Fortinet, Inc.
FORTINET INC (Form: 10-Q, Received: 08/04/2015 17:33:57)
Table of Contents

 
 
 
 
 
 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
  FORM 10-Q  
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2015
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, 2015 , there were 171,151,438 shares of the registrant’s common stock outstanding.




FORTINET, INC.
QUARTERLY REPORT ON FORM 10-Q
For the Quarter Ended June 30, 2015
Table of Contents
 
 
 
 
 
 
Page
 
 
 
 
Part I
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Part II
 
 
 
 
 


 


Table of Contents

Part I

Item 1. Financial Statements
FORTINET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except per share amounts)
 
 
June 30,
2015
 
December 31,
2014
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
481,393

 
$
283,254

Short-term investments
391,634

 
436,766

Accounts receivable—net of sales returns reserve and allowance for doubtful accounts of $5,834 and $6,204 as of June 30, 2015 and December 31, 2014, respectively
176,849

 
184,741

Inventory
68,845

 
69,477

Deferred tax assets
41,463

 
41,484

Prepaid expenses and other current assets
35,326

 
31,143

Total current assets
1,195,510

 
1,046,865

LONG-TERM INVESTMENTS
275,344

 
271,724

PROPERTY AND EQUIPMENT—net
71,465

 
58,919

DEFERRED TAX ASSETS
44,152

 
31,080

GOODWILL
2,824

 
2,824

OTHER INTANGIBLE ASSETS—net
693

 
2,832

OTHER ASSETS
14,888

 
10,530

TOTAL ASSETS
$
1,604,876

 
$
1,424,774

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
42,336

 
$
49,947

Accrued liabilities
29,145

 
29,016

Accrued payroll and compensation
51,545

 
45,875

Income taxes payable
1,096

 
2,689

Deferred revenue
441,177

 
368,929

Total current liabilities
565,299

 
496,456

DEFERRED REVENUE
216,384

 
189,828

INCOME TAXES PAYABLE
56,765

 
45,139

OTHER LIABILITIES
15,601

 
17,385

Total liabilities
854,049

 
748,808

COMMITMENTS AND CONTINGENCIES (Note 8)


 


STOCKHOLDERS’ EQUITY:
 
 
 
Common stock, $0.001 par value — 300,000 shares authorized; 170,449 and 166,443 shares issued and outstanding as of June 30, 2015 and December 31, 2014, respectively
170

 
166

Additional paid-in capital
634,969

 
562,504

Accumulated other comprehensive loss
(309
)
 
(349
)
Retained earnings
115,997

 
113,645

Total stockholders’ equity
750,827

 
675,966

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
1,604,876

 
$
1,424,774

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,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
REVENUE:
 
 
 
 
 
 
 
Product
$
114,777

 
$
85,384

 
$
212,286

 
$
162,149

Service
125,008

 
98,714

 
240,385

 
190,898

Total revenue
239,785

 
184,098

 
452,671

 
353,047

COST OF REVENUE:
 
 
 
 
 
 
 
Product
47,397

 
37,455

 
88,765

 
69,594

Service
22,101

 
20,302

 
44,335

 
38,906

Total cost of revenue
69,498

 
57,757

 
133,100

 
108,500

GROSS PROFIT:
 
 
 
 
 
 
 
Product
67,380

 
47,929

 
123,521

 
92,555

Service
102,907

 
78,412

 
196,050

 
151,992

Total gross profit
170,287

 
126,341

 
319,571

 
244,547

OPERATING EXPENSES:
 
 
 
 
 
 
 
Research and development
37,389

 
29,938

 
73,205

 
58,993

Sales and marketing
111,928

 
74,817

 
212,537

 
142,143

General and administrative
18,018

 
10,444

 
29,979

 
19,454

Total operating expenses
167,335

 
115,199

 
315,721

 
220,590

OPERATING INCOME
2,952

 
11,142

 
3,850

 
23,957

INTEREST INCOME
1,364

 
1,319

 
2,786

 
2,652

OTHER EXPENSE—net
(830
)
 
(574
)
 
(1,507
)
 
(963
)
INCOME BEFORE INCOME TAXES
3,486

 
11,887

 
5,129

 
25,646

PROVISION FOR INCOME TAXES
2,694

 
5,806

 
2,777

 
11,172

NET INCOME
$
792

 
$
6,081

 
$
2,352

 
$
14,474

Net income per share (Note 6):
 
 
 
 
 
 
 
Basic
$

 
$
0.04

 
$
0.01

 
$
0.09

Diluted
$

 
$
0.04

 
$
0.01

 
$
0.09

Weighted-average shares outstanding:
 
 
 
 
 
 
 
Basic
169,930

 
163,161

 
169,009

 
162,778

Diluted
176,234

 
168,345

 
174,983

 
168,015

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,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Net income
$
792

 
$
6,081

 
$
2,352

 
$
14,474

Other comprehensive income (loss)—net of taxes:
 
 
 
 
 
 
 
Foreign currency translation gains

 
1,118

 

 
101

Unrealized gains (losses) on investments
(822
)
 
(21
)
 
63

 
(19
)
Tax benefit (provision) related to items of other comprehensive income or loss
287

 
7

 
(23
)
 
7

Other comprehensive income (loss)—net of taxes
(535
)
 
1,104

 
40

 
89

Comprehensive income
$
257

 
$
7,185

 
$
2,392

 
$
14,563


See notes to condensed consolidated financial statements.




5


FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
 
Six Months Ended
 
June 30,
2015
 
June 30,
2014
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
2,352

 
$
14,474

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
13,382

 
10,914

Amortization of investment premiums
3,881

 
4,752

Stock-based compensation
40,525

 
27,646

Excess tax benefit from stock-based compensation

 
(2,443
)
Other non-cash items—net
1,891

 
3,549

Changes in operating assets and liabilities:
 
 
 
Accounts receivable—net
9,523

 
2,228

Inventory
(7,917
)
 
(3,307
)
Deferred tax assets
(13,072
)
 
(6,470
)
Prepaid expenses and other current assets
(3,492
)
 
(4,523
)
Other assets
(513
)
 
159

Accounts payable
(8,383
)
 
1,253

Accrued liabilities
(228
)
 
1,544

Accrued payroll and compensation
5,670

 
8,665

Other liabilities
(1,884
)
 
15,375

Deferred revenue
97,156

 
47,871

Income taxes payable
10,033

 
(16,987
)
Net cash provided by operating activities
148,924

 
104,700

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of investments
(229,479
)
 
(283,338
)
Sales of investments
22,472

 
22,864

Maturities of investments
240,625

 
273,214

Purchases of property and equipment
(15,688
)
 
(21,022
)
Other

 
(17
)
Net cash provided by (used in) investing activities
17,930

 
(8,299
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
42,647

 
22,518

Taxes paid related to net share settlement of equity awards
(11,362
)
 
(5,521
)
Excess tax benefit from stock-based compensation

 
2,443

Repurchase and retirement of common stock

 
(27,167
)
Net cash provided by (used in) financing activities
31,285

 
(7,727
)
EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS

 
(600
)
NET INCREASE IN CASH AND CASH EQUIVALENTS
198,139

 
88,074

CASH AND CASH EQUIVALENTS—Beginning of period
283,254

 
115,873

CASH AND CASH EQUIVALENTS—End of period
$
481,393

 
$
203,947

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid for income taxes—net
$
10,077

 
$
31,413

NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Transfers of evaluation units from inventory to property and equipment
$
8,923

 
$
5,668

Liability for purchase of property and equipment and asset retirement obligations
$
1,359

 
$
6,946

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 in the United States (“GAAP”) 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 year ended December 31, 2014, contained in our Annual Report on Form 10-K (“Form 10-K”) filed with the SEC on March 2, 2015. 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, 2015 are not necessarily indicative of the results for the full year or for any future periods. The condensed consolidated balance sheet as of December 31, 2014 is derived from the audited consolidated financial statements for the year ended December 31, 2014.

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, 2015 .

In the third quarter of 2014, we reevaluated the selected functional currency of our international subsidiaries due to the nature of our business operations and recorded the cumulative impact of the reevaluation of the functional currency in the consolidated statement of operations. Subsequently, the remeasurement of the assets and liabilities of all international subsidiaries has been recorded in the consolidated statement of operations prospectively. The impact of this reevaluation was not material for 2014 or any of our previously issued financial statements.

Recent Accounting Pronouncements

In July 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2015-11—Inventory—Simplifying the Measurement of Inventory (Topic 330) (“ASU 2015-11”). ASU 2015-11 changes the measurement principle for inventory from the lower of cost or market to lower of cost and net realizable value. It applies to entities that measure inventory using a method other than last-in, first-out or the retail inventory method (e.g., first-in first-out, average cost). ASU 2015-11 will be effective for us beginning on January 1, 2017. We are currently evaluating the impact of ASU 2015-11 on our consolidated financial statements.

In May 2014, the FASB issued Accounting Standards Update No. 2014-09—Revenue from Contracts with Customers (Topic 606) (“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 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. In July 2015, the FASB decided to delay the effective date of the new revenue standard by one year. As such, ASU 2014-09 will be effective for us beginning on January 1, 2018, with the option to adopt earlier on January 1, 2017. We are currently evaluating the impact of ASU 2014-09 on our consolidated financial statements.



7

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



2. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

The following table summarizes our investments as of June 30, 2015 and December 31, 2014 (in thousands):
 
June 30, 2015
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
551,352

 
$
187

 
$
(635
)
 
$
550,904

Commercial paper
46,639

 
2

 
(4
)
 
46,637

Municipal bonds
58,705

 
21

 
(50
)
 
58,676

Certificates of deposit and term deposits (1)
7,760

 

 

 
7,760

U.S. government and agency securities
2,999

 
2

 

 
3,001

Total available-for-sale securities
$
667,455

 
$
212

 
$
(689
)
 
$
666,978

 
December 31, 2014
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
589,526

 
$
365

 
$
(875
)
 
$
589,016

Commercial paper
51,156

 
3

 
(4
)
 
51,155

Municipal bonds
39,745

 
15

 
(39
)
 
39,721

Certificates of deposit and term deposits (1)
22,854

 

 

 
22,854

U.S. government and agency securities
5,749

 
1

 
(6
)
 
5,744

Total available-for-sale securities
$
709,030

 
$
384

 
$
(924
)
 
$
708,490


(1) The majority of our certificates of deposit and term deposits are foreign deposits.

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, 2015 and December 31, 2014 (in thousands):

 
June 30, 2015
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
Corporate debt securities
$
283,789

 
$
(522
)
 
$
41,362

 
$
(113
)
 
$
325,151

 
$
(635
)
Commercial paper
11,769

 
(4
)
 

 

 
11,769

 
(4
)
Municipal bonds
34,667

 
(46
)
 
1,576

 
(4
)
 
36,243

 
(50
)
Total available-for-sale securities
$
330,225

 
$
(572
)
 
$
42,938

 
$
(117
)
 
$
373,163

 
$
(689
)











8

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



 
December 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
$
317,011

 
$
(858
)
 
$
6,011

 
$
(17
)
 
$
323,022

 
$
(875
)
Commercial paper
8,185

 
(4
)
 

 

 
8,185

 
(4
)
Municipal bonds
26,684

 
(39
)
 

 

 
26,684

 
(39
)
U.S. government and agency securities
4,745

 
(6
)
 

 

 
4,745

 
(6
)
Total available-for-sale securities
$
356,625

 
$
(907
)
 
$
6,011

 
$
(17
)
 
$
362,636

 
$
(924
)

The contractual maturities of our investments as of June 30, 2015 and December 31, 2014 were as follows (in thousands):
 
 
June 30,
2015
 
December 31,
2014
Due within one year
$
391,634

 
$
436,766

Due within one to three years
275,344

 
271,724

Total
$
666,978

 
$
708,490


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—net in our condensed consolidated statements of operations. Realized gains and losses from the sale of available-for-sale securities were not significant in any period presented.

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 is attributable to changes in market conditions and not credit quality, and because we have concluded currently that we neither intend to sell nor is it 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, 2015 .

  Fair Value Accounting—We apply the following fair value hierarchy for disclosure of the inputs used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows:

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

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

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

We measure the fair value of money market funds and certain U.S. government and agency securities using quoted prices in active markets for identical assets. The fair value of all other financial instruments was based on quoted prices for similar assets in active markets, or model driven valuations using significant inputs derived from or corroborated by observable market data.
 
We classify investments within Level 1 if quoted prices are available in active markets 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

9

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



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.

Fair Value of Financial Instruments

Assets Measured at Fair Value on a Recurring Basis

The following table presents the fair value of our financial assets measured at fair value on a recurring basis as of June 30, 2015 and December 31, 2014 (in thousands):
 
 
June 30, 2015
 
December 31, 2014
 
 
Aggregate
Fair
Value
 
Quoted
Prices in
Active
Markets For
Identical
Assets
 
Significant
Other
Observable
Remaining
Inputs
 
Aggregate
Fair
Value
 
Quoted
Prices in
Active
Markets For
Identical
Assets
 
Significant
Other
Observable
Remaining
Inputs
 
 
 
 
(Level 1)
 
(Level 2)
 
 
 
(Level 1)
 
(Level 2)
 
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
$
550,904

 
$

 
$
550,904

 
$
589,016

 
$

 
$
589,016

 
Commercial paper
58,634

 

 
58,634

 
51,155

 

 
51,155

 
Municipal bonds
58,676

 

 
58,676

 
39,721

 

 
39,721

 
Certificates of deposit and term deposits
7,760

 

 
7,760

 
22,854

 

 
22,854

 
Money market funds
31,193

 
31,193

 

 
13,311

 
13,311

 

 
U.S. government and agency securities
3,001

 
2,000

 
1,001

 
5,744

 
1,998

 
3,746

 
Total
$
710,168

 
$
33,193

 
$
676,975

 
$
721,801

 
$
15,309

 
$
706,492

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reported as:
 
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
$
43,190

 
 
 
 
 
$
13,311

 
 
 
 
 
Short-term investments
391,634

 
 
 
 
 
436,766

 
 
 
 
 
Long-term investments
275,344

 
 
 
 
 
271,724

 
 
 
 
 
Total
$
710,168

 
 
 
 
 
$
721,801

 
 
 
 
 

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the period ended June 30, 2015 .


3. INVENTORY

Inventory consisted of the following as of June 30, 2015 and December 31, 2014 (in thousands):
 
 
June 30,
2015
 
December 31,
2014
Raw materials
$
12,235

 
$
10,617

Finished goods
56,610

 
58,860

Total inventory
$
68,845

 
$
69,477


Inventory includes finished goods held by distributors where revenue is recognized on a sell-through basis of $1.2 million as of June 30, 2015 and December 31, 2014. Inventory also includes raw materials at contract manufacturers of $4.2 million and $4.8 million as of June 30, 2015 and December 31, 2014, respectively.


10

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



4. PROPERTY AND EQUIPMENT—net

Property and equipment—net consisted of the following as of June 30, 2015 and December 31, 2014 (in thousands):
 
 
June 30,
2015
 
December 31,
2014
Land
$
14,943

 
$
13,895

Building and building improvements
20,298

 
20,166

Evaluation units
38,140

 
31,474

Computer equipment and software
40,616

 
31,821

Furniture and fixtures
7,160

 
5,096

Construction-in-progress
7,923

 
3,902

Leasehold improvements
8,703

 
7,998

Total property and equipment
137,783

 
114,352

Less: accumulated depreciation
(66,318
)
 
(55,433
)
Property and equipment—net
$
71,465

 
$
58,919


Depreciation expense was $6.8 million and $6.0 million during the three months ended June 30, 2015 and June 30, 2014 , respectively. Depreciation expense was $12.8 million and $9.9 million during the six months ended June 30, 2015 and June 30, 2014 , respectively.

5. INVESTMENTS IN PRIVATELY-HELD COMPANIES

As of June 30, 2015 , we had invested a total of $10.3 million in the equity securities of three privately-held companies. Each of these investments is accounted for as a cost-basis investment, as we own less than 20% of the voting securities and do not have the ability to exercise significant influence over operating and financial policies of the respective entities. These investments are carried at historical cost and are recorded as Other assets on our condensed consolidated balance sheets and would be measured at fair value if indicators of impairment existed.

During the six months ended June 30, 2015 , no events have occurred that would adversely affect the carrying value of these investments.

6. 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”) including performance stock units (“PSUs”), and the employee stock purchase plan (“ESPP”). Dilutive shares of common stock are determined by applying the treasury stock method.


11

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



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,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Numerator:
 
 
 
 
 
 
 
Net income
$
792

 
$
6,081

 
$
2,352

 
$
14,474

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Basic shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding—basic
169,930

 
163,161

 
169,009

 
162,778

Diluted shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding—basic
169,930

 
163,161

 
169,009

 
162,778

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Stock options
3,720

 
4,583

 
3,779

 
4,753

RSUs (including PSUs)
2,521

 
600

 
2,131

 
462

ESPP
63

 
1

 
64

 
22

Weighted-average shares used to compute diluted net income per share
176,234

 
168,345

 
174,983

 
168,015

Net income per share:
 
 
 
 
 
 
 
Basic
$

 
$
0.04

 
$
0.01

 
$
0.09

Diluted
$

 
$
0.04

 
$
0.01

 
$
0.09


The following weighted-average shares of common stock were excluded from the computation of diluted net income per share for the periods presented, as their effect would have been anti-dilutive (in thousands):
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Stock options
299

 
4,201

 
274

 
4,323

RSUs (including PSUs)
414

 
593

 
873

 
1,871

ESPP

 

 
84

 
261

 
713

 
4,794

 
1,231

 
6,455



12

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



7. DEFERRED REVENUE

Deferred revenue consisted of the following as of June 30, 2015 and December 31, 2014 (in thousands):
 

13

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



 
June 30,
2015
 
December 31,
2014
Product
$
4,461

 
$
4,642

Service
653,100

 
554,115

Total deferred revenue
$
657,561

 
$
558,757

Reported as:
 
 
 
Current
$
441,177

 
$
368,929

Non-current
216,384

 
189,828

Total deferred revenue
$
657,561

 
$
558,757


8. COMMITMENTS AND CONTINGENCIES

The following table summarizes our future principal contractual obligations as of June 30, 2015 (in thousands):

 
Total
 
2015 (remainder)
 
2016
 
2017
 
2018
 
2019
 
Thereafter
Operating lease commitments
$
50,093

 
$
7,064

 
$
12,054

 
$
8,536

 
$
6,865

 
$
5,684

 
$
9,890

Less: sublease rental income
57

 
57

 

 

 

 

 

Operating lease commitments—net
50,036

 
7,007

 
12,054

 
8,536

 
6,865

 
5,684

 
9,890

Inventory purchase commitments
74,322

 
74,322

 

 

 

 

 

Other contractual commitments and open purchase orders
33,944

 
28,729

 
3,675

 
978

 
305

 
193

 
64

Total
$
158,302

 
$
110,058

 
$
15,729


$
9,514


$
7,170


$
5,877


$
9,954


Operating Leases —We lease certain facilities under various non-cancelable operating leases, which expire through 2025. In addition to the amounts above, certain leases require us to pay variable costs such as taxes, maintenance, insurance, and asset retirement obligations. The terms of certain operating leases also provide for renewal options and escalation clauses. Rent expense was $2.9 million and $2.4 million during the three months ended June 30, 2015 and 2014, respectively. Rent expense was $6.0 million and $5.1 million during the six months ended June 30, 2015 and 2014, respectively. Rent expense is recognized using the straight-line method over the term of the lease.
    
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 analysis, 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, 2015 , we had $74.3 million of open purchase orders with our independent contract manufacturers.
 
In addition to commitments with contract manufacturers, we have other contractual commitments and open purchase orders in the ordinary course of business for which we have not received goods or services. As of June 30, 2015 , we had $33.9 million in other contractual commitments and open purchase orders.


14

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



Warranties —Accrued warranty activities are summarized as follows (in thousands):
 
 
Six Months Ended
 
June 30,
2015
 
June 30,
2014
Accrued warranty balance—beginning of the period
$
4,269

 
$
3,037

Warranty costs incurred
(2,059
)
 
(1,728
)
Provision for warranty for the period
2,294

 
2,560

Adjustment related to pre-existing warranties
171

 
(415
)
Accrued warranty balance—end of the period
$
4,675

 
$
3,454


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 significant accrual for loss contingencies associated with such legal proceedings; determined that a significant 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 various allegations such as damage resulting from product defects and 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 certain defined limits, such as the total amount paid by our customer under the agreement. However, certain agreements include covenants and indemnification provisions including and 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 and, in some instances, to potential liability that is not contractually limited. To date, there have been no awards under such indemnification provisions.

9. STOCKHOLDERS’ EQUITY

Stock-Based Compensation Plans

We have stock-based compensation plans pursuant to which we have granted stock options and RSUs, including PSUs. The Company also has an ESPP for all eligible employees. As of June 30, 2015 , there were a total of 43,655,799 shares of common stock available for grant under our stock-based compensation plans.

Employee Stock Options

The following table summarizes the weighted-average assumptions relating to our employee stock options:
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Expected term in years
4.3

 
4.9

 
4.3

 
4.9

Volatility
38
%
 
43
%
 
38% - 40%

 
43% - 45%

Risk-free interest rate
1.5
%
 
1.7
%
 
1.5
%
 
1.7
%
Dividend rate
%
 
%
 
%
 
%


15

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



The following table summarizes the stock option activity and related information for the periods presented below (in thousands, except exercise prices and contractual life):
 
 
Options Outstanding
 
Number
of Shares
 
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Life (Years)
 
Aggregate
Intrinsic
Value
Balance—December 31, 2014
10,702

 
$
14.98

 
 
 
 
Granted
349

 
34.15

 
 
 
 
Forfeited
(88
)
 
24.70

 
 
 
 
Exercised
(2,860
)
 
11.95

 
 
 
 
Balance—June 30, 2015
8,103

 
$
16.78

 
 
 
 
Options vested and expected to vest—June 30, 2015
8,059

 
$
16.70

 
2.6
 
$
198,516

Options exercisable—June 30, 2015
6,935

 
$
15.03

 
2.2
 
$
182,363


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, 2015 , for all in-the-money options. As of June 30, 2015 , total compensation expense related to unvested stock options granted to employees but not yet recognized was $12.6 million . This expense is expected to be amortized on a straight-line basis over a weighted-average period of 2.0 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,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Weighted-average fair value per share granted
$
12.75

 
$
8.18

 
$
11.54

 
$
8.58

Intrinsic value of options exercised
22,034

 
16,441

 
63,038

 
31,762

Fair value of options vested
2,718

 
4,209

 
6,510

 
8,771


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, 2014
6,291

 
$
22.93

Granted
3,149

 
34.16

Forfeited
(413
)
 
26.01

Vested
(1,069
)
 
22.01

Balance—June 30, 2015
7,958

 
$
27.62

RSUs expected to vest—June 30, 2015
7,468

 
$
27.41



16

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



As of June 30, 2015 , total compensation expense related to unvested RSUs that were granted to employees and non-employees, but not yet recognized, was $207.6 million . This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 3.0 years.

RSUs settle into shares of common stock upon vesting. Upon the vesting of the RSUs, we net-settle the RSUs and withhold a portion of the shares to satisfy minimum statutory employee withholding taxes. Total payment for the employees’ tax obligations to the taxing authorities is reflected as a financing activity within the condensed consolidated statements of cash flows.

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

 
Three Months Ended
 
Six Months Ended
 
June 30,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Shares withheld for taxes
124

 
86

 
345

 
257

Amount withheld for taxes
$
4,762

 
$
1,888

 
$
11,362

 
$
5,521


Performance Stock Units

We have granted PSUs to certain of our executive officers and employees. PSUs granted to executive officers are based on the achievement of the market-based vesting conditions during the performance period, the final settlement of the PSUs will range between 0% and 150% of the target shares underlying the PSUs based on a specified objective formula approved by our Compensation Committee. The PSUs entitle our executive officers to receive a number of shares of our common stock based on the performance of our stock price over a two - or three -year period as compared to the NASDAQ Composite index for the same periods. PSUs granted to our employees who are not executive officers are based on the achievement of personal- and company-based performance vesting conditions during the performance period. The final settlement of these PSUs will range between 50% to 150% of the target shares underlying the PSUs based on specified objective formula approved by our Compensation Committee. The PSUs entitle such employees to receive a number of shares of our common stock based on a one year performance period, and vest equally in the second and third years. There were no PSUs granted during the three months ended June 30, 2015.

The following table summarizes the weighted-average assumptions relating to our PSUs granted to our executive officers:
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Expected term in years
3.0

 
3.0

 
3.0

Volatility
46
%
 
38
%
 
47
%
Risk-free interest rate
0.9
%
 
1.1
%
 
0.9
%
Dividend rate
%
 
%
 
%


17

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



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

 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Shares granted to executive officers and employees
95

 
206

 
120

Weighted-average fair value per share granted
$
21.05

 
$
34.86

 
$
21.21


As of June 30, 2015 , total compensation expense related to unvested PSUs that were granted to certain of our executive officers and employees, but not yet recognized, was $8.0 million . This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 2.3 years .

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,
2015
 
June 30,
2014
Expected term in years
0.5

 
0.5

Volatility
28
%
 
36
%
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,
2015
 
June 30,
2014
Weighted-average fair value per share granted
$
7.56

 
$
5.35

Shares issued under the ESPP
427

 
424

Weighted-average price per share issued
$
21.34

 
$
17.18


There were no shares granted or issued under the ESPP during the three months ended June 30, 2015 and June 30, 2014.


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,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Cost of product revenue
$
210

 
$
178

 
$
350

 
$
291

Cost of service revenue
1,660

 
1,363

 
3,292

 
2,692

Research and development
5,541

 
4,171

 
10,698

 
8,053

Sales and marketing
11,271

 
5,747

 
20,578

 
11,493

General and administrative
3,078

 
3,257

 
5,764

 
5,117

Total stock-based compensation expense
$
21,760

 
$
14,716

 
$
40,682

 
$
27,646


The following table summarizes stock-based compensation expense by award type (in thousands):
 
Three Months Ended
 
Six Months Ended
 
June 30,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Stock options
$
3,017

 
$
4,421

 
$
6,472

 
$
9,113

RSUs (including PSUs)
17,386

 
9,248

 
31,678

 
16,611

ESPP
1,357

 
1,047

 
2,532

 
1,922

Total stock-based compensation expense
$
21,760

 
$
14,716

 
$
40,682

 
$
27,646


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

 
Three Months Ended
 
Six Months Ended
 
June 30,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Income tax benefit associated with stock-based compensation
$
4,266

 
$
4,247

 
$
7,643

 
$
7,813


Share Repurchase Program

In December 2013, our Board of Directors (“Board”) 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 does not require us to purchase a minimum number of shares, and may be suspended, modified or discontinued at any time without prior notice. In October 2014, our Board extended the share repurchase authorization under the Program through December 31, 2015. During the three and six months ended June 30, 2015 , there were no shares repurchased under the Program. As of June 30, 2015 , $122.5 million remains available for future share repurchases under the Program.

10. INCOME TAXES

The effective tax rate was 77% for the three months ended June 30, 2015 , compared to an effective tax rate of 49% for the same period last year. The effective tax rate was 54% for the six months ended June 30, 2015 , compared to an effective tax rate of 44% for the same period last year. The provision for income taxes for the periods presented is comprised of U.S. federal and state taxes, Singapore and other foreign income taxes, withholding tax, and transfer pricing allocations which impact jurisdictional income taxed at various tax rates. During the three and six months ended June 30, 2015 , there were additional unrecognized tax benefits and non-deductible stock-based compensation expense that adversely impacted the quarterly effective tax rate.


19

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



As of June 30, 2015 and December 31, 2014, unrecognized tax benefits were $52.4 million and $44.2 million , respectively. The total amount of $52.2 million in unrecognized tax benefits, if recognized, would favorably impact the effective tax rate. It is our policy to classify accrued interest and penalties related to unrecognized tax benefits in the provision for income taxes. As of June 30, 2015 , we had accrued $5.2 million for estimated interest related to uncertain tax positions.

We file income tax returns in the U.S. federal jurisdiction, and various U.S. state and foreign jurisdictions. The statute of limitations is open for years that generated state net operating loss carryforwards and after 2009 for state jurisdictions. Additionally, we have foreign net operating losses that have an indefinite life. Generally, we are no longer subject to non-U.S. income tax examinations by tax authorities for tax years prior to 2008. We are no longer subject to examination by U.S federal income tax authorities for tax years prior to 2010.

11. DEFINED CONTRIBUTION PLANS

Our tax-deferred savings plan under our 401(k) Plan, permits participating employees to defer a portion of their pre-tax earnings. In Canada, we have a Group Registered Retirement Savings Plan program (the “RRSP”) which permits participants to make tax deductible contributions. Our Board approved 50% matching contributions on employee contributions up to 4% of each employee’s eligible earnings. Our matching contributions to the 401(k) Plan and RRSP during the three months ended
June 30, 2015 and June 30, 2014 were $0.9 million and $0.6 million , respectively. Our matching contributions to the 401(k) Plan and RRSP during the six months ended June 30, 2015 and June 30, 2014 were $1.8 million and $1.2 million , respectively.

12. SEGMENT AND SIGNIFICANT CUSTOMER INFORMATION

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our chief executive officer. Our chief executive officer reviews financial information presented on a consolidated basis, accompanied by information about revenue by geographic region for purposes of allocating resources and evaluating financial performance. We have one business activity, and there are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Accordingly, we have determined that we have one operating segment, and therefore, one reportable segment.
Revenue by geographic region is based on the billing address of the customer. The following table sets forth revenue (in thousands):
 
 
Three Months Ended
 
Six Months Ended
Revenue
June 30,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Americas:
 
 
 
 
 
 
 
United States
$
71,224

 
$
49,672

 
$
129,725

 
$
94,465

Canada
26,191

 
19,909

 
46,649

 
38,733

Other Americas
11,178

 
8,804

 
23,779

 
17,619

Total Americas
108,593

 
78,385

 
200,153

 
150,817

Europe, Middle East, and Africa (“EMEA”)
83,404

 
62,554

 
159,068

 
119,197

Asia Pacific (“APAC”)
47,788

 
43,159

 
93,450

 
83,033

Total revenue
$
239,785

 
$
184,098

 
$
452,671

 
$
353,047



20

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



The following table sets forth property and equipment by geographic region as of June 30, 2015 and December 31, 2014 (in thousands):

 
 
 
 
Property and Equipment net
June 30,
2015
 
December 31,
2014
Americas:
 
 
 
United States
$
50,328

 
$
46,116

Canada
7,902

 
6,054

Other Americas
764

 
875

Total Americas
58,994

 
53,045

EMEA
9,062

 
3,256

APAC
3,409

 
2,618

Total property and equipment—net
$
71,465

 
$
58,919


The following customer, a distributor, accounted for 10% or more of our revenue:
 
Three Months Ended
 
Six Months Ended
 
June 30,
2015
 
June 30,
2014
 
June 30,
2015
 
June 30,
2014
Exclusive Networks Group
17
%
 
14
%
 
17
%
 
14
%

The following customers, each of which is a distributor, accounted for 10% or more of net accounts receivable:

 
June 30,
2015
 
December 31,
2014
Exclusive Networks Group
20
%
 
18
%
Fine Tec Computer
13
%
 
%

13. ACCUMULATED OTHER COMPREHENSIVE LOSS

The following table summarizes the changes in accumulated balances of other comprehensive loss (in thousands):

 
Unrealized Gains (Losses) on Investments
 
Tax benefit (provision) related to items of other comprehensive income or loss
 
Total
Beginning balance as of December 31, 2014
$
(540
)
 
$
191

 
$
(349
)
Other comprehensive income before reclassifications
69

 
(24
)
 
45

Amounts reclassified from accumulated other comprehensive loss
(6
)
 
1

 
(5
)
Net current-period other comprehensive income
63

 
(23
)
 
40

Ending balance as of June 30, 2015
$
(477
)
 
$
168

 
$
(309
)


21

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



The following table provides details about the reclassification out of accumulated other comprehensive loss (in thousands):

Six Months Ended June 30, 2015
Details about Accumulated Other Comprehensive Loss Components
 
Amount Reclassified from Accumulated Other Comprehensive Loss
 
Affected Line Item in the Statement Where Net Income is Presented
Unrealized gains on investments
 
$
(6
)
 
Other expense—net
Tax provision related to items of other comprehensive income
 
1

 
Provision for income taxes
Total reclassification for the period
 
$
(5
)
 
 

14. 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” ), the Euro ( EUR ), and the British Pound ( GBP ”) . 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 of one month. We record changes in the fair value of forward exchange contracts related to balance sheet accounts as Other expense—net in the condensed 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—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 EUR and GBP could adversely impact our operating expenses in the future.

The notional amount of our forward exchange contract to hedge balance sheet accounts were (in thousands):

 
Buy/Sell
 
Notional
Currency—As of June 30, 2015
 
 
 
CAD
Sell
 
$
6,743

 
 
 
 
Currency—As of December 31, 2014
 
 
 
CAD
Buy
 
$
6,879

 
 
 
 

As of June 30, 2015, the fair value of the forward exchange contract was not material.

15. RELATED PARTY TRANSACTIONS

The son of one member of our Board of Directors (“Board”) is a partner of an outside law firm that we utilize for certain complex litigation matters. Expenses for legal services provided by the law firm related to matters that arose subsequent to the member joining our Board were $0.9 million and $0.5 million for the three months ended June 30, 2015 and June 30, 2014 , respectively. Expenses for legal services provided by the law firm related to matters that arose subsequent to the member joining our Board were $2.8 million and $0.7 million for the six months ended June 30, 2015 and June 30, 2014 , respectively. Amounts due and payable to the law firm were $2.3 million and $1.3 million as of June 30, 2015 and December 31, 2014, respectively.


22

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



16. SUBSEQUENT EVENT

In July 2015, we acquired Meru Networks, Inc. (“Meru”), which offers Wi-Fi networking solutions, for a total consideration of approximately $44.0 million . The acquisition expands on our secure wireless vision and enterprise growth focus, broadens our portfolio of solutions , and expands our opportunity to address the global enterprise Wi-Fi market with integrated secure wireless solutions. We are still in the process of evaluating the business combination accounting considerations, including the consideration transferred and the initial purchase price allocation.






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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:
 
continued growth and market share gains;


variability in sales in certain product categories from year to year and between quarters;

expected impact of sales of certain products;

the proportion of our revenue that consists of our product and service revenue, and the mix of billings between products and services;
 
the impact of our product innovation strategy;

growing our sales to large enterprises, service providers, and government organizations and the impact of sales to these organizations on our long-term growth and operating results;

trends in revenue, costs of revenue, and gross margin;
 
trends in our operating expenses, including 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;

continued investments 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;

competition in our markets;

integration of acquired companies and technologies;

implementation of a new enterprise resource planning (“ERP”) system;

our intentions regarding repatriation of cash, cash equivalents and investments held by our international subsidiaries and the sufficiency of our existing cash, cash equivalents and investments to meet our cash needs for at least the next 12 months; and

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 cybersecurity solutions to some of the largest enterprises, service providers and government organizations across the globe, including a majority of the 2015 Fortune 100. Our cybersecurity solutions are fast

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and secure and designed to provide broad, high-performance protection against dynamic security threats while simplifying the information technology (“IT”) infrastructure of our end-customers worldwide.
 
Our flagship integrated network security solution consists of our FortiGate physical and virtual appliance platforms which are deployable in large enterprise, service provider and small and medium-sized business environments, and government organizations. These platforms provide a broad array of integrated security and networking functions to help protect data, applications, and users from network- and content-level security threats. These functions, which can be integrated in a variety of ways, include firewall, intrusion prevention, anti-malware, application control, virtual private network, web-filtering, vulnerability management, anti-spam, mobile security, wireless controller, and wide area network acceleration. Our FortiGate appliance platforms may be deployed as next generation firewalls, data center firewalls, unified threat management systems, internal segmentation firewalls, virtual machine firewalls or cloud firewalls. For wireless networked environments, we offer our FortiWiFi appliances, which integrate wireless access point capabilities into the FortiGate network security platform. Each FortiWiFi appliance provides secure access to the wired and wireless local area networks, as well as various wide area network connections.

The FortiGate platform includes our FortiASICs, which are specifically designed for accelerated processing of security and networking functions, and our FortiOS operating system, which provides the foundation for all FortiGate security functions. Our FortiGuard security subscription and FortiCare technical support services provide end-customers with access to dynamic updates to our application control, anti-malware, intrusion prevention, web filtering, and anti-spam functionality. Our security subscription services are based in part on intelligence gathered by FortiGuard Labs, a large team of threat researchers who detect threats and help protect our customers. By combining multiple proprietary security and networking functions with our purpose-built FortiASIC and FortiOS, our FortiGate solution delivers broad protection against dynamic security threats while reducing the operational burden and costs associated with managing multiple point products.

We complement our FortiGate product line with the FortiManager and FortiAnalyzer product families. FortiManager provides customers with centralized management of multiple FortiGate appliances while FortiAnalyzer provides customers with a single point of network log data collection. These products enable customers to implement security policies across large networks. The FortiGate platform can be expanded with a number of other security systems including email (FortiMail), endpoint (FortiClient), wireless access points (FortiAP), advanced threat protection (FortiSandbox), and application security (FortiWAF, FortiADC, and FortiDDoS).

We offer virtual appliances for the FortiGate, FortiManager, FortiAnalyzer, FortiWeb, FortiMail, FortiCache, and FortiADC product lines that can be used in conjunction with traditional Fortinet physical appliances, such as FortiGate, FortiManager, and FortiAnalyzer, to help ensure the visibility, management, and protection of physical and virtual environments. We also offer on-demand cloud-based versions of FortiGate and FortiWeb.

Financial Highlights

We recorded total revenue of $239.8 million and $452.7 million for the three and six months ended June 30, 2015 , respectively, an increase of 30% and 28% , respectively, compared to the same periods last year. Product revenue was $114.8 million and $212.3 million during the three and six months ended June 30, 2015 , respectively, an increase of 34% and 31% , respectively, compared to the same periods last year. Service revenue was $125.0 million and $240.4 million for the three and six months ended June 30, 2015 , an increase of 27% and 26% , respectively, compared to the same periods last year.

Cash, cash equivalents and investments were $1.15 billion as of June 30, 2015 , an increase of $156.6 million , or 16% , from December 31, 2014.

Deferred revenue was $657.6 million as of June 30, 2015 , an increase of $98.8 million , or 18% , from December 31, 2014 .

We generated cash flows from operating activities of $148.9 million during the six months ended June 30, 2015 , an increase of $44.2 million , or 42% , compared to the same period last year.

In July 2015, we acquired Meru Networks, Inc. (“Meru”), which offers Wi-Fi networking solutions, for a total consideration of approximately $44.0 million.


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Revenue grew as our integrated security platform products put us in a strong competitive position in a robust security market. In addition, we continue to expand and upgrade our enterprise sales force, build out vertical-specific sales teams, strengthen partnerships with enterprise resellers, and gain from our prior sales investments. Our strategy is enabling us to gain market share, win new customers, and expand within existing customer accounts, especially in the large enterprise market. Aside from obtaining new customers, other levers to drive long-term growth and operating leverage include adding more functionality and value in our security and support service offerings to customers. We continue to grow the number of large deals with large enterprises, which is also key to our long-term growth and profitability strategy as these high-end customers tend to provide higher lifetime value and are beneficial to our business model over time.
 
During the three months ended June 30, 2015 , our revenue growth was primarily driven by our growth in the U.S. large enterprise market. We also continued to see diversity of product sales in our FortiGate product family due to increased demand across all product categories. Our high-end products (FortiGate 1000 to 5000 series) accounted for 45% of billings primarily driven by continued enterprise adoption of our high-end appliances such as the FortiGate1500D and 3700D series appliances. Our mid-range products (FortiGate 200 to 800 series) accounted for 24% of billings, and our entry-level products (FortiGate 20 to 100 series) accounted for 31% of billings. During the three months ended June 30, 2014, our high-end products (FortiGate1000 to 5000 series) accounted for 40% of billings primarily due to an increase in billings from large enterprise customers. Our mid-range products (FortiGate 200 to 800 series) accounted for 26% of billings, and our entry-level products (FortiGate 20 to 100 series) accounted for 34% of billings.
 
During the three and six months ended June 30, 2015 , operating expenses increased compared to the same periods last year. The increase was primarily driven by our accelerated pace of hiring and continued investments to expand our sales coverage, grow our marketing capabilities, develop new products, and scale our customer support organization to meet the needs of our expanding customer base. Headcount, including full time equivalent employees, increased to 3,336 as of June 30, 2015 from 2,532 as of June 30, 2014 .

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
 
June 30,
2015
 
June 30,
2014
 
(in thousands)
Revenue
$
239,785

 
$
184,098

Deferred revenue
$
657,561

 
$
480,202

Increase in deferred revenue
$
57,390

 
$
28,899

Billings (non-GAAP)
$
297,175

 
$
212,997

Cash, cash equivalents and investments
$
1,148,371

 
$
910,594

Net cash provided by operating activities
$
84,305

 
$
43,798

Free cash flow (non-GAAP)
$
73,544

 
$
34,094

    
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 FortiGuard security subscription and FortiCare technical 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 plus the change in deferred revenue from the beginning to the end of the period less any deferred revenue balances acquired from business combination(s) during the period, if any. We consider billings to be a useful metric for management and investors because billings drives deferred revenue, which is an important indicator of the health and viability of our business. 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

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as revenue. Second, we may calculate billings in a manner that is different from peer companies that report similar financial measures. Management compensates for these limitations by providing specific information regarding GAAP revenue and evaluating billings together with revenue 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
June 30,
2015
 
June 30,
2014
(in thousands)
Billings:
&#