Fortinet, Inc.
FORTINET INC (Form: 10-Q, Received: 08/05/2014 08:22:58)
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 June 30, 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 July 31, 2014 , there were 163,772,825 shares of the registrant’s common stock outstanding.


Table of Contents







FORTINET, INC.
QUARTERLY REPORT ON FORM 10-Q
For the Quarter Ended June 30, 2014
Table of Contents
 
 
 
 
 
 
Page
 
 
 
 
Part I
 
 
 
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
 
Part II
 
 
 
 
Item 1.
Item 1A.
Item 2.
Item 5.
Item 6.
 


 


Table of Contents




Part I


Item 1. Financial Statements
FORTINET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except per share amounts)
 
 
June 30,
2014
 
December 31,
2013
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
203,947

 
$
115,873

Short-term investments
354,174

 
375,497

Accounts receivable—Net of allowance for doubtful accounts and sales returns of $5,005 and $4,605 as of June 30, 2014 and December 31, 2013, respectively
127,825

 
130,471

Inventory
46,824

 
48,672

Deferred tax assets
50,984

 
50,980

Prepaid expenses and other current assets
23,195

 
14,053

Total current assets
806,949

 
735,546

PROPERTY AND EQUIPMENT—Net
55,300

 
36,652

DEFERRED TAX ASSETS
36,531

 
30,058

LONG-TERM INVESTMENTS
352,473

 
351,675

GOODWILL
2,824

 
2,872

OTHER INTANGIBLE ASSETS—Net
3,377

 
6,841

OTHER ASSETS
7,658

 
4,820

TOTAL ASSETS
$
1,265,112

 
$
1,168,464

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
35,848

 
$
35,599

Accrued liabilities
25,176

 
27,380

Accrued payroll and compensation
43,705

 
34,997

Income taxes payable

 
21,421

Deferred revenue
321,359

 
293,664

Total current liabilities
426,088

 
413,061

DEFERRED REVENUE
158,843

 
138,964

INCOME TAXES PAYABLE
36,551

 
30,208

OTHER LIABILITIES
18,411

 
471

Total liabilities
639,893

 
582,704

COMMITMENTS AND CONTINGENCIES (Note 9)


 
 
STOCKHOLDERS’ EQUITY:
 
 
 
Common stock, $0.001 par value — 300,000 shares authorized; 163,568 and 161,535 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively
163

 
161

Additional paid-in capital
507,053

 
462,644

Accumulated other comprehensive income
1,181

 
1,092

Retained earnings
116,822

 
121,863

Total stockholders’ equity
625,219

 
585,760

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
1,265,112

 
$
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
 
Six Months Ended
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
REVENUE:
 
 
 
 
 
 
 
Product
$
85,384

 
$
66,525

 
$
162,149

 
$
124,475

Services and other
98,714

 
80,903

 
190,898

 
158,773

Total revenue
184,098

 
147,428

 
353,047

 
283,248

COST OF REVENUE:
 
 
 
 
 
 
 
Product
37,455

 
26,948

 
69,594

 
49,906

Services and other
20,302

 
16,760

 
38,906

 
32,930

Total cost of revenue
57,757

 
43,708

 
108,500

 
82,836

GROSS PROFIT:
 
 
 
 
 
 
 
Product
47,929

 
39,577

 
92,555

 
74,569

Services and other
78,412

 
64,143

 
151,992

 
125,843

Total gross profit
126,341

 
103,720

 
244,547

 
200,412

OPERATING EXPENSES:
 
 
 
 
 
 
 
Research and development
29,938

 
25,158

 
58,993

 
48,492

Sales and marketing
74,817

 
55,997

 
142,143

 
105,973

General and administrative
10,444

 
8,788

 
19,454

 
16,779

Total operating expenses
115,199

 
89,943

 
220,590

 
171,244

OPERATING INCOME
11,142

 
13,777

 
23,957

 
29,168

INTEREST INCOME
1,319

 
1,337

 
2,652

 
2,706

OTHER (EXPENSE) INCOME—Net
(574
)
 
(100
)
 
(963
)
 
115

INCOME BEFORE INCOME TAXES
11,887

 
15,014

 
25,646

 
31,989

PROVISION FOR INCOME TAXES
5,806

 
6,035

 
11,172

 
10,761

NET INCOME
$
6,081

 
$
8,979

 
$
14,474

 
$
21,228

Net income per share attributable to common stockholders (Note 7):
 
 
 
 
 
 
 
Basic
$
0.04

 
$
0.06

 
$
0.09

 
$
0.13

Diluted
$
0.04

 
$
0.05

 
$
0.09

 
$
0.13

Weighted-average shares outstanding:
 
 
 
 
 
 
 
Basic
163,161

 
162,247

 
162,778

 
161,767

Diluted
168,345

 
168,042

 
168,015

 
168,033

See notes to condensed consolidated financial statements.


4





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

 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Net income
$
6,081

 
$
8,979

 
$
14,474

 
$
21,228

Other comprehensive income (loss)—net of taxes:
 
 
 
 
 
 
 
Foreign currency translation gains (losses)
1,118

 
(861
)
 
101

 
(1,813
)
Unrealized losses on investments
(21
)
 
(1,468
)
 
(19
)
 
(1,426
)
Tax benefit related to items of other comprehensive income or loss
7

 
513

 
7

 
498

Other comprehensive income (loss)—net of taxes
1,104

 
(1,816
)
 
89

 
(2,741
)
Comprehensive income
$
7,185

 
$
7,163

 
$
14,563

 
$
18,487


See notes to condensed consolidated financial statements.




5





FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
14,474

 
$
21,228

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

 
 
Depreciation and amortization
10,914

 
7,322

Amortization of investment premiums
4,752

 
5,889

Stock-based compensation
27,646

 
20,006

Excess tax benefit from stock-based compensation
(2,443
)
 
(1,894
)
Other non-cash items—net
3,549

 
(925
)
Changes in operating assets and liabilities:

 
 
Accounts receivable—Net
2,228

 
(801
)
Inventory
(3,307
)
 
(16,375
)
Deferred tax assets
(6,470
)
 
(13,205
)
Prepaid expenses and other current assets
(4,523
)
 
(258
)
Other assets
159

 
778

Accounts payable
1,253

 
14,255

Accrued liabilities
1,544

 
732

Other liabilities
15,375

 
(989
)
Accrued payroll and compensation
8,665

 
2,287

Deferred revenue
47,871

 
25,943

Income taxes payable
(16,987
)
 
11,339

Net cash provided by operating activities
104,700

 
75,332

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchase of investments
(283,338
)
 
(275,029
)
Sales of investments
22,864

 
16,691

Maturities of investments
273,214

 
176,378

Purchase of property and equipment
(21,022
)
 
(3,569
)
Payments made in connection with acquisitions—net of cash acquired
(17
)
 
(5,985
)
Net cash used in investing activities
(8,299
)
 
(91,514
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
22,518

 
15,590

Taxes paid related to net share settlement of equity awards
(5,521
)
 

Excess tax benefit from stock-based compensation
2,443

 
1,894

Repurchase and retirement of common stock
(27,167
)
 

Net cash (used in) provided by financing activities
(7,727
)
 
17,484

EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS
(600
)
 
(809
)
NET INCREASE IN CASH AND CASH EQUIVALENTS
88,074

 
493

CASH AND CASH EQUIVALENTS—Beginning of period
115,873

 
122,975

CASH AND CASH EQUIVALENTS—End of period
$
203,947

 
$
123,468

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid for income taxes—net
$
31,413

 
$
11,640

NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Liability for purchase of property and equipment and asset retirement obligations
$
6,946

 
$
1,056

Liability incurred for repurchase of common stock
$
733

 
$

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, 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 and six months ended June 30, 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 as of and for the three and six months ended June 30, 2014 . During the first quarter of fiscal 2014, 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—net is 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 and software
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 now 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

7


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




Cost of revenue and Gross profit amounts, are not material, and the reclassification did not have any impact on our gross margin or net income.

Recent Accounting Pronouncement —In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09 (Topic 606) - Revenue from Contracts with Customers ( ASU 2014-09 ) to create a single, joint revenue standard that is consistent across all industries and markets for companies that prepare their financial statements in accordance with U.S. GAAP. Under ASU 2014-09, an entity is required to recognize revenue upon the transfer of promised goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to receive in exchange for those goods or services. ASU 2014-09 is effective for us beginning on January 1, 2017. We are currently evaluating the impact of ASU 2014-09 on our consolidated financial statements.


2. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

The following table summarizes our investments as of June 30, 2014 and December 31, 2013 (in thousands):
 
 
June 30, 2014
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
567,252

 
$
1,313

 
$
(205
)
 
$
568,360

Commercial paper
75,154

 
2

 
(3
)
 
75,153

Municipal bonds
37,938

 
50

 
(12
)
 
37,976

Certificates of deposit and term deposits
17,402

 
2

 

 
17,404

U.S. government and agency securities
7,749

 
7

 
(2
)
 
7,754

Total available-for-sale securities
$
705,495

 
$
1,374

 
$
(222
)
 
$
706,647


 
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 June 30, 2014 and December 31, 2013 (in thousands):


8


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




 
June 30, 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
$
149,229

 
$
(204
)
 
$
1,019

 
$
(1
)
 
$
150,248

 
$
(205
)
Commercial paper
10,884

 
(3
)
 

 

 
10,884

 
(3
)
Municipal bonds
6,215

 
(10
)
 
4,018

 
(2
)
 
10,233

 
(12
)
U.S. government and agency securities
1,998

 
(2
)
 

 

 
1,998

 
(2
)
Total available-for-sale securities
$
168,326

 
$
(219
)
 
$
5,037

 
$
(3
)
 
$
173,363

 
$
(222
)

 
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):
 
 
June 30,
2014
 
December 31,
2013
Due within one year
$
354,174

 
$
375,497

Due within one to three years
352,473

 
351,675

Total
$
706,647

 
$
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 declines 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 June 30, 2014 .

Realized gains and losses from the sale of available-for-sale securities were not significant in any of the periods presented.


Fair Value of Financial Instruments

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table presents the fair value of our financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2014 and December 31, 2013 (in thousands):
 

9


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




 
June 30, 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
$
568,360

 
$

 
$
568,360

 
$

 
$
604,317

 
$

 
$
604,317

 
$

Commercial paper
75,153

 

 
75,153

 

 
71,363

 

 
71,363

 

Municipal bonds
37,976

 

 
37,976

 

 
38,843

 

 
38,843

 

Certificates of deposit and term deposits
17,404

 

 
17,404

 

 
12,648

 

 
12,648

 

Money market funds
21,139

 
21,139

 

 

 
5,724

 
5,724

 

 

U.S. government and agency securities
7,754

 
1,998

 
5,756

 

 
2,001

 

 
2,001

 

Total
$
727,786

 
$
23,137

 
$
704,649

 
$

 
$
734,896

 
$
5,724

 
$
729,172

 
$

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Contingent consideration
$

 
$

 
$

 
$

 
$
1,850

 
$

 
$

 
$
1,850

Total
$

 
$

 
$

 
$

 
$
1,850

 
$

 
$

 
$
1,850

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reported as:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
$
21,139

 
 
 
 
 
 
 
$
7,724

 
 
 
 
 
 
Short-term investments
354,174

 
 
 
 
 
 
 
375,497

 
 
 
 
 
 
Long-term investments
352,473

 
 
 
 
 
 
 
351,675

 
 
 
 
 
 
Total
$
727,786

 
 
 
 
 
 
 
$
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 and six months ended June 30, 2014 .

We have classified the fair value of contingent consideration arising from the acquisition of Coyote Point Systems, Inc. ( “Coyote”) ( see Note 5), as a Level 3 liability since it is based on a probability-based income approach that includes significant unobservable inputs. The significant unobservable inputs include projected revenues and the percentage probability of occurrence to determine the fair value of the payment. A decrease in the projected revenue during the six months ended June 30, 2014 resulted in no fair value being attributable to the contingent consideration as of June 30, 2014.

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

As of December 31, 2013
$1,850
Less change in fair value of contingent consideration
(1,143)
As of March 31, 2014
707
Less change in fair value of contingent consideration
(707)
As of June 30, 2014
$—

10


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





The change in fair value is included in research and development expense in the condensed consolidated statements of operations.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

We measure certain assets, including Goodwill, Other intangible assets—net, and investments in privately-held companies at fair value on a nonrecurring basis when there are identifiable events or changes in circumstances that may have a significant adverse impact on the fair value of these assets.

During the three and six months ended June 30, 2014, a decrease in the projected cash flow from Coyote resulted in an impairment charge of $2.4 million to adjust the intangible assets acquired from Coyote to a fair value of $2.0 million as of June 30, 2014. The impairment charge is included within Cost of product revenue in the condensed consolidated statements of operations.

We have classified these intangible assets acquired from Coyote as Level 3 assets due to the lack of observable inputs to determine fair value. Significant inputs used in the determination of fair value based on the probability-weighted income approach primarily include internal cash flow projections and discount rates.
 
As of December 31, 2013, we did not have any assets or liabilities measured at fair value on a nonrecurring basis.


3. INVENTORY

Inventory consisted of the following (in thousands):
 
 
June 30,
2014
 
December 31,
2013
Raw materials
$
5,284

 
$
4,319

Finished goods
37,424

 
40,093

Consigned inventory
4,116

 
4,260

Inventory
$
46,824

 
$
48,672


 
4. PROPERTY AND EQUIPMENT—Net
Property and equipment—net consisted of the following (in thousands):
 
 
June 30,
2014
 
December 31,
2013
Land
$
13,895

 
$
13,895

Building and building improvements
17,779

 
610

Evaluation units
26,904

 
23,442

Computer equipment and software
29,948

 
23,556

Furniture and fixtures
4,552

 
1,697

Construction-in-progress
4,332

 
10,947

Leasehold improvements
7,314

 
4,303

Total property and equipment
104,724

 
78,450

Less: accumulated depreciation
(49,424
)
 
(41,798
)
Property and equipment—net
$
55,300

 
$
36,652



11


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




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.

Depreciation expense was $6.0 million and $3.4 million during the three months ended June 30, 2014 and June 30, 2013, respectively. Depreciation expense was $9.9 million and $6.6 million during the six months ended June 30, 2014 and June 30, 2013, respectively.


5. BUSINESS COMBINATIONS

Coyote Point Systems

On March 21, 2013, we acquired all of the outstanding equity securities of 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. As of June 30, 2014, we have estimated there are no contingent earn-out payments.

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. 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 remaining useful life of approximately five 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 and six months ended June 30, 2014 .

During the three months ended June 30, 2014, we reassessed the fair value and the remaining useful life of the developed technologies acquired from Coyote. Based on this reassessment, we recorded an impairment charge of $2.4 million , which reduced the carrying value of the Coyote developed technologies to $2.0 million . The impairment charge is included within Cost of product revenue in the condensed consolidated statements of operations. Subsequent to the impairment, the remaining carrying value of the Coyote developed technologies will be amortized on a straight-line basis over an estimated remaining useful life of approximately five years.

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

 
June 30, 2014
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
Developed technology
$
5,606

 
$
2,625

 
$
2,981

Customer relationships
500

 
104

 
396

Total other intangible assets—net
$
6,106

 
$
2,729

 
$
3,377


 
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 $0.4 million during the three months ended June 30, 2014 and June 30, 2013, respectively. Amortization expense was $1.0 million and $0.7 million for the six months ended June 30, 2014 and June 30, 2013, respectively. The following table summarizes estimated future amortization expense of Other intangible assets—net (in thousands):

 
Amount
Years Ending December 31:
 
2014 (remainder)
$
545

2015
1,091

2016
785

2017
425

2018
425

Thereafter
106

Total
$
3,377



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 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 (in thousands, except per share amounts):
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Numerator:
 
 
 
 
 
 
 
Net income
$
6,081

 
$
8,979

 
$
14,474

 
$
21,228

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Basic shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding-basic
163,161

 
162,247

 
162,778

 
161,767

Diluted shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding-basic
163,161

 
162,247

 
162,778

 
161,767

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Stock options
4,583

 
5,734

 
4,753

 
6,152

RSUs
600

 
32

 
462

 
46

ESPP
1

 
29

 
22

 
68

Weighted-average shares used to compute diluted net income per share
168,345

 
168,042

 
168,015

 
168,033

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.04

 
$
0.06

 
$
0.09

 
$
0.13

Diluted
$
0.04

 
$
0.05

 
$
0.09

 
$
0.13


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
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Stock options
4,201

 
7,472

 
4,323

 
7,483

RSUs
593

 
2,554

 
1,871

 
1,804

ESPP

 

 
261

 

 
4,794

 
10,026

 
6,455

 
9,287



14


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




8. DEFERRED REVENUE

Deferred revenue consisted of the following (in thousands):
 
 
June 30,
2014
 
December 31,
2013
Product
$
4,063

 
$
2,915

Services and other
476,139

 
429,713

Total deferred revenue
$
480,202

 
$
432,628

Reported As:
 
 
 
Current
$
321,359

 
$
293,664

Non-current
158,843

 
138,964

Total deferred revenue
$
480,202

 
$
432,628



9. COMMITMENTS AND CONTINGENCIES

The following table summarizes our future principal contractual obligations as of June 30, 2014 (in thousands):

 
Total
 
2014 (remainder)
 
2015
 
2016
 
2017
 
2018
 
Thereafter
Operating lease commitments
$
34,431

 
$
4,905

 
$
7,814

 
$
6,120

 
$
5,190

 
$
3,966

 
$
6,436

Less: Sublease rental income
876

 
404

 
472

 

 

 

 

Operating lease commitments—net
33,555

 
4,501

 
7,342

 
6,120

 
5,190

 
3,966

 
6,436

Purchase commitments
46,379

 
46,379

 

 

 

 

 

Other contractual commitments
15,987

 
12,131

 
2,717

 
743

 
396

 

 

Total
$
95,921

 
$
63,011

 
$
10,059

 
$
6,863

 
$
5,586

 
$
3,966

 
$
6,436


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. Rent expense is recognized using the straight-line method over the term of the lease. Rent expense was $2.4 million during the three months ended June 30, 2014 and June 30, 2013 . Rent expense was $5.1 million and $4.7 million during the six months ended June 30, 2014 and June 30, 2013, respectively.
    
Purchase Commitments and Other Contractual 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 June 30, 2014 , we had $46.4 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 June 30, 2014 , we had $16.0 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)




 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
Accrued warranty balance—beginning of the period
$
3,037

 
$
2,309

Warranty costs incurred
(1,728
)
 
(1,744
)
Provision for warranty for the period
2,560

 
2,204

Adjustment related to pre-existing warranties
(415
)
 
208

Accrued warranty balance—end of the period
$
3,454

 
$
2,977


Litigation —We are involved in disputes, litigation, and other legal actions. For lawsuits where we are the defendant, we are in the process of 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 (“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 for the periods presented below:
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2014
Expected term in years
4.9

 
4.9

Volatility
43.3
%
 
43.3% - 44.5%

Risk-free interest rate
1.7
%
 
1.7
%
Dividend rate

 


There were no stock options granted during the three and six months ended June 30, 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


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




 
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
218

 
21.36

 
 
 
 
Forfeited
(284
)
 
23.84

 
 
 
 
Exercised
(2,082
)
 
7.32

 
 
 
 
Balance—June 30, 2014
13,373

 
14.00

 
 
 
 
Options vested and expected to vest—June 30, 2014
13,337

 
$
13.98

 
2.97
 
$
152,067

Options exercisable—June 30, 2014
10,952

 
$
11.97

 
2.61
 
$
146,189


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 June 30, 2014 , for all in-the-money options. As of June 30, 2014 , total compensation expense related to unvested stock options granted to employees but not yet recognized was $28.2 million , net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average period of 1.5 years.  

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

 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Weighted-average fair value per share granted
$
8.18

 
$

 
$
8.58

 
$

Intrinsic value of options exercised
$
16,441

 
$
3,058

 
$
31,762

 
$
29,117

Fair value of options vested
$
4,209

 
$
5,486

 
$
8,771

 
$
16,489


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
2,222

 
21.37

Forfeited
(237
)
 
21.81

Vested
(791
)
 
22.55

Balance—June 30, 2014
5,393

 
$
21.75

RSUs expected to vest—June 30, 2014
5,094

 
$
21.78


As of June 30, 2014 , total compensation expense related to unvested RSUs that were granted to employees and non-employees under the Plan, but not yet recognized, was $112.5 million , net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 3.0 years.

The following summarizes the number and value of the shares withheld for employee taxes (in thousands):

17


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





 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2014
Shares withheld for taxes
86

 
257

Amount withheld for taxes
$
1,888

 
$
5,521


No RSUs vested in the three and six months ended June 30, 2013.

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:

 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
Expected term in years
0.5

 
0.5

Volatility
35.9
%
 
48.0
%
Risk-free interest rate
0.1
%
 
0.1
%
Dividend rate

 


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

 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
Weighted-average fair value per share granted
$
5.35

 
$
7.02

Shares issued under the ESPP
424

 
329

Weighted-average price per share issued
$
17.18

 
$
19.91


There were no shares granted or issued under the ESPP during the three months ended June 30, 2014 and June 30, 2013.


18


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




Stock-based Compensation Expense

Stock-based compensation expense is included in costs and expenses as follows (in thousands):
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Cost of product revenue
$
178

 
$
96

 
$
291

 
$
186

Cost of services and other revenue
1,363

 
1,226

 
2,692

 
2,246

Research and development
4,171

 
3,291

 
8,053

 
6,057

Sales and marketing
5,747

 
4,594

 
11,493

 
8,712

General and administrative
3,257

 
1,500

 
5,117

 
2,805

Total stock-based compensation expense
$
14,716

 
$
10,707

 
$
27,646

 
$
20,006


The following table summarizes stock-based compensation expense by award type (in thousands):
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Stock options
$
4,421

 
$
5,135

 
$
9,113

 
$
10,622

RSUs
9,248

 
4,357

 
16,611

 
7,030

ESPP
1,047

 
1,215

 
1,922

 
2,354

Total stock-based compensation expense
$
14,716

 
$
10,707

 
$
27,646

 
$
20,006


Total income tax benefit associated with stock-based compensation that is included as part of the provision for income taxes in the condensed consolidated statements of operations is as follows (in thousands):

 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Income tax benefit associated with stock-based compensation
$
4,247

 
$
2,794

 
$
7,813

 
$
6,381


Share Repurchase Program

On December 6, 2013, our Board of Directors authorized a Share Repurchase Program (“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 may be suspended, modified or discontinued at any time without prior notice. During the three and six months ended June 30, 2014, we repurchased 0.7 million and 1.0 million shares of common stock under the Program in open market transactions for an aggregate purchase price of $14.9 million and $22.5 million , respectively. As of June 30, 2014, $138.6 million remains authorized for future share repurchases under the Program.


11. INCOME TAXES

The effective tax rate was 49% for the three months ended June 30, 2014 , compared to an effective tax rate of 40% for the three months ended June 30, 2013 . The effective tax rate was 44% for the six months ended June 30, 2014, compared to an effective tax of 34% for the six months ended June 30, 2013. The provision for income taxes for the periods presented is comprised of U.S. federal and state taxes, Singapore and other foreign income taxes, and withholding tax, as well as the inclusion of stock compensation benefits and transfer pricing allocations which impact jurisdictional income taxed at various tax rates.


19


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




As of June 30, 2014 and December 31, 2013 , unrecognized tax benefits were $35.7 million and $30.2 million , respectively. The total amount of $ 35.7 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 June 30, 2014 , we had accrued approximately $1.4 million for estimated interest related to uncertain tax positions.


12. EMPLOYEE BENEFIT PLANS

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 June 30, 2014 and June 30, 2013 were $0.6 million and $0.5 million , respectively. Our matching contributions to the 401(k) Plans and RRSP for the six months ended June 30, 2014 and June 30, 2013 were $1.2 million and $1.1 million , respectively.


13. SEGMENT INFORMATION

The following table sets forth revenue by geographic region (in thousands):
 
 
Three Months Ended
 
Six Months Ended
Revenue
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Americas:
 
 
 
 
 
 
 
United States
$
49,672

 
$
38,815

 
$
94,465

 
$
73,603

Other Americas
28,713

 
21,211

 
56,352

 
39,050

Total Americas
78,385

 
60,026

 
150,817

 
112,653

Europe, Middle East, and Africa (“EMEA”)
62,554

 
50,801

 
119,197

 
98,127

Asia Pacific and Japan (“APAC”)
43,159

 
36,601

 
83,033

 
72,468

Total revenue
$
184,098

 
$
147,428

 
$
353,047

 
$
283,248


During the three months and six months ended June 30, 2014 , Exclusive Networks Group accounted for 14% of total revenue. During the three and six months ended June 30, 2013, Exclusive Networks Group accounted for 11% and 12% of total revenue, respectively.

 

20


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




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

Property and Equipment—Net
June 30,
2014
 
December 31,
2013
Americas:
 
 
 
United States
$
43,834

 
$
29,334

Canada
6,828

 
4,372

Other Americas
29

 
45

Total Americas
50,691

 
33,751

EMEA
2,300

 
1,273

APAC
2,309

 
1,628

Total property and equipment—net
$
55,300

 
$
36,652



14. ACCUMULATED OTHER COMPREHENSIVE INCOME

The following table summarizes the changes in accumulated balances of other comprehensive income for the six months ended June 30, 2014 (in thousands):

 
June 30, 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
101

 
(10
)
 
4

 
95

Amounts reclassified from accumulated other comprehensive income

 
(9
)
 
3

 
(6
)
Net current-period other comprehensive income
101

 
(19
)
 
7

 
89

Balance as of June 30, 2014
$
434

 
$
1,149

 
$
(402
)
 
$
1,181


The following table provides details about the reclassification out of accumulated other comprehensive income for the six months ended June 30, 2014 (in thousands):

June 30, 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
 
$
(9
)
 
Other (expense) income—net
Tax provision related to items of other comprehensive income or loss
 
3

 
Provision for income taxes
Total reclassification for the period
 
$
(6
)
 
 



21


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




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, including forward contracts, 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 Other (expense) income—net in our condensed 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 GBP, EUR 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 June 30, 2014 and December 31, 2013 were (in thousands):

 
Buy/Sell
 
Notional
Currency—As of June 30, 2014
 
 
 
CAD
Buy
 
$
20,587

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


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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 and investments in strategic relationships;

expected impact of sales of certain products;
 
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;

expectations regarding spending related to capital expenditures, including improvements and expansion of our new corporate headquarters and other offices and the implementation of our enterprise resource planning system;