Fortinet, Inc.
FORTINET INC (Form: 10-Q, Received: 05/06/2016 18:03:49)
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 March 31, 2016
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 Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   x   No   o  
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  
Large accelerated filer
x
 
 
Accelerated filer
o
Non-accelerated filer
o
(Do not check if smaller reporting company)
 
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes   o      No   x
As of April 29, 2016 , there were 171,671,224 shares of the registrant’s common stock outstanding.




FORTINET, INC.
QUARTERLY REPORT ON FORM 10-Q
For the Quarter Ended March 31, 2016
Table of Contents
 
 
 
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


 


Table of Contents

Part I

ITEM 1.
Financial Statements

FORTINET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except per share amounts)
 
 
March 31,
2016
 
December 31,
2015
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
568,008

 
$
543,277

Short-term investments
384,591

 
348,074

Accounts receivable—net of reserves for sales returns and doubtful accounts of $6,545 and $6,228 at March 31, 2016 and December 31, 2015, respectively
220,135

 
259,563

Inventory
78,239

 
83,868

Prepaid expenses and other current assets
34,728

 
35,761

Total current assets
1,285,701

 
1,270,543

LONG-TERM INVESTMENTS
241,888

 
272,959

DEFERRED TAX ASSETS
131,696

 
119,216

PROPERTY AND EQUIPMENT—net
115,782

 
91,067

OTHER INTANGIBLE ASSETS—net
16,457

 
17,640

GOODWILL
4,692

 
4,692

OTHER ASSETS
15,305

 
14,393

TOTAL ASSETS
$
1,811,521

 
$
1,790,510

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
47,955

 
$
61,500

Accrued liabilities
33,543

 
33,028

Accrued payroll and compensation
58,165

 
61,111

Income taxes payable
9,230

 
8,379

Deferred revenue
538,449

 
514,652

Total current liabilities
687,342

 
678,670

DEFERRED REVENUE
298,739

 
276,651

INCOME TAX LIABILITIES
65,163

 
60,624

OTHER LIABILITIES
17,874

 
19,188

Total liabilities
1,069,118

 
1,035,133

COMMITMENTS AND CONTINGENCIES (Note 10)


 


STOCKHOLDERS’ EQUITY:
 
 
 
Common stock, $0.001 par value—300,000 shares authorized; 171,588 and 171,399 shares issued and outstanding at March 31, 2016 and December 31, 2015, respectively
171

 
171

Additional paid-in capital
718,849

 
687,658

Accumulated other comprehensive income (loss)
294

 
(933
)
Retained earnings
23,089

 
68,481

Total stockholders’ equity
742,403

 
755,377

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
1,811,521

 
$
1,790,510

See notes to condensed consolidated financial statements.


3


FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share amounts)
 
 
Three Months Ended
March 31,
2016
 
March 31,
2015
REVENUE:
 
 
 
Product
$
124,572

 
$
97,509

Service
160,004

 
115,377

Total revenue
284,576

 
212,886

COST OF REVENUE:
 
 
 
Product
49,359

 
41,368

Service
28,390

 
22,234

Total cost of revenue
77,749

 
63,602

GROSS PROFIT:
 
 
 
Product
75,213

 
56,141

Service
131,614

 
93,143

Total gross profit
206,827

 
149,284

OPERATING EXPENSES:
 
 
 
Research and development
44,966

 
35,816

Sales and marketing
147,403

 
100,609

General and administrative
19,802

 
11,961

Restructuring charges
328

 

Total operating expenses
212,499

 
148,386

OPERATING INCOME (LOSS)
(5,672
)
 
898

INTEREST INCOME
1,746

 
1,422

OTHER EXPENSE—net
(1,312
)
 
(677
)
INCOME (LOSS) BEFORE INCOME TAXES
(5,238
)
 
1,643

PROVISION FOR (BENEFIT FROM) INCOME TAXES
(1,809
)
 
83

NET INCOME (LOSS)
$
(3,429
)
 
$
1,560

Net income (loss) per share (Note 8):
 
 
 
Basic
$
(0.02
)
 
$
0.01

Diluted
$
(0.02
)
 
$
0.01

Weighted-average shares outstanding:
 
 
 
Basic
171,745

 
168,077

Diluted
171,745

 
173,720

See notes to condensed consolidated financial statements.


4


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

 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
Net income (loss)
$
(3,429
)
 
$
1,560

Other comprehensive income:
 
 
 
Unrealized gains on investments
1,888

 
885

Tax provision related to other items of other comprehensive income
(661
)
 
(310
)
Other comprehensive income—net of taxes
1,227

 
575

Comprehensive income (loss)
$
(2,202
)
 
$
2,135


See notes to condensed consolidated financial statements.




5


FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income (loss)
$
(3,429
)
 
$
1,560

Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Depreciation and amortization
10,550

 
6,353

Amortization of investment premiums
1,497

 
1,938

Stock-based compensation
30,881

 
18,880

Other non-cash items—net
(372
)
 
159

Changes in operating assets and liabilities:
 
 
 
Accounts receivable—net
38,920

 
23,621

Inventory
(527
)
 
(6,296
)
Deferred tax assets
(13,141
)
 
(7,918
)
Prepaid expenses and other current assets
1,029

 
(1,203
)
Other assets
(911
)
 
507

Accounts payable
(11,426
)
 
(11,305
)
Accrued liabilities
300

 
(3,450
)
Accrued payroll and compensation
(2,945
)
 
(3,149
)
Other liabilities
(1,332
)
 
(1,569
)
Deferred revenue
46,106

 
40,696

Income taxes payable
5,391

 
5,795

Net cash provided by operating activities
100,591

 
64,619

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of investments
(115,672
)
 
(120,991
)
Sales of investments
2,867

 
6,679

Maturities of investments
108,557

 
135,363

Purchases of property and equipment
(29,956
)
 
(4,927
)
Net cash provided by (used in) investing activities
(34,204
)
 
16,124

CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
17,785

 
28,955

Taxes paid related to net share settlement of equity awards
(9,441
)
 
(6,600
)
Repurchase and retirement of common stock
(50,000
)
 

Net cash provided by (used in) financing activities
(41,656
)
 
22,355

NET INCREASE IN CASH AND CASH EQUIVALENTS
24,731

 
103,098

CASH AND CASH EQUIVALENTS—Beginning of period
543,277

 
283,254

CASH AND CASH EQUIVALENTS—End of period
$
568,008

 
$
386,352

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid for income taxes—net
$
5,574

 
$
6,498

NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Transfers of evaluation units from inventory to property and equipment
$
6,671

 
$
3,869

Liability for purchase of property and equipment and asset retirement obligations
$
7,843

 
$
2,140

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, 2015, contained in our Annual Report on Form 10-K (the “Form 10-K”) filed with the SEC on February 26, 2016. 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 months ended March 31, 2016 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, 2015 is derived from the audited consolidated financial statements for the year ended December 31, 2015.

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 months ended March 31, 2016.

Recently Adopted Accounting Standards

In September 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2015-16—Business Combinations—Simplifying the Accounting for Measurement-Period Adjustments, which eliminates the requirement for an acquirer in a business combination to account for measurement-period adjustments retrospectively. Instead, acquirers must recognize measurement-period adjustments during the period in which they determine the amounts, including the effect on earnings of any amounts they would have recorded in previous periods if the accounting had been completed at the acquisition date. We adopted ASU 2015-16 on January 1, 2016. The adoption of ASU 2015-16 did not have any impact on our consolidated financial statements.

In April 2015, the FASB issued ASU 2015-05—Intangibles—Goodwill and Other—Internal—Use Software— Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement, which provides guidance on determining whether a cloud computing arrangement contains a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. We adopted ASU 2015-05 on a prospective basis beginning on January 1, 2016. The impact of ASU 2015-05 did not have a significant impact on our consolidated financial statements.

In February 2015, the FASB issued ASU 2015-02—Consolidation—Amendments to the Consolidation Analysis, which updates the accounting guidance on consolidation requirements. This update changes the guidance with respect to the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. ASU 2015-02 also makes several modifications to the consolidation guidance for variable interest entities (“VIEs”). We adopted ASU 2015-02 on January 1, 2016. The adoption of ASU 2015-02 did not have any impact on our consolidated financial statements.

Recent Accounting Standards Not Yet Effective

In March 2016, the FASB issued ASU 2016-09—Compensation—Stock Compensation—Improvements to Employee Share-Based Payment Accounting, which changes certain aspects of accounting for shared-based payments to employees. The new guidance will require all income tax effects of awards to be recognized in the income statement for the period in which the awards vest or are settled. It also allows an employer to repurchase more of an employee’s shares for tax withholding purposes without triggering liability accounting and to make a policy election to account for forfeitures as they occur. This new guidance will be effective for us beginning on January 1, 2017, and interim periods within those fiscal years. Early adoption is permitted in any annual or interim period for which financial statements have not been issued or made available for issuance, but all of

7

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



the guidance must be adopted in the same period. We are currently evaluating the impact ASU 2016-09 will have on our consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02—Leases, which amends lease accounting requirements to begin recording assets and liabilities arising from leases on the balance sheet. The new guidance will also require significant additional disclosures about the amount, timing and uncertainty of cash flows from leases. This new guidance will be effective for us beginning on January 1, 2019 using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply. We are currently evaluating the impact ASU 2016-02 will have on our consolidated financial statements.

In January 2016, the FASB issued ASU 2016-01—Financial Instruments—Overall—Recognition and Measurement of Financial Assets and Financial Liabilities, which modifies how entities measure equity investments and present changes in the fair value of financial liabilities. Under the new guidance, entities will have to measure equity investments that do not result in consolidation and are not accounted under the equity method at fair value and recognize any changes in fair value in net income unless the investments qualify for the new practicality exception. The practicality exception will apply to those equity investments that do not have a readily determinable fair value and do not qualify for the practical expedient to estimate fair value, and as such these investments may be measured at cost. ASU 2016-01 will be effective for us beginning on January 1, 2018. We do not expect the impact of ASU 2016-01 on our consolidated financial statements to be significant.
   
In July 2015, the FASB issued ASU 2015-11—Inventory—Simplifying the Measurement of Inventory, which changes the measurement principle for inventory from the lower of cost or market to lower of cost and net realizable value. ASU 2015-11 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 or average cost). ASU 2015-11 will be effective for us beginning on January 1, 2017. We do not expect the impact of ASU 2015-11 on our consolidated financial statements to be significant.

In May 2014, the FASB issued ASU 2014-09—Revenue from Contracts with Customers, which creates 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. In March 2016, the FASB issued ASU 2016-08, which clarifies the implementation guidance on principal versus agent considerations. In April 2016, the FASB issued ASU 2016-10, which clarifies the implementation guidance on identifying performance obligations and licensing. These standards 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 these new standards on our consolidated financial statements.

2. FINANCIAL INSTRUMENTS AND FAIR VALUE

The following table summarizes our investments as of March 31, 2016 and December 31, 2015 (in thousands):
 
 
March 31, 2016
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
410,265

 
$
574

 
$
(250
)
 
$
410,589

Commercial paper
75,465

 
7

 
(8
)
 
75,464

Municipal bonds
54,198

 
53

 
(7
)
 
54,244

Certificates of deposit and term deposits (1)
19,847

 

 

 
19,847

U.S. government and agency securities
66,253

 
82

 

 
66,335

Total available-for-sale securities
$
626,028

 
$
716

 
$
(265
)
 
$
626,479


8

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



 
December 31, 2015
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
438,533

 
$
30

 
$
(1,369
)
 
$
437,194

Commercial paper
66,263

 
3

 
(34
)
 
66,232

Municipal bonds
61,050

 
12

 
(40
)
 
61,022

Certificates of deposit and term deposits (1)
14,897

 

 

 
14,897

U.S. government and agency securities
41,727

 
3

 
(42
)
 
41,688

Total available-for-sale securities
$
622,470

 
$
48

 
$
(1,485
)
 
$
621,033

 
 
 
 
 
 
 
 
(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 March 31, 2016 and December 31, 2015 (in thousands):

 
March 31, 2016
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
Corporate debt securities
$
141,018

 
$
(159
)
 
$
50,269

 
$
(91
)
 
$
191,287

 
$
(250
)
Commercial paper
16,754

 
(8
)
 

 

 
16,754

 
(8
)
Municipal bonds
12,710

 
(6
)
 
1,006

 
(1
)
 
13,716

 
(7
)
Total available-for-sale securities
$
170,482

 
$
(173
)
 
$
51,275

 
$
(92
)
 
$
221,757

 
$
(265
)


 
December 31, 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
$
348,534

 
$
(1,187
)
 
$
42,033

 
$
(182
)
 
$
390,567

 
$
(1,369
)
Commercial paper
31,977

 
(34
)
 

 

 
31,977

 
(34
)
Municipal bonds
41,677

 
(36
)
 
1,008

 
(4
)
 
42,685

 
(40
)
U.S. government and agency securities
34,703

 
(42
)
 

 

 
34,703

 
(42
)
Total available-for-sale securities
$
456,891

 
$
(1,299
)
 
$
43,041

 
$
(186
)
 
$
499,932

 
$
(1,485
)

The contractual maturities of our investments as of March 31, 2016 and December 31, 2015 were as follows (in thousands):
 
 
March 31,
2016
 
December 31,
2015
Due within one year
$
384,591

 
$
348,074

Due within one to three years
241,888

 
272,959

Total
$
626,479

 
$
621,033


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

9

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



securities are insignificant in the periods presented and are included in Other expense—net in our condensed consolidated statements of operations. We use the specific identification method to determine the cost basis of investments sold.

The unrealized losses on our available-for-sale securities were caused by fluctuations in market value and interest rates as a result of the economic environment. As the decline in market value are attributable to changes in market conditions and not credit quality, and because we have concluded currently that we neither intend to sell nor 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 March 31, 2016 .

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 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.


10

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



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 March 31, 2016 and December 31, 2015 (in thousands):
 
 
March 31, 2016
 
 
 
December 31, 2015
 
 
 
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
$
410,589

 
$

 
$
410,589

 
$

 
$
437,194

 
$

 
$
437,194

 
$

Commercial paper
82,962

 

 
82,962

 

 
69,231

 

 
69,231

 

Municipal bonds
54,244

 

 
54,244

 

 
61,022

 

 
61,022

 

Certificates of deposit and term deposits
19,847

 

 
19,847

 

 
14,897

 

 
14,897

 

Money market funds
48,599

 
48,599

 

 

 
50,030

 
50,030

 

 

U.S. government and agency securities
66,335

 
50,326

 
16,009

 

 
41,688

 
25,693

 
15,995

 

Total
$
682,576

 
$
98,925

 
$
583,651

 
$

 
$
674,062

 
$
75,723

 
$
598,339

 
$

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reported as:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
$
56,097

 
 
 
 
 
 
 
$
53,029

 
 
 
 
 
 
Short-term investments
384,591

 
 
 
 
 
 
 
348,074

 
 
 
 
 
 
Long-term investments
241,888

 
 
 
 
 
 
 
272,959

 
 
 
 
 
 
Total
$
682,576

 
 
 
 
 
 
 
$
674,062

 
 
 
 
 
 

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the three months ended March 31, 2016 .

3. INVENTORY

Inventory consisted of the following as of March 31, 2016 and December 31, 2015 (in thousands):
 
 
March 31,
2016
 
December 31,
2015
Raw materials
$
15,270

 
$
15,425

Finished goods
62,969

 
68,443

Inventory
$
78,239

 
$
83,868


Inventory includes finished goods held by distributors where revenue is recognized on a sell-through basis of $0.9 million and $1.1 million as of March 31, 2016 and December 31, 2015 , respectively. Inventory also includes materials at contract manufacturers of $4.9 million both as of March 31, 2016 and December 31, 2015 .
 

11

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



4. PROPERTY AND EQUIPMENT—net
Property and equipment—net as of March 31, 2016 and December 31, 2015 consisted of the following (in thousands):
 
 
March 31,
2016
 
December 31,
2015
Land
$
30,321

 
$
21,683

Building and building improvements
39,454

 
28,841

Evaluation units
18,413

 
15,784

Computer equipment and software
49,701

 
45,632

Furniture and fixtures
10,536

 
8,901

Construction-in-progress
8,796

 
8,106

Leasehold improvements
13,182

 
11,179

Total property and equipment
170,403

 
140,126

Less: accumulated depreciation
(54,621
)
 
(49,059
)
Property and equipment—net
$
115,782

 
$
91,067


During the first quarter of 2016, we purchased certain real property in Union City, California, for cash of  $18.5 million  to support the growth in our business operations. Of the total cost, we allocated  $8.7 million to land and $9.8 million to building.
Depreciation expense was $9.4 million and $6.0 million during the three months ended March 31, 2016 and March 31, 2015, respectively.

5. INVESTMENTS IN PRIVATELY-HELD COMPANIES

Our investments in the equity securities of three privately-held companies totaled $10.3 million as of March 31, 2016 and December 31, 2015 . Each of these investments are accounted for as cost-basis investments, 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 sheet and would be measured at fair value if indicators of impairment exist. As of March 31, 2016 , no events have occurred that would adversely affect the carrying value of these investments.

We determined that we had a variable interest in these privately-held companies. However, we determined that we were not the primary beneficiary as we did not have the power to direct their activities that most significantly affect their economic performance. The variable interest entities were not required to be consolidated in our condensed consolidated financial statements.


12

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



6. BUSINESS COMBINATIONS

On July 8, 2015, we completed our acquisition of all of the outstanding shares of Meru Networks, Inc. (“Meru”), a provider of Wi-Fi networking products and services. With this acquisition, we expect to expand on our secure wireless vision and enterprise growth focus, broaden our solutions portfolio, and enhance our opportunity to address the global enterprise Wi-Fi market with integrated and intelligent secure wireless solutions.

In connection with the acquisition, we paid total cash consideration of $40.9 million and incurred $0.4 million of withholding tax liability. In addition, all of the outstanding restricted stock units (“RSUs”) of Meru were converted into RSUs for 53,401 shares of our common stock. The cash payment, along with the estimated fair value of the earned RSUs assumed, resulted in a purchase price of $41.8 million . The total purchase price was as follows (in thousands):

Purchase Price:
 
Cash
$
40,914

Estimated fair value of shares withheld for taxes
379

Estimated fair value of earned equity awards assumed by Fortinet
471

Total purchase price
$
41,764


We accounted for this transaction as a business combination. In 2015, we expensed acquisition-related costs of $1.7 million in general and administrative expenses. The total purchase price was allocated to Meru’s identifiable tangible and intangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date.

Total allocation of the purchase price was as follows (in thousands):

Cash and cash equivalents
$
3,268

Accounts receivable
8,191

Inventory
11,610

Prepaid expenses and other assets
2,409

Property and equipment
920

Deferred tax assets
18,585

Identifiable intangible assets
19,600

Goodwill
1,868

Total assets acquired
66,451

Deferred revenue
9,800

Accounts payable and accrued liabilities
14,887

Total liabilities assumed
24,687

Total purchase price allocation
$
41,764


The goodwill of $1.9 million represents the premium we paid over the fair value of the net tangible liabilities assumed and identified intangible assets acquired, due primarily to Meru’s assembled workforce. The goodwill recorded as part of the Meru acquisition is not deductible for U.S. federal income tax purposes.


13

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



Intangible assets consist primarily of customer relationships and developed technologies. Customer relationships represent Meru’s installed base and the ability to sell existing, in-process and future versions of our products and services to its existing customers. Developed technologies represent the virtualized wireless local area network solutions offering centralized coordination and control of various access points on the network. This includes patented and unpatented technology, know-how, processes, designs and computer software. The estimated useful life and fair values of the acquired identifiable intangible assets were as follows (in thousands, except for estimated useful life):

 
Estimated Useful Life (in years)
 
Fair Values
Customer relationships
5
 
$
12,200

Developed technologies
4
 
7,200

Trade name
0.5
 
200

Total
 
 
$
19,600


Customer relationships and trade name are amortized and the amortization expense is recorded in sales and marketing expenses in the condensed consolidated statement of operations. Developed technologies is amortized and the amortization expense is recorded in cost of product revenue in the condensed consolidated statement of operations.

7. GOODWILL AND OTHER INTANGIBLE ASSETS—net

Goodwill

As of March 31, 2016 , we had goodwill of $4.7 million . There were no impairments to goodwill during the three months ended March 31, 2016 .

Other Intangible Assets—net

The following tables present other intangible assets—net as of March 31, 2016 and December 31, 2015 (in thousands):

 
March 31, 2016
 
Weighted-Average Useful Life (in Years)
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
 
 
Customer relationships
5.0
 
$
12,200

 
$
1,830

 
$
10,370

Developed technologies and other
3.6
 
11,384

 
5,297

 
6,087

Total other intangible assets—net
 
 
$
23,584

 
$
7,127

 
$
16,457


 
December 31, 2015
 
Weighted-Average Useful Life (in Years)
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
 
 
Customer relationships
5.0
 
$
12,200

 
$
1,220

 
$
10,980

Developed technologies and other
3.6
 
11,384

 
4,724

 
6,660

Total other intangible assets—net
 
 
$
23,584

 
$
5,944

 
$
17,640



14

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



Amortization expense was $1.2 million and $0.3 million during the three months ended March 31, 2016 and March 31, 2015, respectively. The following table summarizes estimated future amortization expense of Other intangible assets—net (in thousands):

 
Amount
Years:
 
2016 (remainder)
$
3,417

2017
4,240

2018
4,240

2019
3,340

2020
1,220

Total
$
16,457


8. NET INCOME (LOSS) PER SHARE

Basic net income (loss) per share is computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding, plus the dilutive effects of stock options, RSUs including performance stock units (“PSUs”), and our employee stock purchase plan (“ESPP”). 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 (loss) per share is as follows (in thousands, except per share amounts):
 
 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
Numerator:
 
 
 
Net income (loss)
$
(3,429
)
 
$
1,560

 
 
 
 
Denominator:
 
 
 
Basic shares:
 
 
 
Weighted-average common stock outstanding-basic
171,745

 
168,077

Diluted shares:
 
 
 
Weighted-average common stock outstanding-basic
171,745

 
168,077

Effect of potentially dilutive securities:
 
 
 
Stock options

 
3,837

RSUs (including PSUs)

 
1,741

ESPP

 
65

Weighted-average shares used to compute diluted net income per share
171,745

 
173,720

Net income (loss) per share:
 
 
 
Basic
$
(0.02
)
 
$
0.01

Diluted
$
(0.02
)
 
$
0.01



15

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



The following potentially dilutive shares of common stock were excluded from the computation of diluted net income (loss) per share for the periods presented, as their effect would have been antidilutive (in thousands):
 
 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
Stock options
6,939

 
249

RSUs (including PSUs)
10,020

 
1,333

ESPP
282

 
169

 
17,241

 
1,751


9. RESTRUCTURING CHARGES

In connection with the acquisition of Meru, we initiated planned cost reduction and restructuring activities to improve our cost structure and operational efficiencies starting in the third quarter of 2015. We estimate that we will incur $8.0 million to $8.5 million of restructuring charges, consisting of severance and other benefits, contract terminations and other charges. We incurred $0.3 million of restructuring charges during the three months ended March 31, 2016 , which are included in operating expense in the condensed consolidated statements of operations. To date, we have incurred $7.9 million of charges related to this restructuring. These charges are primarily related to severance payments to be paid in cash.

The following table provides a summary of restructuring activity as of March 31, 2016 (in thousands):

 
Employee Severance and Other Benefits
 
Contract Terminations and Other Charges
 
Total
Balance as of December 31, 2015
$
3,689

 
$
229

 
$
3,918

Costs incurred
328

 

 
328

Less cash payments
(1,282
)
 
(125
)
 
(1,407
)
Less non-cash charges
(89
)
 

 
(89
)
Balance as of March 31, 2016
$
2,646

 
$
104

 
$
2,750


Cash payments for the restructuring activities are expected to be made through 2017, primarily relating to severance payments. The short-term portion of the restructuring reserve of $2.5 million is included in accrued liabilities and the remaining long-term portion of $0.2 million is included in other liabilities on the condensed consolidated balance sheet as of March 31, 2016 .

10. COMMITMENTS AND CONTINGENCIES

The following table summarizes our future principal contractual obligations as of March 31, 2016 (in thousands):

 
Total
 
2016 (remainder)
 
2017
 
2018
 
2019
 
2020
 
Thereafter
Operating lease commitments
$
60,677

 
$
13,411

 
$
12,897

 
$
11,036

 
$
8,734

 
$
5,945

 
$
8,654

Inventory purchase commitments
77,530

 
77,530

 

 

 

 

 

Other contractual commitments and open purchase orders
49,048

 
41,207

 
3,461

 
1,590

 
930

 
930

 
930

Total
$
187,255

 
$
132,148

 
$
16,358


$
12,626


$
9,664


$
6,875


$
9,584



16

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



Operating Leases —We lease certain facilities under various non-cancelable operating leases, which expire through 2026. Certain leases require us to pay variable costs such as taxes, maintenance, and insurance. The terms of certain operating leases also provide for renewal options and escalation clauses. Rent expense was $4.6 million and $3.1 million during the three months ended March 31, 2016 and March 31, 2015, respectively. Rent expense is recognized using the straight-line method over the term of the lease.
    
Inventory Purchase Commitments —Our independent contract manufacturers procure components and build our products based on our forecasts. These forecasts are based on estimates of future demand for our products, which are in turn based on historical trends and an analysis from our sales and marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate component supply, we may issue purchase orders to some of our independent contract manufacturers which may not be cancelable. As of March 31, 2016 , we had $77.5 million of open purchase orders with our independent contract manufacturers that may not be cancelable.
 
Other Contractual Commitments and Open Purchase Orders —In addition to commitments with contract manufacturers, we have open purchase orders and contractual obligations in the ordinary course of business for which we have not received goods or services. As of March 31, 2016 , we had $49.0 million in other contractual commitments that may not be cancelable.

Warranties —Accrued warranty activities are summarized as follows (in thousands):
 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
Accrued warranty balance—beginning of the period
$
3,144

 
$
4,269

Warranty costs incurred
(511
)
 
(1,095
)
Provision for warranty for the period
377

 
945

Adjustment related to pre-existing warranties
(353
)
 
222

Accrued warranty balance—end of the period
$
2,657

 
$
4,341


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 fees, including contingent legal fees with related parties, costs and substantial settlement charges, and possibly subject us to damages and other penalties. 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 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. In some contracts, our exposure under these indemnification provisions is limited by the terms of the contracts to certain defined limits, such as the total amount paid by our customer under the agreement. However, certain agreements include covenants, penalties 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.


17

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



11. STOCKHOLDERS’ EQUITY

Stock-Based Compensation Plans

We have stock-based compensation plans pursuant to which we have granted stock options and RSUs, including PSUs. We also have an ESPP for all eligible employees. As of March 31, 2016 , there were a total of 45,616,141 shares of common stock available for grant under our stock-based compensation plans.

Restricted Stock Units

The following table summarizes the activity and related information for RSUs, including PSUs, 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, 2015
9,257

 
$
32.97

Granted
2,831

 
23.87

Forfeited
(441
)
 
31.94

Vested
(1,014
)
 
28.45

Balance—March 31, 2016
10,633

 
$
30.86

RSUs expected to vest—March 31, 2016
9,959

 
$
30.71


As of March 31, 2016 , total compensation expense related to unvested RSUs, including PSUs, that were granted to employees and non-employees, but not yet recognized, was $303.8 million . This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 3.0 years. We did not grant any PSUs during the three months ended March 31, 2016. The stock-based compensation expense related to PSU awards is not material. 

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
 
March 31,
2016
 
March 31,
2015
Shares withheld for taxes
343

 
221

Amount withheld for taxes
$
9,441

 
$
6,600




18

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



Employee Stock Options


The following table summarizes the weighted-average assumptions relating to our employee stock options:

 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
Expected term in years
4.3

 
4.3

Volatility
43
%
 
40
%
Risk-free interest rate
1.1
%
 
1.5
%
Dividend rate
%
 
%

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, 2015
6,968

 
$
20.03

 
 
 
 
Granted
1,161

 
23.83

 
 
 
 
Forfeited
(49
)
 
35.46

 
 
 
 
Exercised
(906
)
 
5.82

 
 
 
 
Balance—March 31, 2016
7,174

 
$
22.33

 
 
 
 
Options vested and expected to vest—March 31, 2016
7,011

 
$
22.17

 
3.37
 
$
65,127

Options exercisable—March 31, 2016
5,107

 
$
19.71

 
2.24
 
$
56,011


The aggregate intrinsic value represents the pre-tax difference between the exercise price of stock options and the quoted market price of our common stock on March 31, 2016 , for all in-the-money options. As of March 31, 2016 , total compensation expense related to unvested stock options granted to employees but not yet recognized was $19.5 million . This expense is expected to be amortized on a straight-line basis over a weighted-average period of 3.4 years.  

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

 
Three Months Ended
 
March 31, 2016
 
March 31, 2015
Weighted-average fair value per share granted
$
8.68

 
$
11.17

Intrinsic value of options exercised
19,424

 
41,003

Fair value of options vested
2,084

 
3,792




19

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



Employee Stock Purchase Plan

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

 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
Expected term in years
0.5

 
0.5

Volatility
48
%
 
28
%
Risk-free interest rate
0.4
%
 
0.1
%
Dividend rate
%
 
%

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

 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
Weighted-average fair value per share granted
$
7.19

 
$
7.56

Shares issued under the ESPP
614

 
427

Weighted-average price per share issued
$
20.49

 
$
21.34


Stock-based Compensation Expense

Stock-based compensation expense is included in costs and expenses as follows (in thousands):
 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
Cost of product revenue
$
326

 
$
140

Cost of service revenue
2,193

 
1,632

Research and development
7,355

 
5,157

Sales and marketing
17,114

 
9,307

General and administrative
3,893

 
2,686

Total stock-based compensation expense
$
30,881

 
$
18,922


The following table summarizes stock-based compensation expense by award type (in thousands):
 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
RSUs
$
27,082

 
$
14,292

Stock options
1,954

 
3,455

ESPP
1,845

 
1,175

Total stock-based compensation expense
$
30,881

 
$
18,922



20

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



Total income tax benefit associated with stock-based compensation that is recognized in the consolidated statements of operations is as follows (in thousands):
 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
Income tax benefit associated with stock-based compensation
$
7,834

 
$
3,377


Share Repurchase Program

In January 2016, our board of directors approved a new Share Repurchase Program (the “Program”), which authorizes the repurchase of up to $200.0 million of our outstanding common stock through December 31, 2017. 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 the three months ended March 31, 2016 , we repurchased 2.0 million shares of common stock under the Program in open market transactions at an average price of $24.97 per share, for an aggregate purchase price of $50.0 million . As of March 31, 2016 , $150.0 million remains available for future share repurchases under the Program.

12. INCOME TAXES

Our effective tax rate was 35% for the three months ended March 31, 2016, compared to an effective tax rate of 5% for the same period last year. The effective tax rate for the periods presented was comprised of U.S. federal and state taxes, withholding taxes and foreign income taxes. The changes in the tax provision and effective tax rate were primarily because we had a pretax loss for the three months ended March 31, 2016, as compared to having a pretax income for the same period last year. Our effective tax rate for the three months ended March 31, 2016 included the tax benefit from the U.S. federal research and development (“R&D”) credit. The effective tax rate for the three months ended March 31, 2015 did not reflect the tax benefit of the U.S. federal R&D credit as it expired at the end of 2014 and was reinstated retroactively in December 2015.

As of March 31, 2016 and December 31, 2015, unrecognized tax benefits were $63.4 million and $59.7 million , respectively. The total amount of $62.1 million in unrecognized tax benefits, if recognized, would favorably impact the effective tax rate. It is our policy to classify accrued interest and penalties related to unrecognized tax benefits in the provision for income taxes. As of March 31, 2016, we had accrued $6.7 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 2009. We are no longer subject to examination by U.S. federal tax authorities for tax years prior to 2012. We are currently under examination by U.S federal income tax authorities for the tax years 2012, 2013, and 2014.

13. 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 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) Plan and RRSP for the three months ended March 31, 2016 and March 31, 2015 were $1.0 million and $0.8 million , respectively.


21

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



14. 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 tables set forth revenue and property and equipment—net by geographic region (in thousands):
 
 
Three Months Ended
Revenue
March 31,
2016
 
March 31,
2015
Americas:
 
 
 
United States
$
75,558

 
$
58,501

Canada
31,305

 
20,458

Other Americas
13,183

 
12,601

Total Americas
120,046

 
91,560

Europe, Middle East, and Africa (“EMEA”)
105,491

 
75,664

Asia Pacific (“APAC”)
59,039

 
45,662

Total revenue
$
284,576

 
$
212,886


Property and Equipment net
March 31,
2016
 
December 31,
2015
Americas:
 
 
 
United States
$
82,885

 
$
61,064

Other Americas
9,021

 
8,972

Total Americas
91,906

 
70,036

EMEA:
 
 
 
France
14,585

 
13,201

Other EMEA
5,244

 
3,977

Total EMEA
19,829

 
17,178

APAC
4,047

 
3,853

Total property and equipment—net
$
115,782

 
$
91,067


The following customer, which is a distributor, accounted for 10% or more of our revenue:

 
Three Months Ended
 
March 31,
2016
 
March 31,
2015
Exclusive Networks Group
19
%
 
17
%


22

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



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

 
March 31,
2016
 
December 31,
2015
Exclusive Networks Group
21
%
 
23
%
Fine Tec Computers
13
%
 
*

* Represents less than 10%

15. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

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

 
March 31, 2016
 
Unrealized Losses on Investments
 
Tax benefit (provision) related to items of other comprehensive income or loss
 
Total
Beginning balance
$
(1,437
)
 
$
504

 
$
(933
)
Other comprehensive income (loss) before reclassifications
1,891

 
(662
)
 
1,229

Amounts reclassified from accumulated other comprehensive income (loss)
(3
)
 
1

 
(2
)
Net current-period other comprehensive income (loss)
1,888

 
(661
)
 
1,227

Ending balance
$
451

 
$
(157
)
 
$
294


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

Three Months Ended March 31, 2016
Details about Accumulated Other Comprehensive Income Components
 
Amount Reclassified from Accumulated Other Comprehensive Income (Loss)
 
Affected Line Item in the Statement Where Net Income is Presented
Unrealized losses on investments
 
$
(3
)
 
Other expense—net
Tax benefit related to items of other comprehensive loss
 
1

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

16. 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 United States is denominated in foreign currencies and is subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Canadian dollar (“CAD”) and the Euro (“EUR”). To help protect against significant fluctuations in value and the volatility of future cash flows caused by changes in currency exchange rates, we engage in foreign currency risk management activities to hedge balance sheet items denominated in CAD. We do not use these contracts for speculative or trading purposes. All of the derivative instruments are with high quality financial institutions and we monitor the creditworthiness of these parties. These contracts typically have maturities between one and three months. Changes in the fair value of forward exchange contracts related to balance sheet accounts are insignificant and are included in Other expense—net in the condensed consolidated statement of operations. As of March 31, 2016 , the fair value of the forward exchange contracts was not material.


23

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



Additionally, independent of any hedging activities, fluctuations in foreign currency exchange rates may cause us to recognize transaction gains and losses 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 the CAD, long-term material changes in the value of the U.S. dollar against other foreign currencies, such as the EUR, GBP and CNY could adversely impact our operating expenses in the future.

The notional amount of forward exchange contracts to hedge balance sheet accounts as of March 31, 2016 and December 31, 2015 were (in thousands):

 
Buy/Sell
 
Notional
Balance Sheet Contracts:
 
 
 
Currency—As of March 31, 2016
 
 
 
CAD
Sell
 
$
8,540

 
 
 
 
Currency—As of December 31, 2015
 
 
 
CAD
Sell
 
$
7,011


17. RELATED PARTY TRANSACTIONS

The son of one member of our board of directors 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 of directors were $0.3 million and $1.9 million in the three months ended March 31, 2016 and March 31, 2015, respectively. Of such amounts, $0.2 million and $0.5 million were incurred under contingent fee arrangements in the three months ended March 31, 2016 and March 31, 2015, respectively. Amounts due and payable to the law firm were $0.4 million and $5.3 million as of March 31, 2016 and December 31, 2015 , respectively.



24


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 and other revenue, and the mix of billings between products and services;
 
the impact of our product innovation strategy;

drivers of long-term growth and operating leverage, such as increased functionality and value in our security subscription and support service offerings;

growing our sales to enterprise, service provider and government organizations, and the impact of sales to these organizations on our long-term growth, expansion, 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, 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 those discussed in other documents we file with the SEC. 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.


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Business Overview

We provide high performance cybersecurity solutions to a wide variety of enterprises, service providers and government organizations of all sizes across the globe, including a majority of the 2015 Fortune 100. Our cybersecurity solutions are designed to provide broad, rapid protection against dynamic security threats while simplifying the IT infrastructure of our end-customers worldwide.

Our common operating system, centralized management and open application program interfaces allow many of the solutions in our portfolio to be combined to create an integrated security architecture ( Fortinet Security Fabric ) designed to address sophisticated threats and next-generation environments. The Fortinet Security Fabric connects our products, services and ecosystem partner solutions to provide seamless protection at all points in the network, from endpoint to data center to cloud, regardless of whether deployed in physical, virtual or hybrid environments. Our Security Fabric delivers integrated scalability, access, awareness, security and openness both from the cloud and for the cloud. At the core of our Security Fabric is our FortiGate physical and virtual appliances, which ship with a set of broad security services, including firewall, virtual private network, application control, intrusion prevention, web filtering and advanced threat protection. These security services are enabled by our FortiGuard Labs, which provides extensive threat research and a global cloud network to deliver protection services to each FortiGate appliance. FortiGate also has extensive networking capabilities such as switching, routing, native internet protocol version 6 and different modes of deployment. FortiManager provides central management and FortiAnalyzer provides reporting and analytics. The FortiGate platform can be extended to provide enhanced capabilities.

Customers select the functions or combination of functions that best meet their specific security requirements such as a high-speed data center firewall at the network core, a next generation firewall at the edge or a broad unified threat management solution at branch sites. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20 to -100 series, designed for small businesses, FortiGate-200 to -900 series for mid-sized enterprises, to the FortiGate-1000 to -6000 series for large enterprises and service providers. Our network security platform also includes our FortiGuard security subscription services, to which end-customers can subscribe in order to obtain access to dynamic updates to application control, anti-virus, intrusion prevention, web filtering, and anti-spam functionality. End-customers can also choose to purchase FortiCare technical support services for our products. End-customers also often use FortiManager and FortiAnalyzer products in conjunction with a FortiGate deployment to provide centralized management and analysis and reporting capabilities.

We complement our core FortiGate product line with other appliances and software licenses that offer additional protection from security threats to other critical areas of the enterprise, such as our secure wireless and access solutions, advanced threat protection, secure email gateway, web application firewalls, application delivery controllers, database security, distributed denial of service protection, and endpoint security for employee computers and mobile devices. Sales of these complementary products have grown in recent quarters.

Financial Highlights

We recorded total revenue of $284.6 million in the three months ended March 31, 2016 , an increase of 34% compared to the same period last year. Product revenue was $124.6 million in the three months ended March 31, 2016 , an increase of 28% compared to the same period last year. Service revenue was $160.0 million in the three months ended March 31, 2016 , an increase of 39% compared to the same period last year.

Cash, cash equivalents and investments were $1.19 billion as of March 31, 2016 , an increase of $30.2 million , or 3% , from December 31, 2015 .

Deferred revenue was $837.2 million as of March 31, 2016 , an increase of $45.9 million , or 6% , from December 31, 2015 .

We generated cash flows from operating activities of $100.6 million in the three months ended March 31, 2016 , an increase of $36.0 million , or 56% , compared to the same period last year.

We repurchased 2.0 million shares of common stock under our Share Repurchase Program for an aggregate purchase price of $50.0 million in the three months ended March 31, 2016 .

Revenue grew in the three months ended March 31, 2016 compared to the same period last year as our Security Fabric puts us in a strong competitive position in a robust security market. Our strategy to invest in sales and marketing has enabled us to gain more enterprise customers today than we have had in the past. Large enterprises represent significant opportunity for

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cross-sell and upsell, as they tend to purchase more products and services over time. During the three months ended March 31, 2016 , our revenue growth was driven by greater sales volume in our FortiGate product family due to increased demand across all product categories. Our high-end FortiGate products (FortiGate-1000 to -6000 series) accounted for 37% of billings due to strong sales to service providers and large enterprises. Our mid-range products (FortiGate-200 to -900 series) accounted for 28% of billings, and our entry-level products (FortiGate-20 to -100 series) accounted for 35% of billings. Service revenue also increased as we continue to add to and charge more for functionality and value in our FortiGuard security subscription, FortiCare technical support and other offerings.

During the three months ended March 31, 2016 , operating expenses increased by $64.1 million , or 43% , as compared to the same period last year. The increase was primarily driven by our accelerated pace of hiring and investments made to expand our sales coverage, grow our marketing capabilities, develop new products and scale our customer support. We also continue to invest in research and development to strengthen our technology leadership position. We believe that continued product innovation has strengthened our technology and resulted in market share gains. In addition, we incurred expenses from business design and reengineering related to the implementation of an ERP system. Headcount increased by 38% to 4,239 employees and contractors as of March 31, 2016 , up from 3,076 as of March 31, 2015.

Business Model

Our sales strategy is based on a distribution model whereby we primarily sell our products and services directly to distributors which sell to resellers and service providers, which, in turn, sell to our end-customers. In certain cases, we sell directly to government-focused resellers, large service providers and major systems integrators, which have significant purchasing power and unique customer deployment requirements. Typically, FortiGuard security subscription services and FortiCare technical support services are purchased along with our physical and virtual appliances, most frequently as part of a bundle offering that includes hardware and services. We invoice at the time of our sale for the total price of the products and subscription and technical support services, and the invoice generally becomes payable within 30 to 90 days. We generally recognize product revenue up-front and defer revenue for the sale of new, and renewal of existing, FortiGuard security subscription and FortiCare technical support services contracts. We recognize the related service revenue over the service period, which is typically one to three years, although it can be as long as five years. Sales of new and renewal services are a source of recurring revenue and increase our deferred revenue balance, which contributes significantly to our positive cash flow from operations.

Key Metrics

We monitor a number of financial and operating metrics, including the key financial metrics set forth below, in order to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts, and assess operational efficiencies. The following table summarizes revenue, deferred revenue, billings (non-GAAP), cash, cash equivalents and investments, net cash provided by operating activities, and free cash flow (non-GAAP). We discuss revenue below under “—Results of Operations,” and we discuss our cash, cash equivalents, and investments, and net cash provided by operating activities below under “—Liquidity and Capital Resources.” Deferred revenue, billings (non-GAAP), and free cash flow (non-GAAP) are discussed immediately below the following table.

 
Three Months Ended Or As Of
 
March 31, 2016
 
March 31,
2015
 
(in thousands)
Revenue
$
284,576

 
$
212,886

Deferred revenue
$
837,188

 
$
600,171

Billings (non-GAAP)
$
330,461

 
$
254,300

Cash, cash equivalents and investments
$
1,194,487

 
$
1,072,565

Net cash provided by operating activities
$
100,591

 
$
64,619

Free cash flow (non-GAAP)
$
70,635

 
$
59,692

    
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 unrecognized portion of service revenue from FortiGuard security subscription and FortiCare technical support service contracts, which is recognized as revenue ratably

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over the contractual service period. 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 in accordance with GAAP 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. We consider billings to be a useful metric for management and investors because billings drives future 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 instead of GAAP revenue. First, billings include amounts that have not yet been recognized as revenue. Second, we may calculate billings in a manner that is different from peer companies that report similar financial measures. Management accounts for these limitations by providing specific information regarding GAAP revenue and evaluating billings together with GAAP revenue.

A reconciliation of billings to revenue, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

 
Three Months Ended
March 31,
2016
 
March 31,
2015
(in thousands)
Billings:
 
 
 
Revenue
$
284,576

 
$
212,886

Add increase in deferred revenue
45,885

 
41,414

Total billings (Non-GAAP)
$
330,461

 
$
254,300


Free cash flow (Non-GAAP). We define free cash flow as net cash provided by operating activities minus capital expenditures such as purchases of property and equipment. We consider free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after the acquisition of property and equipment, can be used for strategic opportunities, including investing in our business, making strategic acquisitions, repurchasing outstanding common stock and strengthening the balance sheet. Analysis of free cash flow facilitates management’s comparison of our operating results to those of our peer companies. A limitation of using free cash flow rather than the GAAP measure of net cash provided by operating activities as a means for evaluating liquidity is that free cash flow does not represent the total increase or decrease in the cash, cash equivalents and investments balance for the period because it excludes cash provided by or used for other investing and financing activities. Management accounts for this limitation by providing information about our capital expenditures and other investing and financing activities on the face of the cash flow statement and under “—Liquidity and Capital Resources.” A reconciliation of free cash flow to net cash provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

 
Three Months Ended
March 31,
2016
 
March 31,
2015
(in thousands)
Free Cash Flow:
 
 
 
Net cash provided by operating activities
$
100,591

 
$
64,619

Less purchases of property and equipment
(29,956
)
 
(4,927
)
Free cash flow (Non-GAAP)
$
70,635

 
$
59,692


Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, cost of revenue and expenses, and related disclosures. Our estimates include those related to revenue recognition, stock-based compensation expense, valuation of inventory, warranty liabilities, investments, business combinations, restructuring charges, goodwill and other long-lived assets, and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable

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under the circumstances. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

There have been no material changes to our critical accounting policies and estimates as of and for the three months ended March 31, 2016 , as compared to the critical accounting policies and estimates described in the Form 10-K.

Recent Accounting Pronouncements

See Note 1 to the notes to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for information regarding recent accounting pronouncements.




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Results of Operations

Three Months Ended March 31, 2016 and 2015

Revenue

 
Three Months Ended
 
 
 
 
March 31,
2016
 
March 31,
2015
 
 
 
 
Amount
 
% of
Revenue
 
Amount
 
% of
Revenue
 
Change
 
% Change
(in thousands, except percentages)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Product
$
124,572

 
44
%
 
$
97,509

 
46
%
 
$
27,063

 
28
%
Service
160,004

 
56

 
115,377

 
54

 
44,627

 
39

Total revenue
$
284,576

 
100
%
 
$
212,886

 
100
%
 
$
71,690

 
34
%
Revenue by geography:
 
 
 
 
 
 
 
 
 
 
 
Americas
$
120,046

 
42
%
 
$
91,560

 
43
%
 
$
28,486

 
31
%
EMEA
105,491

 
37

 
75,664

 
36

 
29,827

 
39

APAC
59,039

 
21

 
45,662

 
21

 
13,377

 
29

Total revenue
$
284,576

 
100
%
 
$
212,886

 
100
%
 
$
71,690

 
34
%

Total revenue increased by $71.7 million , or 34% , during the three months ended March 31, 2016 compared to the same period last year. On a geographic basis, revenue continued to diversify globally. All three regions experienced revenue growth compared to the same period last year, with the EMEA region contributing to the largest portion of our revenue growth on both an absolute dollar and percentage basis. Product revenue increased by $27.1 million , or 28% , in the three months ended March 31, 2016 compared to the same period last year. The increase in product revenue was primarily driven by greater sales volume in our FortiGate product family across all product categories and in particular for our mid-range products for service providers and large enterprise customers. Service revenue increased by $44.6 million , or 39% , in the three months ended March 31, 2016 compared to the same period last year. The increase in service revenue was primarily due to the recognition of revenue from our growing deferred revenue balance consisting of FortiGuard security subscription and FortiCare technical support contracts sold to a larger customer base, as well as the renewals of similar contracts sold in earlier periods.

Cost of revenue and gross margin
 
 
Three Months Ended
 
 
 
 
March 31,
2016
 
March 31,
2015
 
Change
 
% Change
(in thousands, except percentages)
Cost of revenue:
 
 
 
 
 
 
 
Product
$
49,359

 
$
41,368

 
$
7,991

 
19
%
Service
28,390

 
22,234

 
6,156

 
28

Total cost of revenue
$
77,749

 
$
63,602

 
$
14,147

 
22
%
Gross margin:
 
 
 
 
 
 
 
Product
60.4
%
 
57.6
%
 
2.8
%
 
 
Service
82.3

 
80.7

 
1.6

 
 
Total gross margin
72.7
%
 
70.1
%
 
2.6
%
 
 

Total gross margin increased by 2.6 percentage points in the three months ended March 31, 2016 compared to the same period last year, as both product and service gross margins increased. Product gross margin