Edgar Filing: FORTINET INC

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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 September 30, 2010

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 001-34511



FORTINET, INC.
(Exact name of registrant as specified in its charter)


	Delaware		77-0560389
	(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
	1090 Kifer Road
	Sunnyvale, California		94086
	(Address principal executive offices)		(Zip Code)

(408) 235-7700

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [x] No [ ]

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 [ ] No [ ]

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	[ ]		Accelerated filer	[ ]

Non-accelerated filer	[x]	(Do not check if a smaller reporting company)	Smaller reporting company	[ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [x]

As of October 29, 2010, there were 73,697,694 shares of the registrant's common stock outstanding.

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FORTINET, INC.

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended September 30, 2010

Table of Contents


		Page
Part I
Item 1.	Financial Statements	3
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	23
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	40
Item 4.	Controls and Procedures	40
Part II
Item 1.	Legal Proceedings	41
Item 1A.	Risk Factors	42
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	62
Item 6.	Exhibits	62
	Signatures	63

Table of Contents

Part I

ITEM 1. Financial Statements

FORTINET, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per share amounts)


	September 30, 2010			December 31, 2009
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	77,139		$	212,458
Short-term investments	215,151			47,856
Accounts receivable, net of allowance for doubtful accounts of $303 and $367 at September 30, 2010 and December 31, 2009, respectively	59,562			54,551
Inventory—Net	11,284			10,649
Deferred tax asset	9,876			9,652
Prepaid expenses and other current assets	5,705			3,100
Deferred cost of revenues	3,888			3,951
Total current assets	382,605			342,217
PROPERTY AND EQUIPMENT—Net	6,797			6,387
DEFERRED COST OF REVENUES	6,081			5,743
DEFERRED TAX ASSET—Non-current	31,671			31,671
LONG-TERM INVESTMENTS	60,054			—
OTHER ASSETS	1,239			1,195
TOTAL ASSETS	$	488,447		$	387,213

LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable	$	9,766		$	10,987
Accrued liabilities	15,638			15,050
Accrued payroll and compensation	18,398			13,991
Deferred revenue	158,430			140,537
Total current liabilities	202,232			180,565
DEFERRED REVENUE—Non-current	76,820			61,393
OTHER NON-CURRENT LIABILITIES	2,944			2,803
Total liabilities	281,996			244,761
COMMITMENTS AND CONTINGENCIES (Note 7)
STOCKHOLDERS' EQUITY:
Common stock, $0.001 par value - 300,000 shares authorized; 73,858 and 67,517 shares issued and 73,154 and 66,813 shares outstanding at September 30, 2010 and December 31, 2009, respectively	74			67
Additional paid-in-capital	242,165			204,268
Treasury stock	(2,995		)	(2,995		)
Accumulated other comprehensive income	2,075			1,084
Accumulated deficit	(34,868		)	(59,972		)
Total stockholders' equity	206,451			142,452
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY	$	488,447		$	387,213

See notes to condensed consolidated financial statements.

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FORTINET, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share amounts)


	Three Months Ended						Nine Months Ended
	September 30, 2010			September 30, 2009			September 30, 2010			September 30, 2009
REVENUE:
Product	$	35,913		$	25,550		$	94,060		$	69,327
Services	44,527			36,712			124,116			101,758
Ratable product and services	4,531			3,602			12,921			10,318
Total revenue	84,971			65,864			231,097			181,403
COST OF REVENUE:
Product	13,263			10,428			36,399			29,049
Services	6,565			5,550			19,851			15,955
Ratable product and services	1,615			1,455			4,733			4,062
Total cost of revenue	21,443			17,433			60,983			49,066
GROSS PROFIT:
Product	22,650			15,122			57,661			40,278
Services	37,962			31,162			104,265			85,803
Ratable product and services	2,916			2,147			8,188			6,256
Total gross profit	63,528			48,431			170,114			132,337
OPERATING EXPENSES:
Research and development	12,389			10,797			36,999			31,207
Sales and marketing	26,987			23,468			81,487			69,572
General and administrative	5,993			4,490			16,985			13,678
Total operating expenses	45,369			38,755			135,471			114,457
OPERATING INCOME	18,159			9,676			34,643			17,880
INTEREST INCOME	514			428			1,181			1,677
OTHER INCOME (EXPENSE)—Net	(402		)	(64		)	(565		)	148
INCOME BEFORE INCOME TAXES	18,271			10,040			35,259			19,705
PROVISION FOR INCOME TAXES	4,254			2,151			10,155			3,466
NET INCOME	$	14,017		$	7,889		$	25,104		$	16,239
Net income per share attributable to common stockholders (Note 5):
Basic	$	0.20		$	0.11		$	0.36		$	0.04
Diluted	$	0.18		$	0.10		$	0.33		$	0.04
Weighted-average shares outstanding:
Basic	71,836			58,288			69,188			58,258
Diluted	77,921			64,167			76,645			64,181

See notes to condensed consolidated financial statements

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FORTINET, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)


	Nine Months Ended
	September 30, 2010			September 30, 2009
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	25,104		$	16,239
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	4,233			4,322
Write-off of intangible assets	—			1,075
Gain on disposal of fixed assets	14			—
Amortization of investment premiums	4,934			853
Stock-based compensation	6,846			5,279
Excess tax benefit from employee stock option plans	(4,191		)	(113		)
Changes in operating assets and liabilities:
Accounts receivable—net	(5,011		)	1,932
Inventory	(2,815		)	(1,552		)
Deferred tax assets	(8		)	(6		)
Prepaid expenses and other current assets	(2,905		)	(357		)
Deferred cost of revenues	(274		)	(926		)
Other assets	50			200
Accounts payable	(689		)	1,083
Accrued liabilities	1,711			159
Accrued payroll and compensation	4,312			(689		)
Deferred revenue	33,321			18,758
Income taxes payable	7,327			(501		)
Net cash provided by operating activities	71,959			45,756
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of investments	(311,995		)	(118,662		)
Maturities and sales of investments	80,097			107,283
Purchases of property and equipment	(2,900		)	(4,253		)
Payments made in connection with asset acquisition, net	—			(900		)
Deposits of restricted cash	(4		)	—
Net cash used in investing activities	(234,802		)	(16,532		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options and warrants	23,892			1,908
Offering costs paid in connection with Initial Public Offering	(872		)	—
Repurchase of convertible preferred shares	—			(12,768		)
Repurchase of common shares	—			(2,995		)
Excess tax benefit from employee stock option plans	4,191			113
Net cash provided by (used in) financing activities	27,211			(13,742		)
EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS	313			2,180
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS	(135,319		)	17,662
CASH AND CASH EQUIVALENTS—Beginning of period	212,458			56,571
CASH AND CASH EQUIVALENTS—End of period	$	77,139		$	74,233
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes	$	1,536		$	4,522
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Purchase of property and equipment not yet paid	$	317		$	167

See notes to condensed consolidated financial statements.

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FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Business—Fortinet, Inc. (“Fortinet”) was incorporated in Delaware in November 2000 and is a leading provider of network security appliances and Unified Threat Management (UTM) network security solutions to enterprises, service providers and government entities worldwide. Fortinet's solutions are designed to integrate multiple levels of security protection, including firewall, virtual private networking, antivirus, intrusion prevention, web filtering, antispam and WAN acceleration.

Basis of Presentation and Preparation—The condensed consolidated financial statements include the accounts of Fortinet and its wholly owned subsidiaries (collectively, the “Company,” “we,” “us,” or “our”). All intercompany transactions and balances have been eliminated in consolidation. The accompanying condensed consolidated balance sheet as of September 30, 2010, the condensed consolidated statements of operations for the three and nine months ended September 30, 2010 and September 30, 2009, and the condensed consolidated statements of cash flows for the nine months ended September 30, 2010 and September 30, 2009 are unaudited. The condensed consolidated balance sheet data as of December 31, 2009 was derived from the audited consolidated financial statements which are included in our Annual Report on Form 10-K (“Form 10-K”). The accompanying statements should be read in conjunction with the audited consolidated financial statements and related notes contained in our Form 10-K.

The accompanying unaudited interim condensed consolidated financial statements for the three and nine months ended September 30, 2010 and September 30, 2009 have been prepared on the same basis as the audited consolidated statements and reflect all adjustments, consisting of normal recurring adjustments which are, in the opinion of management, necessary for a fair presentation of our financial position, results of operations, and cash flows for the interim period presented. The statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP” or “GAAP”) pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations. The results of operations for the three and nine months ended September 30, 2010 are not necessarily indicative of the operating results for any subsequent quarter, for the full fiscal year or any future periods.

Until the second quarter of fiscal 2009, we had a 52- to 53-week year ending on the Sunday closest to December 31 of each year. Commencing in the third quarter of fiscal 2009, we began operating and reporting financial results on a calendar quarter and year basis. Our third quarter of fiscal 2009 ended on September 30, 2009. The third quarters of 2010 and 2009 were comprised of 92 and 94 days, respectively. The nine months ended September 30, 2010 and September 30, 2009 were comprised of 273 days and 276 days, respectively.

Use of Estimates—The preparation of condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Such management estimates include implicit service periods for revenue recognition, litigation and settlement costs and other loss contingencies, sales returns and allowances, reserve for bad debt, inventory write-offs, reserve for warranty costs, valuation of deferred tax assets, and tangible and intangible assets. We base our estimates on historical experience and also on assumptions that we believe are reasonable. Actual results could differ from those estimates.

Certain Significant Risks and Uncertainties—We are subject to certain risks and uncertainties that could have a material adverse effect on our future financial position or results of operations, such as the following: changes in level of demand for our products and services, seasonality, the timing of new product introductions, price and sales competition and our ability to adapt to changing market conditions and dynamics, changes in the expenses caused, for example, by fluctuations in foreign currency exchange rates, management of inventory, internal control over financial reporting, market acceptance of our new products and services, demand for UTM products and services in general, failure of our channel partners to perform, the quality of our products and services, general economic conditions, challenges in doing business outside of the United States of America, changes in customer relationships, litigation, or claims against us based on intellectual property, patent, product regulatory or other factors (Note 7), product obsolescence, and our ability to attract and retain qualified employees.

We rely on sole suppliers and independent contract manufacturers for certain of our components and one third-party

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FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

logistics company for distribution of some of our products. The inability of any of these parties to fulfill our supply and logistics requirements could negatively impact our future operating results.

Concentration of Credit Risk—Financial instruments that subject us to concentrations of credit risk consist primarily of cash, cash equivalents, investments, and accounts receivable. We maintain our cash and cash equivalents in fixed income securities with major financial institutions, which our management assesses to be of high credit quality, in order to limit the exposure of each investment. Deposits held with banks may exceed the amount of insurance provided on such deposits.

Credit risk with respect to accounts receivable in general is diversified due to the number of different entities comprising our customer base and their location throughout the world. We perform ongoing credit evaluations of our customers and generally do not require collateral on accounts receivable. We maintain reserves for estimated potential credit losses.

During the three and nine months ended September 30, 2010, no single customer accounted for more than 10% of total net revenue. During the three and nine months ended September 30, 2009, one distributor customer accounted for 11% and 12%, respectively, of total net revenue.

At September 30, 2010, no single customer accounted for more than 10% of net accounts receivable. At December 31, 2009, one distributor customer accounted for 15% of net accounts receivable.

Fair Value of Financial Instruments—Accounting Standards Codification (ASC) 825 (formerly referred to as Statement of Financial Accounting Standards (SFAS) No. 107, Disclosures about Fair Value of Financial Instruments) requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. Due to their short-term nature, the carrying amounts reported in the condensed consolidated financial statements approximate the fair value for cash and cash equivalents, accounts receivable, and accounts payable.

Comprehensive Income—ASC 220 (formerly referred to as SFAS No. 130, Reporting Comprehensive Income) establishes standards for the reporting and displaying of comprehensive income and its components. Comprehensive income includes certain changes in equity from non-owner sources that are excluded from net income. Specifically, cumulative foreign currency translation adjustments and unrealized gains and losses on available-for-sale investments are included in comprehensive income in stockholders' equity.

Foreign Currency Translation—Assets and liabilities of foreign subsidiaries are translated into U.S. dollars using the exchange rates in effect at the balance sheet dates and revenue and expenses are translated using average exchange rates during the period. The resulting foreign translation adjustments are recorded in accumulated other comprehensive income. Foreign currency transaction losses of $0.4 million and $0.1 million, are included in other income (expense), net for the three months ended September 30, 2010 and September 30, 2009, respectively. Foreign currency transaction gains (losses) of $(0.6) million and $0.1 million, are included in other income (expense), net for the nine months ended September 30, 2010 and September 30, 2009, respectively.

Cash, Cash Equivalents and Investments—We consider all highly liquid investments, purchased with original maturities of three months or less, to be cash equivalents. Cash and cash equivalents consist of cash on-hand, balances with banks, and highly liquid investments in money market funds, commercial paper, government securities, certificates of deposit, and corporate debt securities.

We classify our investments as available-for-sale at the time of purchase since it is our intent that these investments are available for current operations, and include these investments on our balance sheet as either short-term or long-term investments depending on their maturity at the time of purchase. Investments with original maturities greater than three months that mature less than one year from the condensed consolidated balance sheet date are classified as short-term investments. Investments with maturities greater than one year from the condensed consolidated balance sheet date are classified as long-term investments.

Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. We consult with our investment managers and consider available quantitative and qualitative evidence in evaluating potential impairment of our investments on a quarterly basis. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new

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FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

cost basis in the investment is established.

Inventory—Inventory is recorded at the lower of cost (using the first-in, first-out method) or market, after we give appropriate consideration to obsolescence and inventory in excess of anticipated future demand. In assessing the ultimate recoverability of inventory, we are required to make estimates regarding future customer demand, the timing of new product introductions, economic trends and market conditions. If the actual product demand is significantly lower than forecasted, we could be required to record additional inventory write-downs, which could have an adverse impact on our gross margins and profitability.

Deferred Cost of Revenues—Deferred cost of revenues represent the unamortized cost of products associated with ratable product and services revenue, which is based upon the actual cost of the hardware sold and is recognized over the service periods of the arrangements. Deferred cost of revenue associated with deferred revenue expected to be recognized within the next twelve months is classified as a current asset and deferred cost of revenue associated with deferred revenue not expected to be recognized within the next twelve months is classified as a non-current asset.

Property and Equipment—Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally one to three years. Evaluation units are transferred from inventory at cost and are amortized over one year from the date of transfer. Leasehold improvements are amortized over the shorter of the estimated useful lives of the improvements or the lease term.

Impairment of Long-Lived Assets—We evaluate events and changes in circumstances that could indicate carrying amounts of long-lived assets, including intangible assets, may not be recoverable. When such events or changes in circumstances occur, we assess the recoverability of long-lived assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the future undiscounted cash flows is less than the carrying amount of those assets, we record an impairment charge in the period in which we make the determination. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

Deferred Revenue—Deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue.

Income Taxes—We record income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences, generally all expected future events other than enactments or changes in the tax law or rates are considered. We assess the likelihood that some portion or all of our deferred tax assets will be recovered from future taxable income within the respective jurisdictions, and to the extent we believe that recovery does not meet the “more-likely-than-not” standard, based solely on its technical merits as of the reporting date, we establish a valuation allowance. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.

We operate in various tax jurisdictions and are subject to audit by various tax authorities. We provide for tax contingencies whenever it is deemed more likely than not that a tax asset has been impaired or a tax liability has been incurred for events such as tax claims or changes in tax laws. Tax contingencies are based upon their technical merits, relevant tax law and the specific facts and circumstances as of each reporting period. Changes in facts and circumstances could result in material changes to the amounts recorded for such tax contingencies.

Stock-Based Compensation—We apply ASC 718 (formerly referred to as SFAS No. 123R) to our stock option grants, which requires compensation expense related to share-based transactions, including employee stock options, to be measured and recognized in the financial statements based on fair value. Under ASC 718, the fair value of each option award is estimated on the grant date using the Black-Scholes option pricing model.

Research and Development Costs—Research and development costs are expensed as incurred.

Software Development Costs—The costs to develop software have not been capitalized as we believe our current software development process is essentially completed concurrent with the establishment of technological feasibility.

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FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Revenue Recognition—We derive revenue from sales of products, including appliances and software, and services, including subscription, support and other services. Our appliances include operating system software that is integrated into the appliance hardware and is deemed essential to its functionality. As a result, we account for revenue in accordance with ASC 985-605 (formerly referred to as Statement of Position 97-2 (SOP 97-2) Software Revenue Recognition), and all related interpretations.

No revenue can be recognized until all of the following criteria have been met:


•	Persuasive evidence of an arrangement exists. Binding contracts or purchase orders are generally used to determine the existence of an arrangement.


•	Delivery has occurred. Delivery occurs when we fulfill an order and title and risk of loss has been transferred or upon delivery of the service contract registration code.


•	The fee is fixed or determinable. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction. In the event payment terms differ from our standard business practices, the fees are deemed to be not fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.


•	Collectability is probable. We assess collectability based primarily on creditworthiness as determined by credit checks and analysis, as well as payment history. Payment terms generally range from 30 to 90 days from invoice date.

For arrangements which include customer acceptance criteria, no revenue is recognized prior to acceptance. We recognize product revenue on sales to distributors that have no right of return and end-customers upon shipment of the appliance, once all other revenue recognition criteria have been met. We also make sales through distributors under agreements that allow for rights of returns. We recognize product revenue on sales made through such distributors upon sale by the distributor to the end-customer, at which time the rights of return lapse. Substantially all of our products have been sold in combination with services which consist of subscriptions and/or support. Subscription services provide access to our antivirus, intrusion prevention, web filtering, and anti-spam functionality. Support services include rights to unspecified software upgrades, maintenance releases and patches, telephone and Internet access to technical support personnel, and hardware support.

We commence our subscription and support services on the date the customer registers the appliance. The customer is then entitled to service for the stated contractual period beginning on the registration date.

We use the residual method to recognize revenue when an arrangement includes one or more elements to be delivered at a future date and vendor-specific objective evidence (“VSOE”) of the fair value of all undelivered elements exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the contract fee is recognized as product revenue. In cases where VSOE of fair value of the undelivered elements does not exist (typically due to a lack of VSOE on the subscription and support services for that specific arrangement), revenue for the entire arrangement is recognized ratably over the performance period of the undelivered elements. Revenue related to these arrangements is included in ratable product and services revenue in the accompanying condensed consolidated statements of operations. VSOE of fair value for elements of an arrangement is based upon the pricing for those services when sold separately. Revenue for professional services and training is recognized upon completion of the related services.

We offer certain sales incentives to channel partners. We reduce revenue for estimates of sales returns and allowances. Additionally, in limited circumstances we may permit end-customers, distributors and resellers to return our products, subject to varying limitations, for a refund within a reasonably short period from the date of purchase. We estimate and record reserves for sales incentives and sales returns based on historical experience.

Accounts Receivable—Trade accounts receivable are recorded at the invoiced amount, net of allowances for doubtful accounts and reserves for sales returns and allowances. The allowance for doubtful accounts is based on our assessment of the collectability of customer accounts. We regularly review the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances and current economic conditions that may affect a customer's ability to pay. The reserve for sales returns and allowances is based on specific criteria including agreements to provide rebates and other

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FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

factors known at the time, as well as estimates of the amount of goods shipped that will be returned. To determine the adequacy of the reserves for sales returns and allowances, we analyze historical experience of actual rebates and returns as well as current product return information.

Warranties—We generally provide a one-year warranty on hardware products and a 90-day warranty on software. A provision for estimated future costs related to warranty activities is recorded as a component of cost of product revenues when the product revenues are recognized, based upon historical product failure rates and historical costs incurred in correcting product failures. In the event we change our warranty reserve estimates, the resulting charge against future cost of sales or reversal of previously recorded charges may materially affect our gross margins and operating results.

Accrued warranty activities are summarized as follows ($ amounts in 000's):


	For The 9 Months Ended And As Of		For The Year Ended And As Of
	September 30, 2010		December 31, 2009
Accrued warranty balance-beginning of the period	2,257		2,882
Warranty costs incurred	(949	)	(1,502	)
Provision for warranty	696		1,169
Adjustments to previous estimates	8		(292	)
Accrued warranty balance-end of the period	2,012		2,257

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), Euro (EUR), British Pound (GBP), and Yen. 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 EUR, GBP, and CAD, and occasionally to hedge future forecasted cash outflows denominated in EUR. We do not use these contracts for speculative or trading purposes. All of the derivative instruments are with high quality financial institutions and we monitor the creditworthiness of these parties. These contracts typically have maturities between one and three months. We record changes in the fair value of forward exchange contracts related to balance sheet accounts as other income (expense), net in the condensed consolidated statement of operations. Gains or losses resulting from settled forward exchange contracts related to future forecasted cash outflows are recorded in operating expenses in the condensed consolidated statement of operations, in the same period the hedged items occurs. Gains or losses resulting from unsettled forward exchange contracts related to future forecasted cash outflows are recorded in other comprehensive income in the condensed consolidated balance sheet.

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, long-term material changes in the value of the U.S. dollar versus the EUR, GBP, CAD or Yen could adversely impact our operating expenses in the future.

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FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The notional amount of forward exchange contracts to hedge cash flows associated with operating expenses and balance sheet accounts as of September 30, 2010 was (amounts in 000's):


To hedge operating cash outflows:	Buy/Sell	Notional
Currency
EUR	Buy	3,000

To hedge balance sheet accounts:
Currency
EUR	Buy	3,631
GBP	Buy	964
CAD	Buy	8,529

Recent Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (FASB) issued revised guidance on disclosures related to fair value measurements. This guidance requires new disclosures about significant transfers in and out of Level 1 and Level 2 and separate disclosures about purchases, sales, issuances, and settlements with respect to Level 3 measurements. The guidance also clarifies existing fair value disclosures about valuation techniques and inputs used to measure fair value. The new disclosures and clarifications of existing disclosures are effective for us beginning in the first quarter of 2010, except for the disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements, which will be effective for us in the first quarter of 2011. The adoption of the relevant disclosures related to transfers in and out of Level 1 and Level 2 in the quarter did not have a material impact on our financial statements and we do not expect the additional disclosures that are required beginning in the first quarter of fiscal 2011 to have a material impact on our financial statements.

In September 2009, the Emerging Issues Task Force (EITF) reached a consensus on ASC 605-25 (formerly referred to as EITF 08-1, Revenue Arrangements with Multiple Deliverables). ASC 605-25 eliminates the criterion for objective and reliable evidence of fair value for the undelivered products or services. Instead, revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables meet both of the following criteria:


•	The delivered items have value to the customer on a stand-alone basis.


•	If the arrangement includes a general right of return relative to the delivered items, delivery or performance of the undelivered items is considered probable and substantially in the control of the vendor.

ASC 605-25 eliminates the use of the residual method of allocation and requires, instead, that arrangement consideration be allocated, at the inception of the arrangement, to all deliverables based on their relative selling price (i.e., the relative selling price method). When applying the relative selling price method, a hierarchy is used for estimating the selling price for each of the deliverables. The hierarchy establishes that the method for determining estimated selling price should be chosen in the following order of priority:


•	VSOE of the selling price;


•	Third-party evidence (TPE) of the selling price - prices of the vendor's or any competitor's largely interchangeable products or services, in standalone sales to similarly situated customers; and


•	Best estimate of the selling price.

In September 2009, the FASB reached a consensus on ASC 985-605 (formerly referred to as EITF 09-3, Certain Revenue Arrangements That Include Software Elements). Arrangements to sell joint hardware and software products where the software and non-software components function together to deliver the product's essential functionality will no longer be scoped into software accounting rules, but will be subject to non-software multiple element accounting guidance (ASC 605-25). ASC 985-605 and ASC 605-25 provide a list of items to consider when determining whether the software and non-software components function together to deliver a product's essential functionality. ASC 985-605 must be adopted for arrangements entered into beginning January 1, 2011, and may be early-adopted. We plan to adopt ASC 985-605 and ASC 605-25 in the first quarter of 2011, and are currently evaluating the impact of adoption on our condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

2. INVESTMENTS AND FAIR VALUE MEASUREMENTS

The following table summarizes our investments in available-for-sale securities ($ amounts in 000's):


	September 30, 2010
	Amortized Cost	Unrealized Gains	Unrealized Losses	Estimated Fair Value
Available-for-sale securities:
U.S. government and agency securities	41,266	26	—	41,292
Corporate debt securities	210,593	387	—	210,980
Commercial paper	22,929	4	—	22,933
Total available-for-sale securities	274,788	417	—	275,205


	December 31, 2009
	Amortized Cost	Unrealized Gains	Unrealized Losses		Estimated Fair Value
Available-for-sale securities:
U.S. government and agency securities	2,000	—	(2	)	1,998
Corporate debt securities	41,840	35	—		41,875
Commercial paper	3,983	—	—		3,983
Total available-for-sale securities	47,823	35	(2	)	47,856

The contractual maturities of our investments are as follows ($ amounts in 000's):


	September 30, 2010	December 31, 2009
Due within one year	215,151	47,856
Due within one to two years	60,054	—
Total	275,205	47,856

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 income in our condensed consolidated statements of operations.

Realized gains or losses from the sale of available-for-sale securities were not significant for any period presented.

Fair Value Accounting—We adopted ASC 820 (formerly referred to as SFAS No. 157, Fair Value Measurement) effective January 1, 2008. ASC 820 establishes a valuation hierarchy for disclosure of the inputs to fair value measurement. 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—Inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. The inputs require significant management judgment or estimation.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following table presents the fair value of our financial assets as of September 30, 2010 or December 31, 2009 using the ASC 820 input categories ($ amounts in 000's):


	September 30, 2010			December 31, 2009
	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)
Total cash, cash equivalents and available-for-sale securities:
U.S. government and agency securities	41,292	—	41,292	1,998	—	1,998
Corporate debt securities	210,980	210,980	—	41,875	41,875	—
Commercial paper	22,933	—	22,933	3,983	—	3,983
Money market funds	31,244	31,244	—	179,444	179,444	—
Cash equivalents and available-for-sale securities	306,449	242,224	64,225	227,300	221,319	5,981
Cash	45,895			33,014
Total cash, cash equivalents and available-for-sale securities	352,344			260,314
Reported as:
Cash and cash equivalents	77,139			212,458
Short-term investments	215,151			47,856
Long-term investments	60,054			—
Total cash, cash equivalents and available-for-sale securities	352,344			260,314

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

We classify items in Level 2 if the investments are valued using observable inputs to quoted market prices, benchmark yields, reported trades, broker/dealer quotes or alternative pricing sources with reasonable levels of price transparency.

We did not hold financial assets or liabilities which were recorded at fair value using inputs in the Level 3 category as of September 30, 2010 or December 31, 2009.

3. INVENTORY—Net

Inventory—net, consisted of the following ($ amounts in 000's):


	September 30, 2010	December 31, 2009
Raw materials	2,989	1,904
Finished goods	8,295	8,745
Inventory—net	11,284	10,649

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4. PROPERTY AND EQUIPMENT—Net

Property and equipment consisted of the following ($ amounts in 000's):


	September 30, 2010		December 31, 2009
Evaluation units	9,949		8,449
Computer equipment and software	9,341		8,827
Furniture and fixtures	1,344		1,191
Leasehold improvements and tooling	4,422		4,134
Total property and equipment	25,056		22,601
Less: accumulated depreciation and amortization	(18,259	)	(16,214	)
Property and equipment—net	6,797		6,387

Depreciation expense was $1.4 million for both the three months ended September 30, 2010 and September 30, 2009. Depreciation expense was $4.2 million and $3.7 million during the nine months ended September 30, 2010 and September 30, 2009, respectively.

5. INCOME PER SHARE

Basic net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding, plus the dilutive effects of stock options and warrants.

In November 2009, all of our outstanding convertible preferred stock converted into common stock in connection with our initial public offering. For periods that ended prior to such conversion, net income per share information is computed using the two-class method. The convertible preferred shares were entitled to receive annual non-cumulative dividends of $0.02, $0.05, $0.12, $0.12 and $0.30 per share for Series A, B, C, D, and E, respectively, payable prior to and in preference to holders of common stock. After the payment of such dividends, convertible preferred shares were further entitled to receive a proportionate amount of any dividends paid on common stock on an if-converted basis. As a result of such dividend rights, the convertible preferred shares were considered to be participating securities. Under the two-class method of computing earnings per share, net income attributable to common stockholders is computed by an adjustment to subtract from net income the portion of current period earnings that the preferred stockholders would have been entitled to receive pursuant to their dividend rights had all of the period's earnings been distributed. No such adjustment to earnings is made during periods with a net loss, as the holders of the convertible preferred shares had no obligation to fund losses.

Subsequent to the issuance of our condensed consolidated financial statements for the nine months ended September 30, 2009, we identified an error related to incorrectly computing our basic and diluted net income per share by using the if-converted method rather than the two class method. In particular, we did not subtract from net income the portion of current period earnings that the preferred stockholders would have been entitled to receive pursuant to their dividend rights had all of the period's earnings been distributed. Accordingly, corrections have been made herein to reflect a decrease in our basic and diluted EPS for the nine months ended September 30, 2009 from $0.34 and $0.11, respectively, previously reported in our prospectus as part of our initial public offering to $0.04 and $0.04, respectively, as corrected. We do not believe this correction is material.

Net income per share information for the three and nine months ended September 30, 2009 gives effect to the repurchase of convertible preferred shares (Note 8). The excess of the fair value of the consideration paid for such preferred stock over the carrying value of the preferred stock represents a return to the preferred stockholders and is treated in a manner similar to the treatment of dividends paid to the holders of preferred stock in the computation of earnings per share. As a result, the premium paid is subtracted to derive net income attributable to common stockholders in determining earnings per share.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per share is as follows ($ and share amounts in 000's, except per share amounts):


	Three Months Ended			Nine Months Ended
	September 30, 2010	September 30, 2009		September 30, 2010	September 30, 2009
Numerator:
Net income	14,017	7,889		25,104	16,239
Premium paid on repurchase of convertible preferred shares	—	—		—	(9,266	)
Income allocated to participating securities	—	(1,499	)	—	(4,496	)
Net income attributable to common stockholders - basic and diluted	14,017	6,390		25,104	2,477

Denominator:
Basic shares:
Weighted-average common shares outstanding - basic	71,836	58,288		69,188	58,258

Diluted shares:
Weighted-average common shares outstanding - basic	71,836	58,288		69,188	58,258
Effect of potentially dilutive securities:
Employee stock options	5,992	5,863		7,368	5,907
Warrants to purchase common stock	93	16		89	16
Weighted-average shares used to compute diluted net income per share	77,921	64,167		76,645	64,181
Net income per share attributable to common stockholders:
Basic	0.20	0.11		0.36	0.04
Diluted	0.18	0.10		0.33	0.04

Net income has been allocated to the common and preferred stock based on their respective rights to share in dividends.

The following outstanding options and convertible preferred stock were excluded from the computation of diluted net income per common share applicable to common stockholders for the periods presented as their effect would have been antidilutive (in 000's):


	Three Months Ended		Nine Months Ended
	September 30, 2010	September 30, 2009	September 30, 2010	September 30, 2009
Options to purchase common stock	1,756	3,918	1,295	9,486
Convertible preferred stock (on an if-converted to common stock basis)	—	37,476	—	37,476
Total	1,756	41,394	1,295	46,962

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

6. DEFERRED REVENUES

Deferred revenues consisted of the following ($ amounts in 000's):


	September 30, 2010	December 31, 2009
Product	6,041	4,141
Services	199,570	168,314
Ratable products and services	29,639	29,475
Total deferred revenues	235,250	201,930
Reported As:
Current	158,430	140,537
Non-current	76,820	61,393
Total deferred revenues	235,250	201,930

7. COMMITMENTS AND CONTINGENCIES

Leases and Minimum Royalties—We lease our facilities under various noncancelable operating leases, which expire through 2015. Rent expense was $1.7 million and $1.5 million for the three months ended September 30, 2010 and September 30, 2009, respectively, and $5.2 million and $4.4 million for the nine months ended September 30, 2010 and September 30, 2009, respectively. Rent expense is recognized using the straight-line method over the term of the lease.

We entered into a Settlement and Patent License Agreement with Trend Micro in January 2006 (see "Litigation" below). The aggregate future noncancelable minimum rental payments on operating leases and minimum royalties payable if we continued paying under the Trend Micro Settlement and License Agreement as of September 30, 2010 are as follows ($ amounts in 000's):


	Rental Payment	Royalty ⁽¹⁾
Fiscal Years:
2010 (remainder)	1,893	250
2011	6,615	1,000
2012	4,849	1,000
2013	3,738	1,000
2014	1,792	500
Thereafter	1,449	500
Total	20,336	4,250
-----------

(1) Consists of minimum royalties claimed by Trend Micro pursuant to the January 2006 settlement and license agreement between Trend Micro and Fortinet, which are subject to dispute (see "Litigation" below). The $250,000 listed in the chart above as the "2010 (remainder)" represents the minimum royalties, pursuant to the settlement and license agreement, for the fourth quarter of fiscal 2010. We have accrued $3.7 million as of September 30, 2010, related to amounts under the settlement and license agreement with Trend Micro which have not been paid pursuant to the dispute.

Contract Manufacturer 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 September 30, 2010, we had $16.3 million of open purchase orders with our independent contract manufacturers that may not be cancelable.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Litigation—In May 2004, Trend Micro Incorporated filed a complaint against us alleging that we infringed a Trend Micro patent related to antivirus software. In January 2006, we settled the lawsuit with Trend Micro. Pursuant to the settlement and license agreement, we initially paid Trend Micro $15.0 million. The settlement and license agreement provides for additional quarterly royalty payments, not expected to exceed 1% of our total revenue each quarter, through 2015. In November 2008, we filed a complaint against Trend Micro in the United States District Court for the Northern District of California alleging, among other claims, that the patents that are the basis for the ongoing royalty payments are invalid and consequently that we have no contractual obligation to pay the royalties. Trend Micro moved to dismiss the case, and, in June 2009, the court dismissed the case without prejudice on procedural grounds. We appealed the dismissal in July 2009. Based on the dispute, we ceased paying royalties under the settlement and license agreement. In August 2009, Trend Micro filed a complaint against us in the Superior Court of the State of California for Santa Clara County alleging breach of contract and seeking a declaratory judgment that we are obligated to make certain royalty payments to Trend Micro. In December 2009, we withdrew our appeal of the June 2009 dismissal by the United States District Court for the Northern District of California and filed a new complaint against Trend Micro in the United States District Court for the Northern District of California alleging, among other claims, that the patents that are the basis for the ongoing royalty payments are invalid and consequently that we have no contractual obligation to pay royalties. We have continued to accrue expense based on the quarterly royalties provided for in the settlement and license agreement. In February 2010, Trend Micro filed demurrers in the state Superior Court action regarding our affirmative defenses that we have no obligation to pay royalties because the Trend Micro patents are invalid or unenforceable. In March 2010, Trend Micro filed a motion to dismiss our new complaint that we filed in the United States District Court for the Northern District of California. In May 2010, the state court denied Trend Micro's demurrer in its entirety. Also in May 2010, the United States District Court for the Northern District of California denied Trend Micro's motion to dismiss without prejudice and stayed the action before that court pending the conclusion of the state court action.

In January 2009, we filed a complaint against Palo Alto Networks, Inc., in the United States District Court for the Northern District of California alleging, among other claims, patent infringement. In September 2009, Palo Alto Networks filed a counterclaim against us alleging infringement of a patent. In July 2010, there was a consolidated hearing presenting the parties' proposed claim constructions and multiple summary judgment motions. In September 2010, the Court ruled that we did not infringe the Palo Alto Networks patent and granted our summary judgment motion thereby dismissing Palo Alto Networks' counterclaim. In October 2010, the Court granted Palo Alto Networks' summary judgment motion that the accused products of Palo Alto Networks did not infringe one of the four patents asserted by us, while denying Palo Alto Networks' summary judgment motion that the patent was invalid. At this time the Court has not ruled on the remaining claim constructions and summary judgment motions.

In August 2009, Enhanced Security Research, LLC (“ESR”), a non-practicing entity, filed a complaint against us in the United States District Court for the District of Delaware alleging infringement by us and other defendants of two patents. A defendant in another case filed a petition for reexamination of one of ESR's asserted patents with the U.S. Patent and Trademark Office (“PTO”), and, in November 2009, we filed a petition with the PTO for reexamination of the other asserted patent. In December 2009, we filed a motion to stay the court proceedings pending resolution of the reexamination proceedings. In June 2010, the Court granted our motion to stay pending the outcome of reexamination proceedings.

In April 2010, an individual, a former stockholder of Fortinet, filed a class action lawsuit against us in the Superior Court of the State of California for the County of Los Angeles alleging violation of various California Corporations' Code sections and related tort claims alleging misrepresentation and breach of fiduciary duty regarding the 2009 repurchase by Fortinet of shares of its stock while we were a privately-held company. In September 2010, the Court granted our motion to transfer the case to the California Superior Court for Santa Clara County.

In July 2010, Network Protection Sciences, LLC, a non-practicing entity, filed a complaint in the United States District Court for the Eastern District of Texas alleging patent infringement by us and other defendants. Currently the case is in the very early stages.

In September 2010, Wordcheck Tech, LLC, a non-practicing entity, filed a complaint in the United States District Court for the Eastern District of Texas alleging patent infringement by us and numerous other defendants. Currently the case is in the very early stages, and we have yet to answer the complaint.

In addition to the above matters, we are subject to other litigation in the ordinary course of business. The results of legal proceedings cannot be predicted with certainty. If we do not prevail in any of these legal matters, our operating results may be materially affected. At this time, we are unable to estimate the financial impact these actions will likely have on us.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Indemnification—Under the indemnification provisions of our standard sales contracts, we agree to defend our customers against third-party claims asserting infringement of certain intellectual property rights, which may include patents, copyrights, trademarks, or trade secrets, and to pay judgments entered on such claims. Our exposure under these indemnification provisions is generally limited to the total amount paid by our customer under the agreement. However, certain agreements include indemnification provisions that could potentially expose us to losses in excess of the amount received under the agreement. To date, there have been no claims under such indemnification provisions.

8. STOCKHOLDERS' EQUITY

Common Shares Reserved for Issuance—At September 30, 2010, we had reserved shares of common stock for issuance as follows (in 000's):


Reserved under stock option plans	19,913
Warrants to purchase common stock	141
Total	20,054

Stock Repurchase—While we were a privately-held company, during the first six months of fiscal 2009, our board of directors approved a stock repurchase authorization. This repurchase authorization allowed us to repurchase up to $20.0 million of our convertible preferred and common stock at $4.25 per share through June 17, 2009. This repurchase authorization expressly excluded our board members and senior management. We repurchased 704,632 shares of common stock and 3,004,165 shares of convertible preferred stock for total consideration of $15.7 million.

9. STOCK PLANS

2000 Stock Plan—During 2000, we adopted the 2000 Stock Option Plan, which was amended and restated in April 2006 and further amended in March 2008 (the “Amended and Restated 2000 Stock Plan”). The Amended and Restated 2000 Stock Plan includes both incentive and non-statutory stock options. Under the Amended and Restated 2000 Stock Plan, we may grant options to purchase up to 21,500,000 shares of common stock to employees, directors and other service providers at prices not less than the fair market value at date of grant for incentive stock options and not less than 85% of fair market value for non-statutory options. Options granted to a person who, at the time of the grant, owns more than 10% of the voting power of all classes of stock shall be at no less than 110% of the fair market value and expire five years from the date of grant. All other options generally have a contractual term of 10 years. Options generally vest over four years.

2008 Stock Plan—On January 28, 2008, our board of directors approved the 2008 Stock Plan (the "2008 Plan") and French Sub-Plan, which includes both incentive and non-statutory stock options. The maximum aggregate number of shares which may be subject to options and sold under the 2008 Plan and the French Sub-Plan is 5,000,000 shares, plus any shares that, as of the date of stockholder approval of the 2008 Plan, have been reserved but not issued under the 2000 Plan or shares subject to stock options or similar awards granted under the 2000 Plan that expire or otherwise terminate without having been exercised in full or that are forfeited to or repurchased by us.

Under the 2008 Plan and the French Sub-Plan, we may grant options to employees, directors and other service providers. In the case of an incentive stock option granted to an employee, who at the time of grant, owns stock representing more than 10% of the total combined voting power of all classes of stock, the exercise price shall be no less than 110% of the fair market value per share on the date of grant and expire five years from the date of grant, and for options granted to any other employee, the per share exercise price shall be no less than 100% of the fair market value per share on the date of grant. In the case of a nonstatutory stock option and options granted to other service providers, the per share exercise price shall be no less than 100% of the fair market value per share on the date of grant.

2009 Equity Incentive Plan—On November 17, 2009, our board of directors approved the 2009 Equity Incentive Plan (the "2009 Plan") and French Sub-Plan, which includes awards of stock options, stock appreciation rights, restricted stock, restricted stock units, and performance units or performance shares. The maximum aggregate number of shares that may be issued under the 2009 Plan is 9,000,000 shares, plus any shares subject to stock options or similar awards granted under the 2008 Plan and the Amended and Restated 2000 Stock Plan that expire or otherwise terminate without having been exercised in full and shares issued pursuant to awards granted under the 2008 Plan and the Amended and Restated 2000 Stock Plan that are

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

forfeited to or repurchased by the Company, with the maximum number of shares to be added to the 2009 Plan pursuant to such terminations, forfeitures and repurchases not to exceed 21,000,000 shares. The shares may be authorized, but unissued or reacquired common stock. The number of shares available for issuance under the 2009 Plan will be increased on the first day of each fiscal year beginning with the 2011 fiscal year, in an amount equal to the lesser of (i) 7,000,000 shares, (ii) five percent (5%) of the outstanding shares on the last day of the immediately preceding fiscal year, or (iii) such number of shares determined by the board of directors.

Under the 2009 Plan and the French Sub-Plan, we may grant awards to employees, directors and other service providers. In the case of an incentive stock option granted to an employee who, at the time of the grant, owns stock representing more than 10% of the voting power of all classes of stock, the exercise price shall be no less than 110% of the fair market value per share on the date of grant and expire five years from the date of grant, and for options granted to any other employee, the per share exercise price shall be no less than 100% of the fair market value per share on the date of grant. In the case of a non statutory stock option and options granted to other service providers, the per share exercise price shall be no less than 100% of the fair market value per share on the date of grant. Options granted to individuals owning less than 10% of the total combined voting power of all classes of stock generally have a contractual term of seven years, and options generally vest over four years.

Stock-based compensation under ASC 718—We apply ASC 718 to our stock option grants, which requires compensation costs related to share-based transactions, including employee stock options, to be recognized in the financial statements based on fair value. Under ASC 718, the fair value of each option award is estimated on the grant date using the Black-Scholes option pricing model. We determined weighted-average valuation assumptions as follows:

Valuation method—We estimate the fair value of stock options granted using the Black-Scholes valuation model.

Expected Term—The expected term represents the period that our stock-based awards are expected to be outstanding. As we do not have sufficient historical experience for determining the expected term of the stock option awards granted, we have based our expected term on the simplified method available under ASC 718-10 (formerly referred to as Staff Accounting Bulletin 110).

Expected Volatility—The computation of expected volatility for the periods presented includes the historical and implied stock volatility of comparable companies from a representative peer group selected based on industry and market capitalization data and to a lesser extent, our weighted historical volatility following our IPO in November 2009.

Fair Value of Common Stock—The fair value of the shares of common stock that underlie the stock options we have granted has historically been determined by our board of directors. Because there was no public market for our common stock prior to our initial public offering in November 2009, our board determined the fair value of our common stock at the time of grant of the option by considering a number of objective and subjective factors, our sales of preferred stock to unrelated third parties, our operating and financial performance, the lack of liquidity of our capital stock and trends in the broader network security and computer networking market.

Risk-Free Interest Rate—We base the risk-free interest rate used in the Black-Scholes valuation model on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent term.

Expected Dividend—The expected dividend weighted-average assumption is based on our current expectations about our anticipated dividend policy.

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


	Three Months Ended		Nine Months Ended
	September 30, 2010	September 30, 2009	September 30, 2010	September 30, 2009
Volatility (%)	41.8	44.2	37.6 - 41.8	44.2 - 51.8
Dividend rate (%)	—	—	—	—
Risk-free interest rate (%)	1.6	2.3	1.6 - 2.4	1.3 - 2.3
Expected term in years	4.6	4.6	4.6	4.6

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Stock-based compensation expense is included in costs and expenses as follows ($ amounts in 000's):


	Three Months Ended		Nine Months Ended
	September 30, 2010	September 30, 2009	September 30, 2010	September 30, 2009
Cost of product revenue	26	25	76	76
Cost of services revenue	242	169	684	465
Research and development	600	516	1,741	1,392
Sales and marketing	1,017	767	2,780	2,103
General and administrative	549	459	1,565	1,243
	2,434	1,936	6,846	5,279

A summary of the option activity under our stock plans and changes during the reporting periods are presented below (in 000's, except per share amounts):


			Options Outstanding
	Shares Available For Grant		Number Of Shares		Weighted- Average Exercise Price ($)	Weighted- Average Remaining Contractual Life (Years)	Aggregate Intrinsic Value ($)
Balance-December 31, 2009	9,049		17,205		5.05
Granted	(2,013	)	2,013		17.17
Forfeited	653		(653	)	9.41
Exercised (aggregate intrinsic value of $88,453)	—		(6,341	)	3.77
Balance—September 30, 2010	7,689		12,224		7.48
Options vested and expected to vest—September 30, 2010			11,887		7.36	4.87	209,748
Options exercisable—September 30, 2010			6,518		4.45	4.30	133,957

At September 30, 2010, total compensation cost related to unvested stock-based awards granted to employees under our stock plans but not yet recognized was $21.3 million, net of estimated forfeitures. This cost is expected to be amortized on a straight-line basis over a weighted-average period of 2.47 years. Future option grants will increase the amount of compensation expense to be recorded in these periods.

The total fair value of awards vested under our stock plans was $1.8 million and $1.4 million for the three months ended September 30, 2010 and September 30, 2009, respectively. The total fair value of awards vested under our stock plans was $6.7 million and $4.3 million for the nine months ended September 30, 2010 and September 30, 2009, respectively. The weighted-average fair value of options granted during the three and nine months ended September 30, 2010 was $6.63 and $6.34 per share, respectively.

Non-employees—During the three months ended September 30, 2010 and September 30, 2009, no options were granted to non-employees in exchange for services. During the nine months ended September 30, 2010, we issued options to purchase 9,400 shares of common stock, at an exercise price of $16.86 per share, to non-employees in exchange for services. No options were granted to non-employees in exchange for services during the nine months ended September 30, 2009. These options vest over periods of up to 48 months, and in accordance with ASC 505-50 (formerly referred to as EITF Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services), we accounted for these options as variable awards. The options were valued using the Black-Scholes option pricing model with the following weighted-average assumptions:

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FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)


	Three Months Ended		Nine Months Ended
	September 30, 2010	September 30, 2009	September 30, 2010	September 30, 2009
Volatility (%)	41.8	44.2	37.6 - 41.8	44.2 - 51.8
Dividend rate (%)	—	—	—	—
Risk-free interest rate (%)	1.6	2.3	1.6 - 2.4	1.3 - 2.3
Expected term in years	4.6 - 6.3	5.6 - 7.0	4.6 - 6.8	5.6 - 7.5

10. INCOME TAXES

The effective tax rate was 23.3% for the three months ended September 30, 2010, compared to an effective tax rate of 21.4% for the three months ended September 30, 2009. The effective tax rate was 28.8% for the nine months ended September 30, 2010, compared to an effective tax rate of 17.6% for the nine months ended September 30, 2009. The provision for income taxes for the three and nine months ended September 30, 2010 is comprised of foreign income taxes, U.S. federal and state taxes, withholding tax, nondeductible compensation and adjustments related to our intercompany transfer pricing. The provision for income taxes for the three and nine months ended September 30, 2009 is comprised primarily of foreign income taxes, U.S. federal alternative minimum tax, state income taxes, and withholding tax.

As of September 30, 2010 and December 31, 2009, unrecognized tax benefits determined in accordance with authoritative guidance on accounting for uncertainty in income taxes, approximated $10.9 million and $3.4 million, respectively. The total amount of 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. For the three and nine months ended September 30, 2010 and September 30, 2009, interest and penalties related to unrecognized tax benefits were immaterial. We do not expect any material unrecognized tax benefits to expire within the next twelve months.

11. EMPLOYEE BENEFIT PLAN

We have established a 401(k) tax-deferred savings plan (the “401(k) Plan”) which permits participants to make contributions by salary deduction pursuant to Section 401(k) of the Internal Revenue Code. We are responsible for administrative costs of the 401(k) Plan and have made no contributions to the 401(k) Plan since inception.

12. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

During the three and nine months ended September 30, 2009, we paid compensation of $39,000 and $124,000, respectively, to two employees who are directly related to a former board member. This individual ceased being a board member as of October 2009.

In February 2008, we entered into a 23-month non-cancelable facility lease agreement, determined to be an arms length transaction, with an entity affiliated with one of our former board members. Under the terms of the agreement, in 2008, we paid approximately $284,000 for tenant improvements and $316,000 for a refundable deposit. For the three and nine months ended September 30, 2009 we paid $198,000 and $696,000, respectively, for office rent and operating expenses. The lease expired on December 31, 2009.

13. SEGMENT INFORMATION

ASC 280 (formerly referred to as SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information) establishes standards for reporting information about operating segments. 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 are considered to be in a single reportable segment and operating unit structure.

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FORTINET, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Revenue by geographic region is based on the billing address of the customer. The following tables set forth revenue, interest income and property and equipment by geographic region ($ amounts in 000's):


	Three Months Ended		Nine Months Ended
Revenue	September 30, 2010	September 30, 2009	September 30, 2010	September 30, 2009
Americas	35,396	26,085	88,103	67,817
Europe, Middle East and Africa (EMEA)	28,926	23,454	85,482	67,239
Asia Pacific and Japan (APAC)	20,649	16,325	57,512	46,347
Total revenue	84,971	65,864	231,097	181,403


	Three Months Ended		Nine Months Ended
Interest Income	September 30, 2010	September 30, 2009	September 30, 2010	September 30, 2009
Americas	512	423	1,173	1,650
EMEA	1	4	6	26
APAC	1	1	2	1
Total interest income	514	428	1,181	1,677


Property and Equipment	September 30, 2010	December 31, 2009
Americas	5,315	4,988
EMEA	519	504
APAC	963	895
Total property and equipment—net	6,797	6,387

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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 of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements include, among other things, statements concerning our expectations:


•	regarding the continued realization of efficiency gains in sales and marketing expenses;


•	regarding the significance of stock compensation as an expense;


•	regarding the proportion of our revenue that consists of our service revenues and future trends with respect to service revenue as we renew existing services contracts and expand our customer base;


•	regarding our royalty payments to Trend Micro;


•	regarding trends in our costs of services revenues, services gross margin and overall gross margin;


•	regarding trends in our operating expenses, including personnel costs, research and development expense, sales and marketing expense and general and administrative expense;


•	regarding investments in sales and marketing to position ourselves for future growth;


•	regarding the sufficiency of our existing cash and cash equivalents to meet our cash needs for at least the next 12 months; and


•	regarding the impact of inflation and foreign currency exchange rates;

as well as other statements regarding our future operations, financial condition and prospects and business strategies. These forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q and, in particular, the risks discussed under the heading “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q and in our other Securities and Exchange Commission filings, including our Annual Report on Form 10-K for the year ended December 31, 2009, which was filed on March 5, 2010. 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 are a leading provider of network security appliances and a market leader in Unified Threat Management ("UTM") network security solutions. We provide broad, integrated and high performance protection against dynamic security threats while simplifying the IT security infrastructure for enterprises, service providers and government entities worldwide. As of September 30, 2010, we had shipped over 600,000 appliances to more than 5,000 channel partners and to more than 100,000 end-customers worldwide, including a majority of the 2010 Fortune Global 100.

Our core UTM product line of FortiGate appliances ships with a set of security and networking capabilities, including firewall, VPN, antivirus, intrusion prevention, Web filtering, antispam and WAN acceleration functionality. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-30, designed for small businesses and branch offices, to the FortiGate-5000 series for large enterprises and service providers. On an annual basis for each of the last three fiscal years, sales of FortiGate products have generally been balanced across entry-level (FortiGate-30 to -100 series), mid-range (FortiGate-200 to -800 series) and high-end (FortiGate-1000 to -5000 series) models with each product category representing approximately one-third of FortiGate sales, with normal variances from quarter to quarter. For example, in the third quarter of 2010 the percentage of our FortiGate related billings from the high-end category was 39% versus 29% in the third quarter of 2009, while the entry-level category decreased from 42% to 34% over the same period, and the mid-range category remained relatively flat. Our UTM solution also includes our FortiGuard security subscription services, which end-customers can subscribe to in order to obtain access to dynamic updates to the antivirus, intrusion prevention, Web filtering and antispam functionality included in our appliances. End-customers can also choose to purchase FortiCare technical support services for our products. We complement our core FortiGate product line with other appliances and software that offer additional protection from security threats to other critical areas of the enterprise, such as messaging, Web-based traffic and

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databases, and employee computers or handheld devices. During the quarter, we introduced new technology that extended or enhanced our FortiGate, FortiAnalyzer, FortiMail, FortiWeb, FortiDB, FortiScan, and FortiSwitch appliances.

We are a global, geographically diversified business, with 58% of our total revenue generated outside of the Americas region. For the third quarter of 2010, $35.4 million, or 42%, of our total revenue was generated from the Americas, representing an increase of 36% over the same period of the prior year. EMEA generated $28.9 million, or 34%, of our total revenue during the third quarter of 2010, representing an increase of 23% over the same period of the prior year. APAC generated $20.6 million, or 24%, of our total revenue during the third quarter of 2010, representing an increase of 26% compared to the same period of the prior year. We sell globally in U.S. dollars, while our international expenses are denominated in local currencies.

Billings, a non-GAAP financial measure that we define as total revenue plus the change in deferred revenue (further described under "Non-GAAP Financial Measures"), was $94.7 million, an increase of 33% compared to the third quarter of 2009. We saw an increase in the number of deals involving sales that were greater than $100,000 and a substantial increase in the number of deals greater than $500,000 compared to the third quarter of 2009. We believe that significant factors driving this increase are increased market share due to continued product innovations, and our increased traction within the high-end enterprise segments, due in part to the investments we have made over the past year to build out our sales organization and sharpen our focus in this area.

Total revenue was $85.0 million for the third quarter of 2010, an increase of 29% compared to the third quarter of 2009. Product revenue was $35.9 million, an increase of 41% compared to the third quarter of 2009. A factor in the product revenue growth was the introduction of new products over the past year. Services revenue was $44.5 million, an increase of 21% compared to the third quarter of 2009. Services revenue is important to our future revenue and profitability as it provides a source of recurring revenue for us, representing 52% and 56% of total revenue for the third quarters of 2010 and 2009, respectively. Ratable product and services revenue was $4.5 million, an increase of 26% compared to the third quarter of 2009.

Our total operating expenses were $45.4 million for the third quarter of 2010, an increase of 17% compared to the same period in the prior year. The 29% increase in revenues compared to the 15% increase in sales and marketing expense from the third quarter of 2009 (as discussed under "Results of Operations" below) demonstrates the leverage that we are achieving from the investment in our sales force during the past year. Although we expect to continue to realize efficiency gains in sales and marketing expense, any additional leverage we realize will be at a decreasing rate, as a portion of the savings we realized in the third quarter of 2010 was due to a 12% decrease in the EUR exchange rate from the prior year, which benefited our European sales expenses. We are also seeing efficiencies in our overall headcount as our annualized third quarter of 2010 revenue per employee, defined as quarterly revenue, annualized and divided by average headcount, has reached $263,000, up from $225,000 for the third quarter of 2009. Although headcount increased slightly during the third quarter of 2010 from 1,287 at the end of the second quarter to 1,300, our pace of hiring was slower than originally targeted for the third quarter, as it was a challenge to hire qualified sales and technical staff as quickly as we had anticipated due in part to seasonality, the competitive landscape and the degree of specialized security expertise required.

Our Business Model

Our sales strategy is based on a distribution model whereby we primarily sell our products and services directly to distributors who sell to resellers and service providers, who, in turn, sell to our end-customers. In certain cases, we sell directly to government-focused resellers, large service providers and major systems integrators, who have significant purchasing power and unique customer deployment requirements. Typically, FortiGuard security subscription services and FortiCare technical support services are purchased along with our appliances. We invoice at the time of our sale for the total price of the products and subscription and support services, and the invoice generally becomes payable within 30 to 90 days. We generally recognize product revenue up-front but defer revenue for the sale of new and renewal subscription and support services contracts. We recognize the related services revenue over the service period, which is typically one year from the date the end-customer registers for these services (the date on which the services can first be used by the customer); although, it could be longer as we are experiencing growth in sales of multi-year support and subscription contracts. Sales of new and renewal services increase our deferred revenue balance, which contributes significantly to our positive cash flow from operations.

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Key Metrics

We monitor the key financial metrics set forth below on a quarterly basis to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. Our total deferred revenue increased by $9.7 million from $225.5 million at June 30, 2010 to $235.3 million at September 30, 2010. Revenue recognized plus the change in deferred revenue from the beginning to the end of the period is a useful metric that management identifies as billings. Billings for services drive deferred revenue, which is an important indicator of the health and visibility of our business, and has historically represented a majority of the quarterly revenue that we recognize. We also ended the third quarter of 2010 with $352.3 million in cash, cash equivalents and investments and have had positive cash flow from operations every fiscal year since 2005. We discuss revenue, gross margin, and the components of operating income and margin below under “Components of Operating Results,” and we discuss our cash, cash equivalents, and investments under “Liquidity and Capital Resources.” Deferred revenue and cash flow from operations are discussed immediately below the following table.


	For The Three Months Ended Or As Of
	September 30, 2010		September 30, 2009
	($ amounts in 000's)
Revenue	84,971		65,864
Gross margin	75	%	74	%
Operating income⁽¹⁾	18,159		9,676
Operating margin	21	%	15	%
Total deferred revenue	235,250		190,375
Increase in total deferred revenue	9,729		5,306
Cash, cash equivalents and investments	352,344		152,390
Cash flows from operating activities	32,193		15,863
Free cash flow⁽²⁾	31,522		14,621
-----------
(1) Includes:
Stock-based compensation expense	2,434		1,936
Non-cash asset acquisition related write-offs	—		93
(2) Free cash flow is a non-GAAP financial measure, which we define as cash flow from operations minus capital
expenditures, as further described below.

Deferred revenue. Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue. The majority of our deferred revenue balance consists of the unamortized portion of services revenue from subscription and support service contracts. We monitor our deferred revenue balance because it represents a significant portion of revenue to be recognized in future periods. We also assess the increase in our deferred revenue balance plus revenue we recognized in a particular period as a measure of our sales activity for that period.

Cash flow from operations. We monitor cash flow from operations as a measure of our overall business performance. Our cash flow from operations is driven in large part by advance payments for both new and renewal contracts for subscription and support services, consistent with our billings for the period. Monitoring cash flow from operations enables us to analyze our financial performance excluding the non-cash effects of certain items such as depreciation, amortization and stock-based compensation expenses, thereby allowing us to better understand and manage the cash needs of our business. Our cash flow from operations was $32.2 million in the third quarter of 2010 and $15.9 million in the third quarter of 2009. In the third quarter of 2010, free cash flow (a non-GAAP financial measure, described under “Non-GAAP Financial Measures” below) was $31.5 million, compared to $14.6 million in the third quarter of 2009.

Non-GAAP Financial Measures

To supplement our condensed consolidated financial statements presented in accordance with U.S. GAAP, we consider certain financial measures that are not prepared in accordance with GAAP, including non-GAAP gross margin, non-GAAP income from operations and non-GAAP operating margin, non-GAAP operating expenses, non-GAAP net income and non-GAAP free cash flow. These non-GAAP measures are not based on any standardized methodology prescribed by GAAP and are not necessarily comparable to similar measures presented by other companies. Non-GAAP gross margin is gross margin as reported on our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense,

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which is a non-cash charge, and for the third quarter of 2009 only, non-cash asset acquisition related write-offs. Non-GAAP income from operations is operating income, as reported on our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense and for the third quarter of 2009 only, non-cash asset acquisition related write-offs. The non-cash asset acquisition related write-offs that we exclude from our third quarter of 2009 non-GAAP financial measures are charges for intangible assets that have no future value, but these charges do not include amortization related to the intangible assets that provide an ongoing benefit to our recurring operations. Non-GAAP operating margin is non-GAAP income from operations divided by revenue. Non-GAAP operating expenses exclude the impact of stock-based compensation expense. Non-GAAP net income is net income plus stock-based compensation expense and non-cash asset acquisition related write-offs, less the related tax effects. Free cash flow, an alternative non-GAAP measure of liquidity, is defined as net cash provided by operating activities less capital expenditures.

We use these non-GAAP financial measures internally in analyzing our financial results and believe they are useful to investors, as a supplement to GAAP measures, in evaluating our ongoing operational performance and enhancing an overall understanding of our past financial performance, as they help illustrate underlying trends in our business that could otherwise be masked by the effect of the expenses that we exclude in these non-GAAP financial measures. Furthermore, we use many of these measures to establish budgets and operational goals for managing our business and evaluating our performance. We also believe that the use of these non-GAAP financial measures provides an additional tool for investors to use in comparing our recurring core business operating results over multiple periods with other companies in our industry, many of which present similar non-GAAP financial measures to investors.

These non-GAAP financial measures should not be considered in isolation from, or as a substitute for, financial information prepared in accordance with GAAP. There are a number of limitations related to the use of these non-GAAP financial measures versus the nearest GAAP equivalent of these financial measures. First, these non-GAAP financial measures exclude certain recurring, non-cash charges such as stock-based compensation expense and asset acquisition related write-offs. Stock-based compensation has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and is an important part of our employees' compensation that reflects their performance. Second, the expenses that we exclude in our calculation of these non-GAAP financial measures may differ from the expenses, if any, that our peer companies may exclude when they report their results of operations. We compensate for these limitations by providing the nearest GAAP equivalents of these non-GAAP financial measures and describing these GAAP equivalents in our Results of Operations below.

The following tables reconcile GAAP gross margin, income from operations, operating margin, certain operating expenses and net income as reported on our condensed consolidated statements of operations to non-GAAP gross margin, non-GAAP income from operations, non-GAAP operating margin, certain non-GAAP operating expenses and non-GAAP net income for the third fiscal quarters of 2010 and 2009. For the third quarter of 2010, both GAAP and non-GAAP results below include approximately $0.4 million of payroll tax expense resulting from the exercise of employee stock options during the quarter. Payroll tax expense associated with stock option exercises during the third quarter of 2009 was immaterial.

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	Three Months Ended
	September 30, 2010		September 30, 2009
	Amount	% of Revenue	Amount	% of Revenue
	($ amounts in 000's)
Total revenue	84,971		65,864

GAAP gross profit and margin	63,528	74.8	48,431	73.5
Stock-based compensation expense	268	0.3	194	0.3
Non-cash asset acquisition related write-offs	—	—	93	0.1
Non-GAAP gross profit and margin	63,796	75.1	48,718	73.9

GAAP income from operations and margin	18,159	21.4	9,676	14.7
Stock-based compensation expense:
Cost of revenue	268	0.3	194	0.3
Research and development	600	0.7	516	0.8
Sales and marketing	1,017	1.2	767	1.2
General and administrative	549	0.6	459	0.7
Total stock-based compensation	2,434	2.8	1,936	3.0
Non-cash asset acquisition related write-offs	—	—	93	0.1
Non-GAAP income from operations and margin	20,593	24.2	11,705	17.8


	Three Months Ended
	September 30, 2010				September 30, 2009
	Amount		% of Revenue		Amount		% of Revenue
	($ amounts in 000's)
Operating Expenses:
Research and development expenses:
GAAP research and development expenses	12,389		14.6		10,797		16.4
Stock-based compensation	(600	)	(0.7	)	(516	)	(0.8	)
Non-GAAP research and development expenses	11,789		13.9		10,281		15.6

Sales and marketing expenses:
GAAP sales and marketing expenses	26,987		31.8		23,468		35.6
Stock-based compensation	(1,017	)	(1.2	)	(767	)	(1.2	)
Non-GAAP sales and marketing expenses	25,970		30.6		22,701		34.4

General and administrative expenses:
GAAP general and administrative expenses	5,993		7.1		4,490		6.8
Stock-based compensation	(549	)	(0.6	)	(459	)	(0.7	)
Non-GAAP general and administrative expenses	5,444		6.5		4,031		6.1

Total operating expenses:
GAAP operating expenses	45,369		53.4		38,755		58.8
Stock-based compensation	(2,166	)	(2.5	)	(1,742	)	(2.6	)
Non-GAAP operating expenses	43,203		50.9		37,013		56.2

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	Three Months Ended
	September 30, 2010		September 30, 2009
	($ amounts in 000's)
Net Income:
GAAP net income	14,017		7,889
Stock-based compensation expense⁽¹⁾	2,434		1,936
Non-cash asset acquisition related write-offs⁽¹⁾	—		93
Provision for income taxes⁽²⁾	4,254		2,151
Non-GAAP income before provision for income taxes	20,705		12,069
Tax effects related to non-GAAP adjustments⁽³⁾	(7,247	)	(2,865	)
Non-GAAP net income	13,458		9,204

Non-GAAP net income per share - diluted	0.17		0.14

Shares used in per share calculation - diluted	77,921		64,167
-----------

(1) Stock-based compensation expense and non-cash asset acquisition related write-offs are added back to GAAP net income to reconcile to non-GAAP income before taxes.

(2) Provision for income taxes is our GAAP provision that must be added to GAAP net income to reconcile to non-GAAP income before taxes.

(3) We used a 35% effective tax rate in 2010 to calculate non-GAAP net income for the third quarter of 2010. We believe the 35% effective tax rate is a reasonable estimate of an intermediate normalized tax rate under our existing global operating structure. Our effective tax rate for the third quarter of 2009 was 24% which reflects only our foreign tax provision as our US operations had net operating losses to offset any taxable income.


	Three Months Ended
	September 30, 2010	September 30, 2009
	($ amounts in 000's)
Billings:
Revenue	84,971	65,864
Increase in deferred revenue	9,729	5,306
Total Billings (Non-GAAP)	94,700	71,170


	Three Months Ended
	September 30, 2010		September 30, 2009
	($ amounts in 000's)
Cash Flow:
Net cash provided by operating activities	32,193		15,863
Less purchases of property and equipment	(671	)	(1,242	)
Free cash flow (Non-GAAP)	31,522		14,621
Net cash provided by (used in) investing activities*	(84,943	)	3,850
Net cash provided by financing activities	11,890		1,025
-----------

* Includes purchases of property and equipment

Components of Operating Results

Revenue

We derive our revenue from sales of our products and subscription and support services. We recognize our revenue in accordance with the guidance in ASC 985-605-25 (formerly referred to as SOP 97-2, Software Revenue Recognition and SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions) which is discussed in

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further detail in “Critical Accounting Policies and Estimates - Revenue Recognition” below. According to ASC 985-605-25, revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable and collectability is probable.

Our total revenue is comprised of the following:

•

Product revenue. Product revenue is generated from sales of our appliances and software. The substantial majority of our product revenue has been generated by our FortiGate line of appliances, and we do not expect this to change in the foreseeable future. Product revenue also includes revenue derived from sales of FortiManager, FortiAnalyzer, FortiSwitch, FortiMail, FortiDB, FortiWeb, FortiAP, FortiScan, FortiCarrier, and FortiBridge appliances, and our FortiClient and virtual domain, or VDOM, software. We generally recognize revenue for products sold to distributors through the “sell-in” method upon shipment to the distributor, and for “sell-through” distributors, upon sale to their end-customer. As a percentage of total revenue, we expect our product revenue may vary from quarter-to-quarter based on seasonal and cyclical factors discussed below under “Quarterly Results of Operations” but generally may remain at comparable levels or decline modestly over time, as services revenue becomes a larger portion of our business as our customers renew existing services contracts and we expand our customer base.

•

Services revenue. Services revenue is generated primarily from FortiCare technical support services for software updates, maintenance releases and patches, Internet access to technical content, telephone and Internet access to technical support personnel and hardware support, and FortiGuard security subscription services related to antivirus, intrusion prevention, Web filtering and antispam updates. We recognize revenue from subscription and support services over the service performance period. Our typical contractual support and subscription term is one year from the date of registration, although, it could be longer as we are experiencing growth in the sales of multi-year support and subscription contracts. We also generate a small portion of our revenue from professional services and training services, and we recognize this revenue as service is provided. As a percentage of total revenue, although we expect our services revenue to remain at comparable levels or increase as our customers renew existing service contracts, our services revenue growth rate depends significantly on our billings growth rate, as well as the growth of our customer base.

•

Ratable product and services revenue. Ratable product and services revenue is generated from sales of our products and services in cases where the fair value of the services being provided cannot be segregated from the value of the entire sale. In these cases, the value of the entire sale is deferred and recognized ratably over the life of the service performance period. See “Critical Accounting Policies and Estimates - Revenue Recognition.” In fiscal 2009 and the first nine months of fiscal 2010, ratable product and service revenue represented approximately five to six percent of total revenue.

Cost of revenue

Our total cost of revenue is comprised of the following:

•

Cost of product revenue. A substantial majority of the cost of product revenue consists of third-party manufacturing costs. Our cost of product revenue also includes product testing costs, write-offs for excess and obsolete inventory, royalty payments, amortization and any impairment of applicable acquired intangible assets, warranty costs, shipping and allocated facilities costs, stock-based compensation costs, and personnel costs associated with logistics and quality control. Personnel costs include cash-based personnel costs such as salaries, benefits and bonuses. Royalties reflect amounts related to Trend Micro since 2006, which Trend Micro claims are owed through 2015, as discussed in “Item 1 - Legal Proceedings.” For fiscal 2008 and fiscal 2009, this royalty represented approximately one percent of total revenue and we do not expect this percentage to increase substantially in the foreseeable future.

•

Cost of services revenue. Cost of services revenue is primarily comprised of cash-based personnel costs associated with our FortiGuard Labs team and our technical support, professional services and training teams, as well as depreciation, supplies, data center, data communications, facility-related costs and stock-based compensation costs. We expect our cost of services revenue will increase as we continue to invest in subscription and support services to meet the needs of our growing customer base.


•	Cost of ratable product and services revenue. Cost of ratable product and services revenue is comprised primarily of deferred product costs and services-related costs.

Gross profit. Gross profit as a percentage of revenue, or gross margin, has been and will continue to be affected by a

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variety of factors, including the average sales price of our products, any excess inventory write-offs, manufacturing costs, the mix of products sold and the mix of revenue between products and services. We believe our overall gross margin for the near term may decline modestly compared to that achieved through the first three quarters of 2010.

Services revenue has historically increased as a percentage of total revenue since inception, and this trend has had a positive effect on our total gross margin given the higher services gross margins compared to product gross margins. Our services gross margins increased from the second quarter of fiscal 2007 through the fourth quarter of fiscal 2008 and we have generally maintained services gross margins at those levels in fiscal 2009 and the first three quarters of fiscal 2010. We do not, however, expect these margins to increase, in a meaningful way, in the future as we continue to invest in our support infrastructure.

Operating expenses. Our operating expenses consist of research and development, sales and marketing and general and administrative expenses. Personnel costs are the most significant component of operating expenses and consist of cash-based personnel costs such as salaries, benefits, bonuses and, with regard to the sales and marketing expense, sales commissions. They also include non-cash charges, specifically, stock-based compensation. We expect personnel costs to continue to increase in absolute dollars as we hire new employees.

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Research and development. Research and development expense consists primarily of cash-based personnel costs. Additional research and development expenses include ASIC and system prototypes and certification-related expenses, depreciation of capital equipment, facility-related expenses and stock-based compensation expenses. The majority of our research and development is focused on both software development and the ongoing development of our hardware platform. We record all research and development expenses as incurred, except for capital equipment which is depreciated over time. Our development teams are primarily located in Canada, China, and California. We expect our spending for research and development to increase in absolute dollars but intend for research and development expenses to remain comparable to recent periods as a percentage of total revenue.

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Sales and marketing. Sales and marketing expense is the largest component of our operating expenses and primarily consists of cash-based personnel costs. Additional sales and marketing expenses include stock-based compensation, promotional and other marketing expenses, travel, depreciation of capital equipment and facility-related expenses. We intend to hire additional personnel focused on sales and marketing and expand our sales and marketing efforts worldwide in order to increase our presence in new geographic markets and enterprise verticals, add new customers and increase penetration within our existing customer base. Accordingly, we expect sales and marketing expenses to increase in absolute dollars and to continue to be our largest operating expense.

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General and administrative. General and administrative expense consists of cash-based personnel costs as well as professional fees, stock-based compensation, depreciation of capital equipment and software, and facility-related expenses. General and administrative personnel include our executive, finance, human resources, information technology and legal organizations. Our professional fees principally consist of outside legal, auditing, accounting, information technology and other consulting costs. We expect that general and administrative expense will increase in absolute dollars as we hire additional personnel, make improvements to our information technology infrastructure, defend our intellectual property, and incur significant additional costs for the compliance requirements of operating as a public company, including the costs associated with SEC reporting, Sarbanes-Oxley Act compliance and insurance.

Interest income. Interest income consists of income earned on our cash, cash equivalents and investments. We have historically invested our cash in money market funds, commercial paper, corporate debt securities and U.S. government debt securities.

Other income (expense), net. Other income (expense), net consists primarily of foreign exchange and related hedging gains and losses. Foreign exchange gains and losses relate to foreign currency exchange re-measurement. The hedging gains and losses are related to our settled balance sheet hedges.

Provision for income taxes. Our income tax provision is based on our worldwide estimated annualized effective tax rate. We are subject to tax in the United States as well as other tax jurisdictions or countries in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to current U.S. income tax. Our effective tax rates differ from the statutory rate primarily due to foreign income subject to different tax rates than the U.S., research and development tax credits (when applicable), withholding tax, nondeductible compensation and adjustments related to our intercompany transfer pricing.

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

We believe the accounting policies and estimates discussed under Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009 reflect our more significant judgments and estimates used in the preparation of the consolidated financial statements. There have been no material changes to the critical accounting policies and estimates as filed in such report.

Results of Operations

Three Months Ended September 30, 2010 and September 30, 2009

Revenue


	Three Months Ended
	September 30, 2010		September 30, 2009
	Amount	% of Revenue	Amount	% of Revenue	$ Change	% Change
	($ amounts in 000's)
Revenue:
Product	35,913	42.3	25,550	38.8	10,363	40.6
Services	44,527	52.4	36,712	55.7	7,815	21.3
Ratable product and services	4,531	5.3	3,602	5.5	929	25.8
Total revenue	84,971	100.0	65,864	100.0	19,107	29.0

Revenue by Geography:
Americas	35,396	41.7	26,085	39.6	9,311	35.7
EMEA	28,926	34.0	23,454	35.6	5,472	23.3
APAC	20,649	24.3	16,325	24.8	4,324	26.4
Total revenue	84,971	100.0	65,864	100.0	19,107	29.0

Total revenue increased $19.1 million, or 29.0%, in the third quarter of 2010 as compared to the third quarter of 2009. The Americas region contributed the largest portion of this growth with increased sales to enterprise and service provider customers, while the APAC and EMEA regions demonstrated significant year-over-year growth as well. Product revenue increased $10.4 million, or 40.6%, compared to the third quarter of 2009. The increase in product revenue was primarily driven by higher product sales volume and a greater mix of our high-end products due to increased sales to enterprise and service provider customers, exemplified by a 50 percent increase in deals over $100,000. Services revenue increased $7.8 million, or 21.3%, in the third quarter of 2010 compared to the third quarter of 2009 due to recognition of revenue from our growing deferred revenue balance consisting of subscription and support contracts sold to a larger customer base. The growth in ratable product and services revenue was due to a slight decrease in the weighted-average service period over which such revenue was recognized, as the result of a decrease in the average contractual term of support contracts related to these arrangements.

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Cost of revenue and gross margin


	Three Months Ended
	September 30, 2010	September 30, 2009	$ Change	% Change
	($ amounts in 000's)
Cost of revenue:
Product	13,263	10,428	2,835	27.2
Services	6,565	5,550	1,015	18.3
Ratable product and services	1,615	1,455	160	11.0
Total cost of revenue	21,443	17,433	4,010	23.0

Gross margin (%):
Product	63.1	59.2	3.9
Services	85.3	84.9	0.4
Ratable product and services	64.4	59.6	4.8
Total gross margin	74.8	73.5	1.3

Total gross margin increased 1.3 percentage points in the third quarter of 2010 primarily due to improved product margins. Product gross margin increased 3.9 percentage points in the third quarter of 2010 compared to 2009 primarily due to an increase in the mix of high-end product sales to enterprise and service provider customers. The increased margin was also partly attributed to indirect product costs and warranty-related costs increasing $0.4 million, but representing a lower percentage of product revenue compared to the third quarter of 2009. From time to time, we have experienced sales of previously reserved inventory. During the third quarter of 2010, we experienced a positive impact of 0.7 percentage points due to the sale of fully reserved inventory compared to 1.1 percentage points in the third quarter of 2009. The 0.4 percentage point increase in services gross margin was primarily due to our services business model and increased leverage in our cost structure. Services cost increased by $1.0 million primarily due to $0.7 million of higher cash-based personnel costs. Travel, depreciation, and occupancy-related costs increased a combined $0.3 million. Ratable product and services gross margin increased 4.8 percentage points, relatively in line with product gross margins, as a result of leveraging our indirect product cost structure, such as manufacturing overhead, and lower direct product costs as a percentage of revenue.

Operating Expenses


	Three Months Ended
	September 30, 2010		September 30, 2009
	Amount	% of Revenue	Amount	% of Revenue	$ Change	% Change
	($ amounts in 000's)
Operating expenses:
Research and development	12,389	14.6	10,797	16.4	1,592	14.7
Sales and marketing	26,987	31.8	23,468	35.6	3,519	15.0
General and administrative	5,993	7.1	4,490	6.8	1,503	33.5
Total operating expenses	45,369	53.5	38,755	58.8	6,614	17.1

Research and development expense

Research and development expense increased $1.6 million, or 14.7%, in the third quarter of 2010 compared to the third quarter of 2009 primarily due to an increase of $0.8 million in cash-based personnel costs as a result of increased headcount to support the development of new products and continued enhancements of our existing products. Occupancy-related costs increased $0.5 million due to expansion into a new office facility and product development expenses increased $0.3 million. A 6% increase in the Canadian dollar exchange rate against the US dollar also significantly contributed to the increase in research and development expense.

Sales and marketing expense

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Sales and marketing expense increased $3.5 million, or 15.0%, in the third quarter of 2010 compared to the third quarter of 2009 primarily due to increased cash-based personnel costs of $3.5 million based on increased headcount in our sales organization in order to expand our global footprint, a $0.3 million increase in travel expense and a $0.3 million increase in stock-based compensation expense. These increases were offset by $0.6 million of lower marketing related expenses as a result of continued focus around expense control. A 12% decrease in the Euro exchange rate against the US dollar also contributed to the decrease in sales and marketing expense. As a percentage of revenue, sales and marketing expenses decreased 3.9 percentage points due to the leverage we are achieving from the investment in our salesforce during the past year, as evidenced by our revenue growth of 29.0% outpacing our sales and marketing expenses growth of 15.0%. However, we intend to continue to make investments in sales and marketing in the near term to position ourselves for future growth.

General and administrative expense

In the third quarter of 2010, general and administrative expense increased $1.5 million, or 33.5%, compared to the third quarter of 2009. The increase was primarily due to a $1.2 million increase in legal expenses to support various patent litigation matters, increased cash-based personnel costs of $0.2 million, and a $0.1 million increase in stock-based compensation.

Interest income and other income (expense), net


	Three Months Ended
	September 30, 2010		September 30, 2009		$ Change		% Change
	($ amounts in 000's)
Interest income	514		428		86		20.1
Other income (expense), net	(402	)	(64	)	(338	)	528.1