Web application firewalls, databases, protection against distributed denial of service attacks (DDoS) and endpoint security for employee computers and mobile devices. Sales of these complementary products and related services represent less than 10% of our total revenue.

Financial Highlights

We recorded total revenue of $168.9 million during the three months ended March 31, 2014 . This represents an increase of 24% during the three months ended March 31, 2014 , compared to the same period last year. Product revenue was $76.8 million , an increase of 32% during the three months ended March 31, 2014 , compared to the same period last year. Services and other revenue was $92.2 million during the three months ended March 31, 2014 , an increase of 18% , compared to the same period last year.

Cash, cash equivalents and investments were $888.3 million as of March 31, 2014 , an increase of $45.3 million from December 31, 2013 .

Deferred revenue was $451.3 million as of March 31, 2014 , an increase of $18.7 million from December 31, 2013 .

We generated cash flows from operating activities of $60.9 million during the three months ended March 31, 2014 , an increase of 60% compared to the same period last year.

We received $20.0 million pursuant to a six year mutual covenant-not-to-sue and release agreement with Palo Alto Networks, Inc. during the three months ended March 31, 2014 .

We repurchased 0.3 million shares of common stock under our previously-announced Share Repurchase Program for an aggregate purchase price of $7.5 million during the three months ended March 31, 2014 .

During the three months ended March 31, 2014 , revenue grew as a result of our focused execution and increased investment in sales and marketing, as well as continued commitment to product development, which strengthened our technology advantage. We also continued to gain traction with several recently introduced FortiGate products, including demand for certain of our high speed, low latency next-generation enterprise data center security product.

We continue to invest in research and development to strengthen our technology leadership position, sales and marketing to expand brand awareness, and our global sales team and distribution channels to expand our global reach and sales capacity and meet increasing customer expectations about the quality and functionality of our products. We continue to focus on selling to large customers, such as enterprise and service providers. As a result, we experienced increased deal volumes driven by traction in enterprise data center deployments and large enterprise deals, with particular strength in the financial and telecommunication sectors.

Sales of FortiGate products have generally been 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, with some degree of variability from year to year and between quarters.

During the three months ended March 31, 2014 , operating expenses increased by 30% compared to the same period last year. The increase was primarily driven by our accelerated pace of hiring to support our growth as we continued to invest in expanding our sales coverage, developing new products and scaling our customer support organization to meet the needs of our growing customer base. Headcount increased to 2,389 as of March 31, 2014 from 2,077 as of March 31, 2013.

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Key Financial 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. The following table summarizes revenue, deferred revenue, billings (non-GAAP), cash, cash equivalents and investments, net cash provided by operating activities, and free cash flow (non-GAAP). We discuss revenue below under “— Results of Operations,” and we discuss our cash, cash equivalents, and investments, and net cash provided by operating activities below under “—Liquidity and Capital Resources.” Deferred revenue, billings (non-GAAP), and free cash flow (non-GAAP) are discussed immediately below the following table.

 
Three Months Ended Or As Of
 
March 31,
2014
 
March 31,
2013
 
(in thousands)
Revenue
$
168,949

 
$
135,820

Deferred revenue
$
451,303

 
$
376,414

Increase in deferred revenue
$
18,675

 
$
13,229

Billings (non-GAAP)
$
187,624

 
$
148,499

Cash, cash equivalents and investments
$
888,314

 
$
782,538

Net cash provided by operating activities
$
60,902

 
$
38,111

Free cash flow (non-GAAP)
$
49,584

 
$
36,577

    
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.

Billings (Non-GAAP). 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 combinations. We consider billings to be a useful metric for management and investors because billings 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. There are a number of limitations related to the use of billings versus revenue calculated in accordance with GAAP. First, billings include amounts that have not yet been recognized as revenue. Second, we may calculate billings in a manner that is different from other companies that report similar financial measures. We compensate for these limitations by providing specific information regarding GAAP revenue and evaluating billings together with revenues calculated in accordance with GAAP. A reconciliation of billings to revenue, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

 
Three Months Ended
March 31,
2014
 
March 31,
2013
(in thousands)
Billings:
 
 
 
Revenue
$
168,949

 
$
135,820

Add increase in deferred revenue
18,675

 
13,229

Less deferred revenue balance acquired in business combination

 
(550
)
Total billings (Non-GAAP)
$
187,624

 
$
148,499


Free cash flow (Non-GAAP). Free cash flow is defined as net cash provided by operating activities less capital expenditures. We consider free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after the acquisition of property and equipment, can be used for strategic opportunities, including investing in our business, making acquisitions, and strengthening the balance sheet. Analysis of free cash flow facilitates comparisons of our operating results to competitors' operating results. A limitation of using free cash flow versus the GAAP measure of net cash provided by operating activities as a means for evaluating liquidity is that free cash flow does not represent the total increase or decrease in the cash balance from operations for the period

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because it excludes cash used for capital expenditures. We compensate for this limitation by providing information about our capital expenditures on the face of the cash flow statement and under “Liquidity and Capital Resources”. A reconciliation of free cash flow to net cash provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

 
Three Months Ended
March 31,
2014
 
March 31,
2013
(in thousands)
Free Cash Flow:
 
 
 
Net cash provided by operating activities
$
60,902

 
$
38,111

Less purchases of property and equipment
(11,318
)
 
(1,534
)
Free cash flow (Non-GAAP)
$
49,584

 
$
36,577


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, cost of 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, goodwill and other long-lived assets 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 to our critical accounting policies for the three months ended March 31, 2014 . During the quarter we prospectively modified the expected term calculation used in accounting for stock-based compensation expense and the estimated useful lives of building improvements and furniture and fixtures.

Stock-Based Compensation Expense —Beginning in the first quarter of fiscal 2014, we changed the methodology of calculating the expected term, which is one of the assumptions used in determining the fair value of our employee stock options under the Black Scholes option pricing model. The expected term represents the period that our stock-based awards are estimated to be outstanding. We believe that we have sufficient historical experience for determining the expected term of the stock option award, and therefore, we calculated our expected term based on historical experience instead of using the simplified method.

Property and Equipment —Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets as follows:

 
Estimated Useful Lives
Building and building improvements
20 years
Evaluation units
1 year
Computer equipment, software and tooling
1-2 years
Furniture and fixtures
3 - 5 years
Leasehold improvements
Shorter of useful life or lease term

Effective March 2014, we moved into our new corporate headquarters. The useful life of building improvements placed into service during the three months ended March 31, 2014, in association with our new corporate headquarters is estimated to be 20 years. The useful life of furniture and fixtures now ranges from 3 to 5 years as we placed new furniture and fixtures into service at the new corporate headquarters.

Reclassification —Beginning in the first quarter of 2014, the amounts previously reported as Ratable and other revenue have been combined with the amounts previously reported as Services revenue in the Condensed Consolidated Statements of Operations. The combined amounts are being presented as Services and other revenue in the Condensed Consolidated Statements of Operations. The related Cost of revenue and Gross profit, including prior period amounts, have also

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been combined to conform to the current period presentation. The Ratable and other revenue amounts, including the related Cost of revenue and Gross profit amounts, are not material.


Results of Operations

Revenue
 
 
Three Months Ended
 
 
 
 
March 31,
2014
 
March 31,
2013
 
 
 
 
Amount
 
% of
Revenue
 
Amount
 
% of
Revenue
 
Change
 
% Change
(in thousands except percentage)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Product
$
76,765

 
45
%
 
$
57,950

 
43
%
 
$
18,815

 
32
%
Services and other
92,184

 
55

 
77,870

 
57

 
14,314

 
18

Total revenue
$
168,949

 
100
%
 
$
135,820

 
100
%
 
$
33,129

 
24
%
Revenue by geography:
 
 
 
 
 
 
 
 
 
 
 
Americas
$
72,432

 
43
%
 
$
52,627

 
39
%
 
$
19,805

 
38
%
EMEA
56,643

 
33

 
47,326

 
35

 
9,317

 
20

APAC
39,874

 
24

 
35,867

 
26

 
4,007

 
11

Total revenue
$
168,949

 
100
%
 
$
135,820

 
100
%
 
$
33,129

 
24
%

Total revenue increased by $33.1 million , or 24% , in the three months ended March 31, 2014 compared to the same period last year. All three regions experienced revenue growth compared to the same period last year, with Americas contributing the largest portion of our revenue growth. Product revenue increased by $18.8 million , or 32% in the three months ended March 31, 2014, 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 for our entry-level products for smaller enterprises, our mid-range products for mid to large enterprises and branch deployments, and our high-end products for large enterprise and service provider customers. We also experienced strong demand for some of our more recently introduced high-end appliances.

Services and other revenue increased by $14.3 million , or 18% , in the three months ended March 31, 2014 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. In addition, we grew our FortiGuard subscription offerings and FortiCare support, as well as increase in our professional services revenues from existing large enterprise customers.


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Cost of revenue and gross margin
 
 
Three Months Ended
 
 
 
 
March 31,
2014
 
March 31,
2013
 
Change
 
% Change
(in thousands except percentage)
Cost of revenue:
 
 
 
 
 
 
 
Product
$
32,139

 
$
22,958

 
$
9,181

 
40
%
Services and other
18,604

 
16,170

 
2,434

 
15

Total cost of revenue
$
50,743

 
$