Edgar Filing: FORTINET INC

Fortinet 20130930 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



T	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013



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

For the transition period from to

Commission file number: 001-34511

______________________________________

FORTINET, INC.

(Exact name of registrant as specified in its charter)

______________________________________



Delaware	77-0560389
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)



1090 Kifer Road Sunnyvale, California	94086
(Address of principal executive offices)	(Zip Code)

(408) 235-7700

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.



Large accelerated filer	x		Accelerated filer	o
Non-accelerated filer	o	(Do not check if smaller reporting company)	Smaller reporting company	o

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

As of October 29, 2013, there were 163,460,178 shares of the registrant’s common stock outstanding.

FORTINET, INC.

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended September 30, 2013

Table of Contents




		Page

	Part I

Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012	3
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2013 and 2012	4
	Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2013 and 2012	5
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2013 and 2012	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	26
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	43
Item 4.	Controls and Procedures	43

	Part II

Item 1.	Legal Proceedings	44
Item 1A.	Risk Factors	44
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	66
Item 3.	Defaults Upon Senior Securities	66
Item 4.	Mine Safety Disclosures	66
Item 5.	Other Information	66
Item 6.	Exhibits	66
	Signatures	67

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Part I


ITEM 1.	Financial Statements

FORTINET, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per share amounts)



	September 30, 2013		December 31, 2012
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	144,546	$	122,975
Short-term investments	368,472		290,719
Accounts receivable—Net	107,802		107,642
Inventory	46,876		21,060
Prepaid expenses and other current assets	38,271		26,878
Total current assets	705,967		569,274
PROPERTY AND EQUIPMENT—Net	28,380		25,638
LONG-TERM INVESTMENTS	327,987		325,892
GOODWILL AND OTHER INTANGIBLE ASSETS—Net	10,612		2,117
DEFERRED TAX ASSETS—Non-current	51,996		48,525
OTHER ASSETS	3,200		4,051
TOTAL ASSETS	$	1,128,142	$	975,497

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	33,257	$	20,816
Accrued liabilities	32,317		22,263
Accrued payroll and compensation	30,450		28,957
Deferred revenue	271,302		247,268
Total current liabilities	367,326		319,304
DEFERRED REVENUE—Non-current	128,871		115,917
INCOME TAXES PAYABLE—Non-current	30,568		28,778
OTHER LIABILITIES	1,424		564
Total liabilities	528,189		464,563
COMMITMENTS AND CONTINGENCIES (Note 8)
STOCKHOLDERS’ EQUITY:
Common stock, $0.001 par value — 300,000 shares authorized; 163,329 and 161,757 shares issued and 163,329 and 160,348 shares outstanding as of September 30, 2013 and December 31, 2012, respectively	163		162
Additional paid-in capital	455,279		400,075
Treasury stock	—		(2,995		)
Accumulated other comprehensive income	1,653		3,091
Retained earnings	142,858		110,601
Total stockholders’ equity	599,953		510,934
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	1,128,142	$	975,497

See notes to condensed consolidated financial statements.

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FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share amounts)



	Three Months Ended						Nine Months Ended
	September 30, 2013			September 30, 2012			September 30, 2013			September 30, 2012
REVENUE:
Product	$	69,687		$	63,027		$	194,162		$	177,923
Services	83,883			69,782			239,447			197,332
Ratable and other revenue	1,129			3,459			4,338			7,222
Total revenue	154,699			136,268			437,947			382,477
COST OF REVENUE:
Product	27,126			23,995			77,032			66,997
Services	16,374			13,166			48,207			36,846
Ratable and other revenue	430			647			1,527			2,135
Total cost of revenue	43,930			37,808			126,766			105,978
GROSS PROFIT:
Product	42,561			39,032			117,130			110,926
Services	67,509			56,616			191,240			160,486
Ratable and other revenue	699			2,812			2,811			5,087
Total gross profit	110,769			98,460			311,181			276,499
OPERATING EXPENSES:
Research and development	26,421			20,498			74,913			60,553
Sales and marketing	56,687			44,743			162,660			131,038
General and administrative	9,382			7,449			26,161			19,473
Total operating expenses	92,490			72,690			263,734			211,064
OPERATING INCOME	18,279			25,770			47,447			65,435
INTEREST INCOME	1,282			1,318			3,988			3,606
OTHER EXPENSE—Net	(1,151		)	(317		)	(1,036		)	(315		)
INCOME BEFORE INCOME TAXES	18,410			26,771			50,399			68,726
PROVISION FOR INCOME TAXES	7,381			9,565			18,142			23,397
NET INCOME	$	11,029		$	17,206		$	32,257		$	45,329
Net income per share:
Basic	$	0.07		$	0.11		$	0.20		$	0.29
Diluted	$	0.07		$	0.10		$	0.19		$	0.27
Weighted-average shares outstanding:
Basic	162,906			158,751			162,150			157,416
Diluted	168,666			166,791			168,054			166,127

See notes to condensed consolidated financial statements.

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FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited, in thousands)



	Three Months Ended						Nine Months Ended
	September 30, 2013			September 30, 2012			September 30, 2013			September 30, 2012
Net income	$	11,029		$	17,206		$	32,257		$	45,329
Other comprehensive income (loss), net of reclassification adjustments:
Foreign currency translation gains (losses)	912			1,092			(901		)	867
Unrealized gains (losses) on investments	600			1,968			(826		)	3,441
Unrealized losses on cash flow hedges	—			(19		)	—			—
Tax (provision) benefit related to items of other comprehensive income or loss	(209		)	(618		)	289			(1,133		)
Other comprehensive income (loss), net of tax	1,303			2,423			(1,438		)	3,175
Comprehensive income	$	12,332		$	19,629		$	30,819		$	48,504

See notes to condensed consolidated financial statements.

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FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)



	Nine Months Ended
	September 30, 2013			September 30, 2012
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	32,257		$	45,329
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	11,511			8,076
Amortization of investment premiums	8,900			10,002
Stock-based compensation expense	31,784			23,928
Excess tax benefit from employee stock option plans	(2,504		)	(9,611		)
Other non-cash items, net	520			893
Changes in operating assets and liabilities:
Accounts receivable—Net	589			5,680
Inventory	(31,344		)	(14,977		)
Prepaid expenses and other current assets	219			(71		)
Other assets	(13,928		)	(2,630		)
Accounts payable	11,054			3,049
Accrued payroll and compensation	1,400			1,563
Accrued and other liabilities	2,631			1,301
Deferred revenue	36,425			45,192
Income taxes payable	11,202			15,849
Net cash provided by operating activities	100,716			133,573
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of investments	(419,124		)	(523,389		)
Sales of investments	25,488			25,768
Maturities of investments	303,852			343,174
Purchases of property and equipment	(6,729		)	(20,283		)
Payments made in connection with acquisitions, net of cash acquired	(7,635		)	(749		)
Net cash used in investing activities	(104,148		)	(175,479		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock	24,470			36,006
Taxes paid related to net share settlement of equity awards	(966		)	—
Excess tax benefit from employee stock option plans	2,504			9,611
Net cash provided by financing activities	26,008			45,617
EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS	(1,005		)	(235		)
NET INCREASE IN CASH AND CASH EQUIVALENTS	21,571			3,476
CASH AND CASH EQUIVALENTS—Beginning of period	122,975			71,990
CASH AND CASH EQUIVALENTS—End of period	$	144,546		$	75,466
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes	$	19,721		$	10,335
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Purchase of property and equipment not yet paid	$	1,349		$	722
Liability incurred in connection with business acquisition	$	100		$	201

See notes to condensed consolidated financial statements.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Preparation

The unaudited condensed consolidated financial statements of Fortinet, Inc. and its wholly owned subsidiaries (collectively, “we,” “us,” or “our”) have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information as well as the instructions to Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements, and should be read in conjunction with our audited consolidated financial statements as of and for the fiscal year ended December 31, 2012, contained in our Annual Report on Form 10-K (“Form 10-K”) filed with the SEC on February 27, 2013. In the opinion of management, all adjustments, which only includes normal recurring adjustments, considered necessary for a fair presentation have been included. All intercompany balances, transactions and cash flows have been eliminated. The results of operations for the three and nine months ended September 30, 2013 are not necessarily indicative of the operating results for any subsequent quarter, for the full year or for any future periods. The condensed consolidated balance sheets as of December 31, 2012 are derived from the audited consolidated financial statements for the year ended December 31, 2012.

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.

During the three and nine months ended September 30, 2013, we recorded a non-recurring out-of-period adjustment of $3.0 million to correct the presentation on our condensed consolidated balance sheets relating to our repurchase of 1,409,264 shares during the fiscal year ended December 31, 2009. This reclassification adjustment resulted in a decrease to the outstanding treasury stock balance and a corresponding decrease to additional paid-in capital. We believe the impact of the adjustment is not material to the current or prior fiscal periods. The shares that we repurchased in 2009 were retired immediately after repurchase. There was no outstanding treasury stock balance at September 30, 2013.

There have been no material changes in our significant accounting policies as of and for the three and nine months ended September 30, 2013, as compared to the significant accounting policies described in the Form 10-K, except for the inclusion of policies related to goodwill and other indefinite-lived assets, long-term investments, and stock-based compensation expense pertaining to performance stock units (“PSUs”).

Goodwill and other indefinite-lived intangible assets

Goodwill represents the excess of purchase consideration over the estimated fair value of net assets of businesses acquired in a business combination. Goodwill and other indefinite-lived intangible assets such as in-process research and development acquired in a business combination are not amortized, but instead tested for impairment at least annually during the fourth quarter. We perform our annual goodwill impairment analysis at the reporting unit level. As of September 30, 2013, we had one reporting unit.

In reviewing goodwill for impairment we have the option to (i) assess qualitative factors to determine whether it is more-likely-than-not that the fair value of the reporting unit is less than its carrying amount or (ii) bypass the qualitative assessment and proceed directly to a quantitative assessment. If we opt to perform a qualitative assessment, the factors we may review include, but are not limited to (a) macroeconomic conditions; (b) industry and market considerations; (c) cost factors; (d) overall financial performance; (e) other relevant entity-specific events such as changes in management, strategy, customers, or litigation; (f) events affecting the reporting unit; or (g) or sustained decrease in share price. If we believe, as a result of the qualitative assessment, that it is more-likely-than-not that the fair value of the reporting unit is less than its carrying amount, the quantitative impairment test will be required. Otherwise, no further testing will be required. A quantitative assessment utilizes a two-step process. In the first step, the fair value of the reporting unit is determined, and is compared against its carrying amount, including goodwill. We consider a combination of an income-based approach using projected discounted cash flows and a market-based approach using multiples of comparable companies to determine the fair value. The fair value of the reporting unit is estimated using significant judgment based on a combination of the income and the market approaches. Under the income approach, we estimate fair value of the reporting unit based on the present value of forecasted future cash flows that

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

the reporting unit is expected to generate over its remaining life. Under the market approach, we estimate fair value of our reporting unit based on an analysis that compares the value of the reporting unit to values of other companies in similar lines of business. If the fair value of the reporting unit does not exceed its carrying value, then we perform the second step to measure the amount of impairment loss. The amount of impairment is determined by comparing the implied fair value of reporting unit goodwill to the carrying value of the goodwill. When the carrying value of the reporting unit's goodwill exceeds its implied fair value, we record an impairment loss equal to the difference.

Determining the fair value of the reporting unit requires us to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, operating trends, risk-adjusted discount rates, future economic and market conditions and determination of appropriate market comparables. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates. We may also test goodwill and other intangible assets for impairment between annual tests in the presence of impairment indicators. Acquired in-process research and development assets are classified as indefinite-lived intangible assets until the successful completion or abandonment of the associated research and development efforts. Upon successful completion of the associated research and development efforts, the useful life of the asset is determined and the asset is amortized over its useful life. If the associated research and development efforts are abandoned, an impairment loss is recognized for the carrying value of the related asset.

Long-term investments

Investments in privately held companies where we own less than 20% of the voting stock and have no indicators of significant influence over operating and financial policies of those companies are included in Long-term investments in the consolidated balance sheets and are accounted for under the cost method. For these non-quoted investments, we regularly review the assumptions underlying the operating performance and cash flow forecasts based on information provided by these privately held companies. If it is determined that an other-than-temporary decline exists in an equity security, we write down the investment to its fair value and record the related impairment as an investment loss in our consolidated statements of operations. As of September 30, 2013, we only have one investment of $2.0 million in a privately-held company accounted for under the cost method.

Stock-Based Compensation Expense - Performance Stock Units

PSUs are restricted stock units (“RSUs”) that contain both service-based and market-based vesting conditions. PSUs vest over a specified service period upon the satisfaction of certain market-based vesting conditions, and settle into shares of our common stock upon vesting over a two- or three-year period. The fair value of a PSU is calculated using the Monte Carlo simulation model on the grant date and is based on the market price of our common stock on the grant date modified to reflect the impact of the market-based vesting condition, including the estimated payout level based on that condition. We do not adjust compensation cost for subsequent changes in the expected outcome of the market-based vesting conditions.

Certain prior period amounts have been combined on the condensed consolidated balance sheets and statements of cash flows to conform to the current period presentation.

Recent Accounting Pronouncements

In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2013-02, Comprehensive Income (Topic 220)—Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income (“ASU 2013-02”). ASU 2013-02 requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under GAAP to be reclassified in its entirety to net income. For other amounts that are not required under GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under GAAP that provide additional detail about those amounts. We adopted ASU 2013-02 on January 1, 2013, and presented the effects within Note 16, Accumulated Other Comprehensive Income.

In July 2013, the FASB issued ASU No. 2013-11, Income Taxes (Topic 740)-Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (“ASU 2013-11”). ASU 2013-11 provides guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, similar tax loss, or tax credit carryforward exists. This new standard requires the netting of unrecognized tax benefits (“UTBs”) against a deferred tax asset for a loss or other carryforward that would apply in settlement of the uncertain

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

tax positions. UTBs will be netted against all available same-jurisdiction loss or other tax carryforwards that would be utilized, rather than only against carryforwards that are created by the UTBs. ASU 2013-11 will be effective for us beginning in the first quarter of fiscal 2014. Early adoption is permitted. Since ASU 2013-11 only impacts financial statement disclosure requirements for unrecognized tax benefits, we do not expect its adoption to have an impact on our financial position or results of operations.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

2. INVESTMENT IN PRIVATELY-HELD COMPANY

In August 2013, we invested $2.0 million in equity securities in HyTrust, a privately-held company. This investment is accounted for as a cost-basis investment, as we own less than 20% of the voting securities and do not have the ability to exercise significant influence over operating and financial policies of the entity. As of September 30, 2013, no events have occurred that would adversely affect the carrying value of this investment. We did not record any impairment charges for this investment during the three and nine months ended September 30, 2013.

3. FINANCIAL INSTRUMENTS AND FAIR VALUE

The following table summarizes our investments ($ amounts in 000’s):



	September 30, 2013
	Amortized Cost	Unrealized Gains	Unrealized Losses		Fair Value
U.S. government and agency securities	2,000	—	—		2,000
Corporate debt securities	566,962	1,336	(441	)	567,857
Commercial paper	81,955	13	(6	)	81,962
Municipal bonds	34,554	44	(14	)	34,584
Certificates of deposit and term deposits	8,053	3	—		8,056
Total available-for-sale securities	693,524	1,396	(461	)	694,459

	December 31, 2012
	Amortized Cost	Unrealized Gains	Unrealized Losses		Fair Value
Corporate debt securities	529,738	1,814	(161	)	531,391
Commercial paper	39,229	22	(6	)	39,245
Municipal bonds	36,787	83	—		36,870
Certificates of deposit and term deposits	9,099	6	—		9,105
Total available-for-sale securities	614,853	1,925	(167	)	616,611

The following table shows the gross unrealized losses and the related fair values of our investments that have been in a continuous unrealized loss position, as of September 30, 2013 ($ amounts in 000’s):



	Less Than 12 Months			12 Months or Greater			Total
	Fair Value	Unrealized Losses		Fair Value	Unrealized Losses		Fair Value	Unrealized Losses
Corporate debt securities	232,721	(434	)	5,309	(7	)	238,030	(441	)
Commercial paper	20,076	(6	)	—	—		20,076	(6	)
Municipal bonds	12,941	(14	)	—	—		12,941	(14	)
Total available-for-sale securities	265,738	(454	)	5,309	(7	)	271,047	(461	)

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table shows the gross unrealized losses and the related fair values of our investments that have been in a continuous unrealized loss position, as of December 31, 2012 ($ amounts in 000’s):



	Less Than 12 Months			12 Months or Greater			Total
	Fair Value	Unrealized Losses		Fair Value	Unrealized Losses		Fair Value	Unrealized Losses
Corporate debt securities	133,006	(156	)	5,010	(5	)	138,016	(161	)
Commercial paper	8,464	(6	)	—	—		8,464	(6	)
Total available-for-sale securities	141,470	(162	)	5,010	(5	)	146,480	(167	)

The contractual maturities of our investments were as follows ($ amounts in 000’s)



	September 30, 2013	December 31, 2012
Due within one year	368,472	290,719
Due within one to three years	325,987	325,892
Total available-for-sale securities	694,459	616,611

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

The following table presents the fair value of our financial assets measured at fair value on a recurring basis as of September 30, 2013 and December 31, 2012 ($ amounts in 000’s):



	September 30, 2013			December 31, 2012
	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)
U.S. government and agency securities	2,000	—	2,000	—	—	—
Corporate debt securities	574,578	—	574,578	531,391	—	531,391
Commercial paper	83,262	—	83,262	41,994	—	41,994
Municipal bonds	34,584	—	34,584	36,870	—	36,870
Certificates of deposit and term deposits	8,056	—	8,056	9,105	—	9,105
Money market funds	45,897	45,897	—	39,871	39,871	—
	748,377	45,897	702,480	659,231	39,871	619,360

Reported as:
Cash equivalents	53,918			42,620
Short-term investments	368,472			290,719
Long-term investments	325,987			325,892
Total	748,377			659,231

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the three and nine months ended September 30, 2013.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

4. INVENTORY

Inventory consisted of the following ($ amounts in 000’s):



	September 30, 2013	December 31, 2012
Raw materials	7,765	4,958
Finished goods	39,111	16,102
Inventory	46,876	21,060

5. PROPERTY AND EQUIPMENT—Net

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



	September 30, 2013		December 31, 2012
Land	13,895		13,895
Building and building improvements	610		610
Evaluation units	21,986		18,322
Computer equipment and software	22,785		17,176
Furniture and fixtures	1,709		1,501
Construction-in-process	1,295		—
Leasehold improvements and tooling	5,532		5,354
Total property and equipment	67,812		56,858
Less: accumulated depreciation	(39,432	)	(31,220	)
Property and equipment—net	28,380		25,638

Depreciation expense was $3.8 million and $2.7 million for the three months ended September 30, 2013 and September 30, 2012, respectively. Depreciation expense was $10.4 million and $7.2 million for the nine months ended September 30, 2013 and September 30, 2012, respectively.

6. NET INCOME PER SHARE

Basic net income per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding, plus the dilutive effects of stock options, RSUs, and the employee stock purchase plan (“ESPP”). Potentially dilutive shares of common stock are determined by applying the treasury stock method.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



	Three Months Ended		Nine Months Ended
	September 30, 2013	September 30, 2012	September 30, 2013	September 30, 2012
Numerator:
Net income	11,029	17,206	32,257	45,329

Denominator:
Basic shares:
Weighted-average common stock outstanding-basic	162,906	158,751	162,150	157,416
Diluted shares:
Weighted-average common stock outstanding-basic	162,906	158,751	162,150	157,416
Effect of potentially dilutive securities:
Stock options	5,525	8,019	5,844	8,694
RSUs	213	—	50	—
ESPP	22	21	10	17
Weighted-average shares used to compute diluted net income per share	168,666	166,791	168,054	166,127
Net income per share:
Basic	0.07	0.11	0.20	0.29
Diluted	0.07	0.10	0.19	0.27

The following weighted-average shares of common stock were excluded from the computation of diluted net income per share for the periods presented, as their effect would have been antidilutive (in 000’s):



	Three Months Ended		Nine Months Ended
	September 30, 2013	September 30, 2012	September 30, 2013	September 30, 2012
Stock options	6,640	5,686	7,364	6,847
RSUs	1,416	388	2,383	130
ESPP	407	303	399	300
	8,463	6,377	10,146	7,277

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

7. DEFERRED REVENUE

Deferred revenue consisted of the following ($ amounts in 000’s):



	September 30, 2013	December 31, 2012
Product	5,114	5,411
Services	389,571	348,548
Ratable and other revenue	5,488	9,226
Total deferred revenue	400,173	363,185
Reported As:
Current	271,302	247,268
Non-current	128,871	115,917
Total deferred revenue	400,173	363,185

8. COMMITMENTS AND CONTINGENCIES

Leases—We lease certain facilities under various non-cancelable operating leases, which expire through 2020. Rent expense was $2.4 million and $2.1 million for the three months ended September 30, 2013 and September 30, 2012, respectively. Rent expense was $7.1 million and $6.5 million for the nine months ended September 30, 2013 and September 30, 2012, respectively. Rent expense is recognized using the straight-line method over the term of the lease. The aggregate future non-cancelable minimum rental payments on operating leases as of September 30, 2013 are as follows ($ amounts in 000’s):



	Rental Payment
Fiscal Years:
2013 (remainder)	2,675
2014	7,715
2015	5,342
2016	4,279
2017	3,738
Thereafter	7,779
Total	31,528

Contract Manufacturer and Other Commitments—Our independent contract manufacturers procure components and build our products based on our forecasts. These forecasts are based on estimates of future demand for our products, which are in turn based on historical trends and an analysis from our sales and marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate component supply, we issue non-cancelable purchase orders to some of our independent contract manufacturers. As of September 30, 2013, we had $46.6 million of open purchase orders with our independent contract manufacturers that may not be cancelable.

In addition to commitments with contract manufacturers, we have open purchase orders and contractual obligations in the ordinary course of business for which we have not received goods or services. As of September 30, 2013, we had $10.2 million in other purchase commitments.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Warranties—We generally provide a 1-year warranty on hardware products and a 90-day warranty on software.

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



	For The Nine Months Ended
	September 30, 2013		September 30, 2012
Accrued warranty balance—beginning of the period	2,309		2,582
Warranty costs incurred	(2,670	)	(1,843	)
Provision for warranty, including warranty assumed from Xtera	3,134		1,604
Changes in prior period estimates	274		(307	)
Accrued warranty balance—end of the period	3,047		2,036

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

In July 2010, Network Protection Sciences, LLC (“NPS”), 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. In December 2011, the United States District Court for the Eastern District of Texas ordered the case to be transferred to the Northern District of California. In June 2012, the United States District Court for the Northern District of California dismissed the other defendants for misjoinder, and the case thereafter proceeded with Fortinet as the sole defendant. Between June and August 2013, we filed a number of pretrial motions with the Court. As a result of those motions, the Court found that NPS had engaged in litigation misconduct. The Court also granted our motion to strike NPS’s expert report on the issue of damages. Shortly thereafter, in September 2013, NPS agreed to abandon the case and we did not make any payments related to this case. NPS and its principals furthermore agreed not to sue us on related patents. The litigation related to NPS is no longer material to us.

In June 2012, we received a letter from SRI International, (“SRI”) claiming that we infringed certain SRI patents. Subsequently, we filed a complaint in the United States District Court for the Northern District of California seeking declaratory relief and a judgment that the SRI patents were invalid, unenforceable and not infringed by any of our products or services. The case is proceeding in the United States District Court for the Northern District of California. The case is currently in the early stages, and we have determined that, as of this time, there is not a reasonable possibility that a material loss has been incurred.

Indemnification—Under the indemnification provisions of our standard sales contracts, we agree to defend our customers against third-party claims asserting infringement of certain intellectual property rights, which may include patents, copyrights, trademarks, or trade secrets, and to pay judgments entered on such claims. Our exposure under these indemnification provisions is generally limited by the terms of our contracts to the total amount paid by our customer under the agreement. However, certain agreements include indemnification provisions 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.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

9. STOCKHOLDERS’ EQUITY

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

Employee Stock Options

In August 2012, we began to primarily grant RSUs instead of stock options to employees, non-employees and members of the board of directors.

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



	Three Months Ended	Nine Months Ended
	September 30, 2013	September 30, 2013	September 30, 2012
Expected term in years	4.6	4.6	4.6
Volatility (%)	47.8	47.8	46.4 - 51.9
Risk-free interest rate (%)	1.2	1.2	0.7 - 0.9
Dividend rate (%)	—	—	—

There were no stock options granted during the three months ended September 30, 2012.

The following table summarizes the stock option activity and related information for the periods presented below (in 000’s, except per share amounts, exercise prices and contractual life):



	Options Outstanding
	Number of Shares		Weighted- Average Exercise Price ($)	Weighted- Average Remaining Contractual Life (Years)	Aggregate Intrinsic Value ($)
Balance—December 31, 2012	18,571		12.40
Granted	209		21.11
Forfeited	(631	)	21.82
Exercised	(2,210	)	5.33
Balance—September 30, 2013	15,939		13.12	3.5	134,415
Options vested and expected to vest—September 30, 2013	15,914		13.11	3.5	134,407
Options exercisable—September 30, 2013	11,781		9.98	3.1	129,937

The aggregate intrinsic value represents the pre-tax difference between the exercise price of stock options and the quoted market price of our common stock on September 30, 2013, for all in-the-money options. As of September 30, 2013, total compensation expense related to unvested stock options granted to employees but not yet recognized was $46.0 million, net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average period of 2.0 years.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Additional information related to our stock options is summarized below ($ amounts in 000’s, except per share amounts):



	Three Months Ended		Nine Months Ended
	September 30, 2013	September 30, 2012	September 30, 2013	September 30, 2012
Weighted-average fair value per share granted	8.61	—	8.61	11.13
Intrinsic value of options exercised	7,880	32,623	36,997	83,313
Fair value of options vested	5,063	6,823	21,553	19,897

Restricted Stock Units

The following table summarizes the activity and related information for RSUs for the period presented below (in 000’s, except per share amounts):



	Restricted Stock Units Outstanding
	Number of Shares		Weighted-Average Grant-Date Fair Value per Share ($)
Balance—December 31, 2012	830		23.73
Granted	3,871		21.86
Forfeited	(251	)	22.97
Vested	(144	)	24.86
Balance—September 30, 2013	4,306		21.98
RSUs expected to vest—September 30, 2013	3,988		22.01

As of September 30, 2013, total compensation expense related to unvested RSUs that were granted to employees and non-employees, but not yet recognized, was $86.3 million, net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 3.4 years.

RSUs settle into shares of common stock upon vesting. RSUs that were previously granted began vesting in August 2013. Upon the vesting of the RSUs, we net-settled the RSUs and withheld a portion of the shares to satisfy minimum statutory employee withholding taxes. Total payment for the employees’ tax obligations to the taxing authorities is reflected as a financing activity within the condensed consolidated statements of cash flows. These net settlements had the effect of share repurchases by us as they reduced and retired the number of shares that would have otherwise been issued as a result of the vesting and did not represent an expense to us.

The following summarizes the number and value of the shares withheld for employee taxes for the three and nine months ended September 30, 2013 ($ amount in 000’s, except share amount):



Shares withheld for taxes	45
Amount withheld for taxes	966

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Performance Stock Units

During the three and nine months ended September 30, 2013, we granted PSUs under the Plan to certain of our executive officers. Based on the achievement of the market-based vesting conditions during the performance period, the final settlement of the PSUs will range between 0% and 150% of the target shares underlying the PSUs based on a specified objective formula approved by our Compensation Committee. The PSUs entitle our executive officers to receive a number of shares of our common stock based on the performance of our stock price over a two- or three-year period as compared to the NASDAQ Composite index for the same periods.

The following table summarizes the weighted-average assumptions relating to our PSUs for the three and nine months ended September 30, 2013:



Expected term in years	2.97
Volatility (%)	50.11
Risk-free interest rate (%)	0.67
Dividend rate (%)	—

The target number of shares underlying the PSUs that were granted to certain of our executive officers during the three months ended September 30, 2013, totaled 180,000 shares that had a grant date fair value of $22.06 per share.

As of September 30, 2013, total compensation expense related to unvested PSUs that were granted to certain of our executive officers, but not yet recognized, was $3.8 million, net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 2.8 years.

Employee Stock Purchase Plan

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



	Three Months Ended		Nine Months Ended
	September 30, 2013	September 30, 2012	September 30, 2013	September 30, 2012
Expected term in years	0.5	0.5	0.5	0.5
Volatility (%)	35.1	43.1	44.0	53.7
Risk-free interest rate (%)	0.1	0.2	0.1	0.1
Dividend rate (%)	—	—	—	—

Additional information related to our ESPP is provided below (in 000’s, except per share amounts):



	Three Months Ended		Nine Months Ended
	September 30, 2013	September 30, 2012	September 30, 2013	September 30, 2012
Weighted-average fair value per share granted ($)	5.04	6.63	6.11	7.06
Shares issued under the ESPP	343,761	288,884	672,397	576,833
Weighted-average price per share issued ($)	17.90	20.29	18.88	18.90

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Stock-based Compensation Expense

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



	Three Months Ended		Nine Months Ended
	September 30, 2013	September 30, 2012	September 30, 2013	September 30, 2012
Cost of product revenue	91	85	277	237
Cost of services revenue	1,297	1,018	3,543	2,704
Research and development	3,548	2,525	9,605	6,774
Sales and marketing	5,215	3,879	13,927	10,797
General and administrative	1,627	1,323	4,432	3,416
Total stock-based compensation expense	11,778	8,830	31,784	23,928

The following table summarizes stock-based compensation expense by award type ($ amounts in 000’s)



	Three Months Ended		Nine Months Ended
	September 30, 2013	September 30, 2012	September 30, 2013	September 30, 2012
Stock options	5,180	6,985	15,801	19,982
RSUs	5,408	576	12,439	576
ESPP	1,190	1,269	3,544	3,370
Total stock-based compensation expense	11,778	8,830	31,784	23,928

Total income tax benefit from employee stock option plans that is recognized in the consolidated statements of operations is as follows ($ amounts in 000’s):



	Three Months Ended		Nine Months Ended
	September 30, 2013	September 30, 2012	September 30, 2013	September 30, 2012
Income tax benefit from employee stock option plans	3,176	6,685	9,557	17,073

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

10. INCOME TAXES

The effective tax rate was 40% for the three months ended September 30, 2013, compared to an effective tax rate of 36% for the three months ended September 30, 2012. The effective tax rate was 36% for the nine months ended September 30, 2013, compared to an effective tax rate of 34% for the nine months ended September 30, 2012. The provision for income taxes for the periods presented is comprised of foreign income taxes, U.S. federal and state taxes, and withholding tax.

As of September 30, 2013 and December 31, 2012, unrecognized tax benefits were $28.7 million and $27.8 million, respectively. The total amount of $28.3 million in unrecognized tax benefits, if recognized, would favorably impact the effective tax rate.

It is our policy to classify accrued interest and penalties related to unrecognized tax benefits in the provision for income taxes. As of September 30, 2013, we had accrued approximately $2.3 million for estimated interest related to uncertain tax provisions.

The State of California has been conducting an audit of our state income tax returns for fiscal 2010 and fiscal 2011. We do not expect this audit to have a significant detrimental effect on our income tax liability nor have a material impact on our results of operations.

11. EMPLOYEE BENEFIT PLAN

The 401(k) tax-deferred savings plan (the “401(k) Plan”) permits participants to make contributions by salary deduction pursuant to Section 401(k) of the Internal Revenue Code of 1986, as amended. Under the 401(k) Plan, participating employees may defer a portion of their pre-tax earnings, up to the annual contribution limit specified by the Internal Revenue Service (“IRS”). In Canada, we have a Group Registered Retirement Savings Plan program (the “RRSP”) which permits participants to make tax deductible contributions up to the maximum contribution limits under the Income Tax Act. Our matching contributions to the 401(k) Plan and RRSP were $0.6 million and $0.4 million for the three months ended September 30, 2013 and September 30, 2012, respectively. Our matching contributions to the 401(k) Plan and RRSP were $1.6 million and $1.4 million for the nine months ended September 30, 2013 and September 30, 2012, respectively.

12. SEGMENT AND SIGNIFICANT CUSTOMER INFORMATION

The following tables set forth revenue and property and equipment by geographic region ($ amounts in 000’s):



	Three Months Ended		Nine Months Ended
Revenue	September 30, 2013	September 30, 2012	September 30, 2013	September 30, 2012
Americas:
United States	40,654	38,674	114,257	103,983
Other Americas	24,794	18,543	63,844	51,587
Total Americas	65,448	57,217	178,101	155,570
Europe, Middle East and Africa (“EMEA”)	51,373	45,566	149,500	130,116
Asia Pacific and Japan (“APAC”)	37,878	33,485	110,346	96,791
Total revenue	154,699	136,268	437,947	382,477

During each of the three and nine months ended September 30, 2013, Exclusive Networks Group accounted for 11% of total revenue. During the three and nine months ended September 30, 2012, Exclusive Networks Group accounted for 10% and 11% of total revenue, respectively. No other customers accounted for more than 10% of our total revenue during the three and nine months ended September 30, 2013 and 2012.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



Property and Equipment —Net	September 30, 2013	December 31, 2012
Americas:
United States	21,288	18,764
Canada	3,924	4,376
Other Americas	61	87
Total Americas	25,273	23,227
EMEA	1,459	1,213
APAC	1,648	1,198
Total property and equipment—net	28,380	25,638

13. FOREIGN CURRENCY DERIVATIVES

The notional amounts of forward exchange contracts to hedge balance sheet accounts as of September 30, 2013 and December 31, 2012 were ($ amounts in 000’s):



	Buy/Sell	Notional
Balance Sheet Contracts:
Currency - As of September 30, 2013
Canadian dollar	Buy	25,367

Currency - As of December 31, 2012
Canadian dollar	Buy	17,968

14. BUSINESS COMBINATIONS

Xtera

On September 13, 2013, we acquired certain assets of Xtera Communications, Inc. (“Xtera”), including certain load balancing products and certain patents, for a total consideration of $1.8 million, of which $1.7 million was paid in cash on the acquisition date and $0.1 million payment in cash is contingent upon attainment of revenue milestones. This acquisition will enable us to enhance our load balancing solutions in our product portfolio.

We accounted for this acquisition as a purchase of a business and, accordingly, the total purchase price was allocated to the identifiable tangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date. The fair value assigned to the intangible assets acquired was determined using the income approach which discounts expected cash flows to present value using our estimates and assumptions.

In connection with this acquisition, we acquired net tangible assets of $0.2 million, intangible assets of $1.5 million, and recognized an estimated contingent obligation of $0.1 million payable upon attainment of revenue milestones.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table summarizes the fair value of assets acquired and liabilities assumed as of the acquisition date ($ amounts in 000’s):



Current assets	459
Finite-lived intangible assets	1,525
Total assets acquired	1,984
Current liabilities	234
Total liabilities assumed	234
Total purchase price	1,750

Identified finite-lived intangible assets consist of developed technology that will be amortized as cost of revenue, ratably on a straight-line basis over an estimated useful life of 3 years. Pro-forma results of operations have not been presented because the acquisitions, individually and collectively, were not material to our results of operations.

Coyote Point Systems

On March 21, 2013, we acquired all of the outstanding equity securities of Coyote Point Systems, Inc. (“Coyote”), a provider of application delivery, load balancing and acceleration solutions, for $6.0 million in cash. The acquisition also includes a contingent obligation for up to $5.5 million in future earn-out payments to former stockholders of Coyote, if specified future operational objectives, service conditions and financial results are met within two years of the acquisition date. Of the maximum $5.5 million in contingent earn-out payments, up to $3.5 million will be payable after eighteen months from the acquisition date, and up to $2.0 million will be payable after two years from the acquisition date. As the future earn-out payments are also contingent upon one of Coyote's former stockholder's employment during the earn-out period, these contingent obligations are being recorded as compensation expense ratably over the earn-out periods.

We accounted for this acquisition as a purchase of a business and, accordingly, the total purchase price was allocated to Coyote’s identifiable tangible and intangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date. The fair value assigned to the intangible assets acquired was determined using the income approach which discounts expected cash flows to present value using our estimates and assumptions.

The following table summarizes the fair value of assets acquired and liabilities assumed as of the acquisition date ($ amounts in 000’s):



Cash and cash equivalents	206
Other current assets	501
Finite-lived intangible assets	2,800
Indefinite-lived intangible assets	2,600
Goodwill	2,766
Other assets	88
Total assets acquired	8,961
Current liabilities	1,078
Long-term liabilities	1,898
Total liabilities assumed	2,976
Total purchase price	5,985

Of the total acquired identified intangible assets, we allocated $2.3 million to developed technology, $0.5 million to customer relationships, and $2.6 million to in-process research and development (“IPR&D”) as of the acquisition date. Identified finite-lived intangible assets consist of developed technology and customer relationships that are being amortized as cost of revenue and sales and marketing expense, respectively, ratably on a straight-line basis, each over an estimated useful life of 6 years. Identified indefinite-lived intangible assets consisted of acquired IPR&D relating to existing research and development projects at the time of acquisition. The goodwill of $2.8 million represents the premium we paid over the fair value of the net tangible liabilities assumed and identified intangible assets acquired. We paid this premium for a number of

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

reasons, primarily for acquiring developed and in-process technology. None of the goodwill recognized as a result of the acquisition is deductible for income tax purposes. The financial results of this acquisition were considered immaterial for purposes of pro-forma financial disclosures. During the three months ended September 30, 2013, we completed the development of technology associated with the IPR&D projects, and started amortizing this developed technology as cost of revenue ratably on a straight-line basis over an estimated useful life of 6 years.

XDN

On December 7, 2012, we completed the acquisition of XDN, Inc., a provider of cloud-based content delivery solutions, for a total consideration of $0.5 million. We accounted for this acquisition as a purchase of a business and, accordingly, the total purchase price was allocated to identifiable intangible assets acquired based on their estimated fair market value as of the acquisition date. The purchase price allocation resulted in purchased identifiable intangible assets of $0.5 million. Identifiable intangible assets consist of developed technology. The fair value assigned to identifiable intangible assets acquired was determined using the market approach, which compares the value of the purchased assets to similar assets in similar lines of business. These purchased identifiable intangible assets are being amortized as cost of revenue ratably over three years. The financial results of this acquisition were considered immaterial for purposes of pro forma financial disclosures.

IntruGuard

On March 8, 2012, we completed the acquisition of IntruGuard Devices, Inc. (“IntruGuard”), a supplier of Distributed Denial of Services ("DDoS"), prevention products, for a total consideration of $1.0 million. Of the total consideration, $0.4 million was withheld in escrow as security for IntruGuard’s indemnification obligations. We accounted for this acquisition as a purchase of a business and, accordingly, the total purchase price was allocated to tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair market values as of the acquisition date. The purchase price allocation resulted in purchased tangible assets of $53,000 and liabilities of $43,000, and purchased identifiable intangible assets of $0.9 million. Identifiable intangible assets consist of purchased technology. The fair value assigned to identifiable intangible assets acquired was determined using the income approach, which discounts expected future cash flows to present value using estimates and assumptions determined by us. Purchased identifiable intangible assets are being amortized as cost of revenue ratably over three years. Of the $0.4 million previously withheld in escrow, $0.2 million and $0.2 million were released to the selling stockholders during the three months ended September 30, 2012 and the three months ended March 31, 2013, respectively. The financial results of this acquisition were considered immaterial for purposes of pro forma financial disclosures.

15. GOODWILL AND OTHER INTANGIBLE ASSETS—NET

Goodwill

We recorded $2.8 million of goodwill based on the purchase price allocation of the acquisition of Coyote during the nine months ended September 30, 2013. There were no impairments to goodwill during the three and nine months ended September 30, 2013.

Other Intangible Assets—Net

The following tables present other intangible assets ($ amounts in 000’s):

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



	September 30, 2013
	Gross	Accumulated Amortization	Net
Finite-lived other intangible assets:
Developed technology⁽¹⁾	9,909	2,520	7,389
Customer relationships	500	43	457
Total other intangible assets	10,409	2,563	7,846

⁽¹⁾ This amount includes the completed IPR&D acquired from Coyote of $2.6 million. During the three months ended September 30, 2013, we completed the associated IPR&D projects and transferred the IPR&D to developed technology. We started amortizing this developed technology as cost of revenue ratably on a straight-line basis over an estimated useful life of 6 years.



	December 31, 2012
	Gross	Accumulated Amortization	Net
Finite-lived other intangible assets:
Developed technology	3,541	1,424	2,117
Total other intangible assets	3,541	1,424	2,117

Amortization expense was $0.4 million and $0.3 million for the three months ended September 30, 2013 and September 30, 2012, respectively. Amortization expense was $1.1 million and $0.7 million for the nine months ended September 30, 2013 and September 30, 2012, respectively. The following table summarizes estimated future amortization expense of other intangible assets with finite lives for future fiscal years ($ amounts in 000’s):



	Amount
Fiscal Years:
2013 (remainder)	615
2014	2,095
2015	1,679
2016	1,287
2017	900
Thereafter	1,270
Total	7,846

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

16. ACCUMULATED OTHER COMPREHENSIVE INCOME

The following table summarizes the changes in accumulated balances of other comprehensive income for the nine months ended September 30, 2013 ($ amounts in 000's):



	Foreign Currency Translation Gains and Losses		Unrealized Gains and Losses on Investments		Tax benefit or provision related to items of other comprehensive income or loss		Total
Beginning balance	1,948		1,758		(615	)	3,091
Other comprehensive income before reclassifications	(901	)	(819	)	287		(1,433	)
Amounts reclassified from accumulated other comprehensive income	—		(8	)	3		(5	)
Net current-period other comprehensive income	(901	)	(827	)	290		(1,438	)
Ending balance	1,047		931		(325	)	1,653

The following table provides details about the reclassification out of accumulated other comprehensive income for the nine months ended September 30, 2013 ($ amounts in 000s):



Details about Accumulated Other Comprehensive Income Components	Amount Reclassified from Accumulated Other Comprehensive Income		Affected Line Item in the Statement Where Net Income is Presented
Unrealized gains on investments	(8	)	Other expense, net
Tax provision related to items of other comprehensive income or loss	3		Provision for income taxes
Total reclassification for the period	(5	)

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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, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (“Exchange Act”). These statements include, among other things, statements concerning our expectations regarding:


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


•	the expected impact of certain acquisitions, asset purchases and strategic investments;


•	expected impact of sales of certain products;


•	the significance of stock-based compensation as an expense;


•	the proportion of our revenue that consists of our product and service revenues, and the mix of billings between products and services;


•	the impact of our product innovation strategy;


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


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


•	trends in revenue, costs of revenue, and gross margin;


•	trends in our operating expenses, including personnel costs, research and development expense, sales and marketing expense and general and administrative expense, and expectations regarding these expenses as a percentage of revenue;


•	continued investments in research and development to strengthen our technology leadership position and in sales and marketing;


•	expectations regarding uncertain tax benefits and our effective tax rate;


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


•	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 in Part II, Item 1A. Risk Factors and elsewhere in this Quarterly Report on Form 10-Q and in our other SEC filings, including the Form 10-K. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Business Overview

We provide network security solutions, which enable broad, integrated and high performance protection against dynamic security threats while simplifying the IT security infrastructure for enterprises, service providers and governmental entities worldwide. From inception through September 30, 2013, we shipped over 1,300,000 appliances via more than 19,000 channel partners to more than 170,000 end-customers worldwide, including a majority of the 2012 Fortune Global 100.

Our core Unified Threat Management (“UTM”)/Next Generation Firewall (“NGFW”) and Data Center Firewall (“DCFW”) product line of FortiGate physical and virtual appliances ships with a set of security and networking capabilities,

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including firewall, VPN, application control, anti-malware, intrusion prevention, Web filtering, anti-spam and WAN acceleration functionality. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20, designed for small businesses, to the FortiGate-5000 series for large enterprises, telecommunications carriers, and service providers. Our UTM/NGFW/DCFW solution also includes our FortiGuard security subscription services, which end-customers can subscribe to in order to obtain access to dynamic updates to intrusion prevention, application control, anti-malware, Web filtering, vulnerability management and anti-spam functionality included in our appliances. End-customers can also choose to purchase FortiCare technical support services for our products. End-customers also often use FortiManager and FortiAnalyzer products in conjunction with a FortiGate deployment to provide centralized management, analysis and reporting capabilities.

We complement our core FortiGate product line with other appliances and software that offer additional protection from security threats to other critical areas of the enterprise, such as messaging, Web application firewalls, databases, protection against DDoS, endpoint security for employee computers and mobile devices, wireless access points and application delivery controllers. Although sales of these complementary products have grown in recent quarters, these products still represent less than 10% of our total revenue.

On September 13, 2013, we acquired certain assets of Xtera Communications, Inc. (“Xtera”) in order to add products to enhance our load balancing solutions and to add patents to our patent portfolio .

In August 2013, we invested in and entered into a strategic go-to-market alliance agreement with HyTrust, a privately-held company, that specializes in cloud security automation in order to strengthen our commitment to virtualization and data center security.

Financial Highlights

•

We recorded total revenue of $154.7 million and $437.9 million during the three and nine months ended September 30, 2013, respectively. This represents an increase of 14% and 15% during the three and nine months ended September 30, 2013, respectively, compared to the same periods last year. Product revenue was $69.7 million and $194.2 million during the three and nine months ended September 30, 2013, respectively, an increase of 11% and 9%, respectively, compared to the same periods last year. Services revenue was $83.9 million and $239.4 million during the three and nine months ended September 30, 2013, respectively, an increase of 20% and 21%, respectively, compared to the same periods last year.


•	We generated cash flows from operating activities of $100.7 million during the nine months ended September 30, 2013, a decrease of 25% compared to the same period last year.


•	Cash, cash equivalents and investments were $841.0 million as of September 30, 2013, an increase of $101.4 million from December 31, 2012.


•	Deferred revenue was $400.2 million as of September 30, 2013, an increase of $37.0 million from December 31, 2012.

During the three and nine months ended September 30, 2013, revenue grew as a result of a slightly better business environment, along with our focus on improving sales execution and productivity of our sales force. We also continued to gain traction with several recently introduced products, including new FortiGate entry-level appliances such as the FG-60D and FG-90D with its WIFI counterparts; the FG-200D and FG-800C mid-range appliance; and the FG-3600C and FG-5001C for large enterprises and service providers.

We continue to invest in research and development to strengthen our technology leadership position, as well as sales and marketing to expand brand awareness, strengthen our value proposition, and expand our global sales team and distribution channels. During the three and nine months ended September 30, 2013, we experienced higher sales volume in our FortiGate product family, particularly entry-level products, wireless security and access point products, which contributed to the largest portion of the growth during this period. During the three and nine months ended September 30, 2013, we experienced an increase in the number of deals involving sales greater than $100,000 when compared to the same periods last year as the number of deals involving sales greater than $100,000 was 187 and 547 in the three and nine months ended September 30, 2013, respectively, compared to 168 and 489 in the three and nine months ended September 30, 2012, respectively. The number of deals involving sales greater than $250,000 was 61 and 174 in the three and nine months ended September 30, 2013, respectively, compared to 61 and 163 in the three and nine months ended September 30, 2012, respectively. Additionally, the number of deals involving sales greater than $500,000 was 19 and 52 in the three and nine months ended September 30, 2013,

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respectively, compared to 16 and 54 in the three and nine months ended September 30, 2012, respectively. We expect some variability in this metric, and remain focused on investing in our sales and marketing and research and development resources in order to expand our reach into new high-growth verticals and emerging markets. Moreover, we expect such investments to help us to meet increasing customer expectations about the quality and functionality of our products, as we continue to sell to large enterprises and service providers. While we have experienced some success selling to large enterprises, across key verticals, including service provider, government, retail, financial services and education, we experienced increased pressure from the macro-economic environment in APAC during the three and nine months ended September 30, 2013, and there can be no assurance we will be successful selling into these vertical customer segments.

During the three and nine months ended September 30, 2013, operating expenses increased by 27% and 25% compared to the same periods last year. The increase was primarily driven by additional headcount as we continued to invest in the development of new products and expand our sales coverage. Headcount increased to 2,238 as of September 30, 2013 from 1,854 as of September 30, 2012. Our accelerated pace of hiring continued during the three and nine months ended September 30, 2013, particularly in sales and marketing, research and development, and technical support.

Key Metrics

We monitor the key financial metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts, and assess operational efficiencies. Our total deferred revenue increased by $10.5 million from $389.7 million as of June 30, 2013 to $400.2 million as of September 30, 2013. Revenue recognized plus the change in deferred revenue from the beginning to the end of the period less any deferred revenue balances acquired from business combinations 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 revenue that we recognize in a typical quarter. As of September 30, 2013, we had $841.0 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 “—Results of Operations,” 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.



	Three Months Ended Or As Of
	September 30, 2013		September 30, 2012
	($ amounts in 000’s)
Revenue	154,699		136,268
Gross margin	72	%	72	%
Operating income ⁽¹⁾	18,279		25,770
Operating margin	12	%	19	%
Total deferred revenue	400,173		340,078
Increase in total deferred revenue	10,491		8,710
Cash, cash equivalents and investments	841,005		690,303
Cash provided by operating activities	25,384		40,770
Free cash flow (Non-GAAP)⁽²⁾	22,224		24,342
___________________
(1) Includes:
Stock-based compensation expense	11,778		8,830
Patent settlement income	478		478

(2) See “—Cash flow from operations” below for a definition of free cash flow.

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 define billings as revenue recognized during a period plus the change in deferred revenue from the beginning to the end of the period less any deferred revenue balances acquired from business combination(s) during the period. The following table reflects the reconciliation of billings to revenue. For a discussion of the limitations of non-GAAP financial measures, see “—Other Non-GAAP Financial Measures” below.

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	Three Months Ended
	September 30, 2013	September 30, 2012
	($ amounts in 000’s)
Billings:
Revenue	154,699	136,268
Add increase in deferred revenue	10,491	8,710
Total billings (Non-GAAP)	165,190	144,978

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 our billings growth, profitability, and our ability to successfully manage our working capital. Monitoring cash flow from operations and free cash flow 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. Free cash flow, an alternative non-GAAP financial measure of liquidity, is defined as net cash provided by operating activities less capital expenditures. The following table provides a reconciliation of free cash flow to cash provided by operating activities. For a discussion of the limitations of non-GAAP financial measures, see “—Other Non-GAAP Financial Measures” below.



	Three Months Ended
	September 30, 2013		September 30, 2012
	($ amounts in 000’s)
Free Cash Flow:
Net cash provided by operating activities	25,384		40,770
Less purchases of property and equipment	(3,160	)	(16,428	)
Free cash flow (Non-GAAP)	22,224		24,342

Other Non-GAAP Financial Measures

To supplement our consolidated financial statements presented in accordance with GAAP, we consider certain financial measures that are not prepared in accordance with GAAP, including billings and free cash flow discussed above as well as non-GAAP gross margin, non-GAAP operating income, non-GAAP operating margin, non-GAAP operating expenses, and non-GAAP net income. These non-GAAP financial measures are not based on any standardized methodology prescribed by GAAP and are not necessarily comparable to similar measures presented by other companies.

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, offset by patent settlement income. Effective second quarter of fiscal 2013, our non-GAAP financial measures exclude amortization expense of certain intangible assets. Prior period amounts have been adjusted to conform to current period presentation. Stock-based compensation expense 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’ overall compensation. 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

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operations. We compensate for these limitations by providing the nearest GAAP equivalents of these non-GAAP financial measures and describing these GAAP equivalents in the section entitled “—Results of Operations” below.

Non-GAAP gross margin represents gross margin as reported in our consolidated statements of operations, excluding the impact of stock-based compensation expense and amortization expense of certain intangible assets, both of which are non-cash charges. Non-GAAP operating income is operating income, as reported in our consolidated statements of operations, excluding the impact of stock-based compensation expense, amortization expense of certain intangible assets, and the income we receive from a patent settlement. Non-GAAP operating margin is non-GAAP operating income divided by revenue. The following table reconciles GAAP gross profit, GAAP gross margin, GAAP operating income, and GAAP operating margin to non-GAAP gross profit, non-GAAP gross margin, non-GAAP operating income, and non-GAAP operating margin for the three months ended September 30, 2013 and September 30, 2012.



	Three Months Ended
	September 30, 2013			September 30, 2012
	Amount ($)		% of Revenue	Amount ($)		% of Revenue
	($ amounts in 000’s)
Total revenue	154,699			136,268
GAAP gross profit and margin	110,769		72	98,460		72
Stock-based compensation expense	1,388		1	1,103		1
Amortization expense of certain intangible assets ⁽¹⁾	423		—	226		—
Non-GAAP gross profit and margin	112,580		73	99,789		73
GAAP operating income and margin	18,279		12	25,770		19
Stock-based compensation expense:
Cost of revenue	1,388		1	1,103		1
Research and development	3,548		2	2,525		1
Sales and marketing	5,215		3	3,879		3
General and administrative	1,627		1	1,323		1
Total stock-based compensation expense	11,778		7	8,830		6
Amortization expense of certain intangible assets ⁽¹⁾	423		—	226		—
Patent settlement income	(478	)	—	(478	)	—
Non-GAAP operating income and margin	30,002		19	34,348		25


(1)	Effective second quarter of fiscal 2013, amortization expense of certain intangible assets is excluded from GAAP gross profit and margin, and GAAP operating income and margin to reconcile to non-GAAP financial metrics. Prior period amounts have been adjusted to conform to current period presentation.

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Non-GAAP operating expenses represent operating expenses, as reported in our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense and the income from a patent settlement. The following table reconciles GAAP operating expenses to non-GAAP operating expenses for the three months ended September 30, 2013 and September 30, 2012.



	Three Months Ended
	September 30, 2013				September 30, 2012
	Amount ($)		% of Revenue		Amount ($)		% of Revenue
	($ amounts in 000’s)
Operating Expenses:
Research and development expenses:
GAAP research and development expenses	26,421		17		20,498		15
Stock-based compensation expense	(3,548	)	(2	)	(2,525	)	(1	)
Non-GAAP research and development expenses	22,873		15		17,973		14
Sales and marketing expenses:
GAAP sales and marketing expenses	56,687		37		44,743		33
Stock-based compensation expense	(5,215	)	(3	)	(3,879	)	(3	)
Non-GAAP sales and marketing expenses	51,472		34		40,864		30
General and administrative expenses:
GAAP general and administrative expenses	9,382		6		7,449		5
Stock-based compensation expense	(1,627	)	(1	)	(1,323	)	(1	)
Patent settlement income	478		—		478		—
Non-GAAP general and administrative expenses	8,233		5		6,604		4
Total operating expenses:
GAAP operating expenses	92,490		60		72,690		53
Stock-based compensation expense	(10,390	)	(6	)	(7,727	)	(5	)
Patent settlement income	478		—		478		—
Non-GAAP operating expenses	82,578		54		65,441		48

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Non-GAAP net income represents net income, as reported in our condensed consolidated statements of operations, excluding the impact of stock-based compensation expense, amortization expense of certain intangible assets, and income from a patent settlement. The following table reconciles GAAP net income to non-GAAP net income for the three months ended September 30, 2013 and September 30, 2012.



	Three Months Ended
	September 30, 2013		September 30, 2012
	($ and share amounts in 000’s, except per share amounts)
Net Income:
GAAP net income	11,029		17,206
Stock-based compensation expense ⁽¹⁾	11,778		8,830
Amortization expense of certain intangible assets ⁽²⁾	423		226
Patent settlement income ⁽³⁾	(478	)	(478	)
Provision for income taxes ⁽⁴⁾	7,381		9,565
Non-GAAP income before provision for income taxes	30,133		35,349
Non-GAAP provision for income taxes ⁽⁵⁾	(9,944	)