FTNT - 2014.09.30.10Q
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, 2014
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from              to             
Commission file number: 001-34511
______________________________________
 FORTINET, INC.
(Exact name of registrant as specified in its charter)
______________________________________

Delaware
77-0560389
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
899 Kifer Road
Sunnyvale, California
94086
(Address of principal executive offices)
(Zip Code)
(408) 235-7700
(Registrant’s telephone number, including area code)



Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 (“Exchange Act”) during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x  No  o 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. 
Large accelerated filer
x
 
 
Accelerated filer
o
Non-accelerated filer
o
(Do not check if smaller reporting company)
 
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  o     No  x
As of October 31, 2014, there were 164,855,943 shares of the registrant’s common stock outstanding.


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


 

Table of Contents




Part I


Item 1. Financial Statements
FORTINET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except per share amounts)
 
 
September 30,
2014
 
December 31,
2013
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
258,096

 
$
115,873

Short-term investments
402,495

 
375,497

Accounts receivable—Net of allowance for doubtful accounts and sales returns of $5,537 and $4,605 as of September 30, 2014 and December 31, 2013, respectively
116,382

 
130,471

Inventory
51,344

 
48,672

Deferred tax assets
51,297

 
50,980

Prepaid expenses and other current assets
16,826

 
14,053

Total current assets
896,440

 
735,546

LONG-TERM INVESTMENTS
303,168

 
351,675

PROPERTY AND EQUIPMENT—Net
56,812

 
36,652

DEFERRED TAX ASSETS
42,276

 
30,058

GOODWILL
2,824

 
2,872

OTHER INTANGIBLE ASSETS—Net
3,104

 
6,841

OTHER ASSETS
7,977

 
4,820

TOTAL ASSETS
$
1,312,601

 
$
1,168,464

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
36,520

 
$
35,599

Accrued liabilities
25,662

 
27,380

Accrued payroll and compensation
40,692

 
34,997

Income taxes payable
2,490

 
21,421

Deferred revenue
329,132

 
293,664

Total current liabilities
434,496

 
413,061

DEFERRED REVENUE
170,880

 
138,964

INCOME TAXES PAYABLE
40,532

 
30,208

OTHER LIABILITIES
17,467

 
471

Total liabilities
663,375

 
582,704

COMMITMENTS AND CONTINGENCIES (Note 9)


 
 
STOCKHOLDERS’ EQUITY:
 
 
 
Common stock, $0.001 par value — 300,000 shares authorized; 164,904 and 161,535 shares issued and outstanding as of September 30, 2014 and December 31, 2013, respectively
165

 
161

Additional paid-in capital
537,450

 
462,644

Accumulated other comprehensive income
114

 
1,092

Retained earnings
111,497

 
121,863

Total stockholders’ equity
649,226

 
585,760

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
1,312,601

 
$
1,168,464

See notes to condensed consolidated financial statements.


3
Table of Contents




FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share amounts)
 
 
Three Months Ended
 
Nine Months Ended
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
REVENUE:
 
 
 
 
 
 
 
Product
$
87,731

 
$
69,687

 
$
249,880

 
$
194,162

Services and other
105,617

 
85,012

 
296,515

 
243,785

Total revenue
193,348

 
154,699

 
546,395

 
437,947

COST OF REVENUE:
 
 
 
 
 
 
 
Product
35,636

 
27,126

 
105,230

 
77,032

Services and other
21,249

 
16,804

 
60,155

 
49,734

Total cost of revenue
56,885

 
43,930

 
165,385

 
126,766

GROSS PROFIT:
 
 
 
 
 
 
 
Product
52,095

 
42,561

 
144,650

 
117,130

Services and other
84,368

 
68,208

 
236,360

 
194,051

Total gross profit
136,463

 
110,769

 
381,010

 
311,181

OPERATING EXPENSES:
 
 
 
 
 
 
 
Research and development
30,790

 
26,421

 
89,783

 
74,913

Sales and marketing
80,433

 
56,687

 
222,576

 
162,660

General and administrative
9,789

 
9,382

 
29,243

 
26,161

Total operating expenses
121,012

 
92,490

 
341,602

 
263,734

OPERATING INCOME
15,451

 
18,279

 
39,408

 
47,447

INTEREST INCOME
1,339

 
1,282

 
3,991

 
3,988

OTHER EXPENSE—Net
(1,005
)
 
(1,151
)
 
(1,968
)
 
(1,036
)
INCOME BEFORE INCOME TAXES
15,785

 
18,410

 
41,431

 
50,399

PROVISION FOR INCOME TAXES
11,729

 
7,381

 
22,901

 
18,142

NET INCOME
$
4,056

 
$
11,029

 
$
18,530

 
$
32,257

Net income per share (Note 7):
 
 
 
 
 
 
 
Basic
$
0.02

 
$
0.07

 
$
0.11

 
$
0.20

Diluted
$
0.02

 
$
0.07

 
$
0.11

 
$
0.19

Weighted-average shares outstanding:
 
 
 
 
 
 
 
Basic
164,294

 
162,906

 
163,289

 
162,150

Diluted
169,727

 
168,666

 
168,735

 
168,054

See notes to condensed consolidated financial statements.


4
Table of Contents




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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Net income
$
4,056

 
$
11,029

 
$
18,530

 
$
32,257

Other comprehensive (loss) income—net of taxes:
 
 
 
 
 
 
 
Foreign currency translation (losses) gains
(432
)
 
912

 
(333
)
 
(901
)
Unrealized (losses) gains on investments
(977
)
 
600

 
(993
)
 
(826
)
Tax benefit (provision) related to items of other comprehensive loss or income
342

 
(209
)
 
348

 
289

Other comprehensive (loss) income—net of taxes
(1,067
)
 
1,303

 
(978
)
 
(1,438
)
Comprehensive income
$
2,989

 
$
12,332

 
$
17,552

 
$
30,819


See notes to condensed consolidated financial statements.




5
Table of Contents




FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
18,530

 
$
32,257

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

 
 
Depreciation and amortization
16,519

 
11,511

Amortization of investment premiums
6,680

 
8,900

Stock-based compensation
42,313

 
31,784

Excess tax benefit from stock-based compensation
(4,325
)
 
(2,504
)
Other non-cash items—net
3,801

 
520

Changes in operating assets and liabilities:

 
 
Accounts receivable—Net
13,140

 
589

Inventory
(11,095
)
 
(31,344
)
Deferred tax assets
(12,186
)
 
(14,806
)
Prepaid expenses and other current assets
(2,781
)
 
204

Other assets
(159
)
 
893

Accounts payable
3,806

 
11,054

Accrued liabilities
2,818

 
3,630

Other liabilities
14,350

 
(999
)
Accrued payroll and compensation
5,651

 
1,400

Deferred revenue
68,006

 
36,425

Income taxes payable
(3,850
)
 
11,202

Net cash provided by operating activities
161,218

 
100,716

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of investments
(388,808
)
 
(419,124
)
Sales of investments
27,282

 
25,488

Maturities of investments
371,837

 
303,852

Purchases of property and equipment
(26,802
)
 
(6,729
)
Payments made in connection with acquisitions—net of cash acquired
(17
)
 
(7,635
)
Net cash used in investing activities
(16,508
)
 
(104,148
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
40,529

 
24,470

Taxes paid related to net share settlement of equity awards
(8,506
)
 
(966
)
Excess tax benefit from stock-based compensation
4,325

 
2,504

Repurchase and retirement of common stock
(38,235
)
 
—

Net cash (used in) provided by financing activities
(1,887
)
 
26,008

EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS
(600
)
 
(1,005
)
NET INCREASE IN CASH AND CASH EQUIVALENTS
142,223

 
21,571

CASH AND CASH EQUIVALENTS—Beginning of period
115,873

 
122,975

CASH AND CASH EQUIVALENTS—End of period
$
258,096

 
$
144,546

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid for income taxes—net
$
38,755

 
$
19,721

NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Liability for purchase of property and equipment and asset retirement obligations
$
4,710

 
$
1,349

Liability incurred for repurchase of common stock
$
379

 
$
—

Liability incurred in connection with business acquisition
$
—

 
$
100

See notes to condensed consolidated financial statements.

6
Table of Contents




FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Preparation—The unaudited condensed consolidated financial statements of Fortinet, Inc. and its wholly owned subsidiaries (collectively, “we,” “us,” or “our”) have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States (“U.S.”) for interim financial information as well as the instructions to Form 10-Q pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements, and should be read in conjunction with our audited consolidated financial statements as of and for the fiscal year ended December 31, 2013, contained in our Annual Report on Form 10-K (“Form 10-K”) filed with the SEC on March 3, 2014. In the opinion of management, all adjustments, which includes normal recurring adjustments, considered necessary for a fair presentation have been included. All intercompany balances, transactions and cash flows have been eliminated. The results of operations for the three and nine months ended September 30, 2014 are not necessarily indicative of the operating results for the full year or for any future periods. The condensed consolidated balance sheets as of December 31, 2013 are derived from the audited consolidated financial statements for the year ended December 31, 2013.

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

There have been no material changes to our significant accounting policies as of and for the three and nine months ended September 30, 2014. During the first quarter of fiscal 2014, we prospectively modified the expected term calculation used in accounting for stock-based compensation expense and the estimated useful lives of building improvements, and furniture and fixtures. During the third quarter of fiscal 2014, we reevaluated the functional currency selection for certain of our international subsidiaries and prospectively applied the U.S. dollar.

Stock-Based Compensation Expense—Beginning in the first quarter of fiscal 2014, we changed the methodology of calculating the expected term, which is one of the assumptions used in determining the fair value of our employee stock options under the Black Scholes option pricing model. The expected term represents the period that our stock-based awards are estimated to be outstanding. We believe that we have sufficient historical experience since becoming a publicly-traded company for estimating the expected term of the stock option awards, and therefore, we calculated our expected term based on historical experience instead of using the simplified method.

Currency Translation Adjustment—Prior to the third quarter of fiscal 2014, the assets and liabilities of our international subsidiaries were translated into U.S. dollars using the applicable exchange rates. The resulting foreign translation adjustments were included in the consolidated balance sheets as a component of accumulated other comprehensive income (loss) and in the consolidated statements of comprehensive income.

We reevaluated the selected functional currency of our international subsidiaries due to the nature of our business operations. We recorded the cumulative impact of the reevaluation of the functional currency in the condensed consolidated statement of operations for the three months ended September 30, 2014. The remeasurement of the assets and liabilities of all international subsidiaries will be recorded in the consolidated statement of operations prospectively. The impact of this reevaluation is not material for any of our previously issued financial statements.

Property and Equipment—Property and equipment—net is stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets as follows:

 
Estimated Useful Lives
Building and building improvements
20 years
Evaluation units
1 year
Computer equipment and software
1-2 years
Furniture and fixtures
3 - 5 years
Leasehold improvements
Shorter of useful life or lease term

7
Table of Contents

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




In March 2014, we moved into our new corporate headquarters and estimated the useful life of the building and related improvements to be 20 years. The useful life of furniture and fixtures placed in service in the new building is estimated to be 3 to 5 years.

Reclassification—Beginning in the first quarter of 2014, the amounts previously reported as Ratable and other revenue have been combined with the amounts previously reported as Services revenue in the condensed consolidated statements of operations. The combined amounts are now being presented as Services and other revenue in the condensed consolidated statements of operations. The related Cost of revenue and Gross profit, including prior period amounts, have also been combined to conform to the current period presentation. The Ratable and other revenue amounts, including the related Cost of revenue and Gross profit amounts, are not material, and the reclassification did not have any impact on our gross margin or net income.

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


2. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

The following table summarizes our investments as of September 30, 2014 and December 31, 2013 (in thousands):
 
 
September 30, 2014
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
587,087

 
$
763

 
$
(606
)
 
$
587,244

Commercial paper
58,250

 
4

 
(1
)
 
58,253

Municipal bonds
33,260

 
42

 
(25
)
 
33,277

Certificates of deposit and term deposits
21,143

 
1

 
—

 
21,144

U.S. government and agency securities
5,748

 
2

 
(5
)
 
5,745

Total available-for-sale securities
$
705,488

 
$
812

 
$
(637
)
 
$
705,663


 
December 31, 2013
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
603,185

 
$
1,506

 
$
(374
)
 
$
604,317

Commercial paper
69,356

 
7

 
—

 
69,363

Municipal bonds
38,815

 
48

 
(20
)
 
38,843

Certificates of deposit and term deposits
12,645

 
3

 
—

 
12,648

U.S. government and agency securities
2,000

 
1

 
—

 
2,001

Total available-for-sale securities
$
726,001

 
$
1,565

 
$
(394
)
 
$
727,172



The following table shows the gross unrealized losses and the related fair values of our investments that have been in a continuous unrealized loss position as of September 30, 2014 and December 31, 2013 (in thousands):



8
Table of Contents

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




 
September 30, 2014
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
Corporate debt securities
$
244,554

 
$
(605
)
 
$
1,017

 
$
(1
)
 
$
245,571

 
$
(606
)
Commercial paper
2,396

 
(1
)
 
—

 
—

 
2,396

 
(1
)
Municipal bonds
12,201

 
(25
)
 
2,000

 
—

 
14,201

 
(25
)
U.S. government and agency securities
4,745

 
(5
)
 
—

 
—

 
4,745

 
(5
)
Total available-for-sale securities
$
263,896

 
$
(636
)
 
$
3,017

 
$
(1
)
 
$
266,913

 
$
(637
)

 
December 31, 2013
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
Corporate debt securities
$
182,795

 
$
(374
)
 
$
500

 
$
—

 
$
183,295

 
$
(374
)
Commercial paper
7,897

 
—

 
—

 
—

 
7,897

 
—

Municipal bonds
14,736

 
(20
)
 
—

 
—

 
14,736

 
(20
)
Total available-for-sale securities
$
205,428

 
$
(394
)
 
$
500

 
$
—

 
$
205,928

 
$
(394
)

The contractual maturities of our investments are as follows (in thousands):
 
 
September 30,
2014
 
December 31,
2013
Due within one year
$
402,495

 
$
375,497

Due within one to three years
303,168

 
351,675

Total
$
705,663

 
$
727,172


Available-for-sale securities are reported at fair value, with unrealized gains and losses, net of tax, included as a separate component of stockholders’ equity and in total comprehensive income. Realized gains and losses on available-for-sale securities are included in Other expense—net in our condensed consolidated statements of operations.

The unrealized losses on our available-for-sale securities were caused by fluctuations in market value and interest rates as a result of the economic environment. As the declines in market value are attributable to changes in market conditions and not credit quality, and because we have concluded currently that we neither intend to sell nor it is more likely than not that we will be required to sell these investments prior to a recovery of par value, we do not consider these investments to be other-than temporarily impaired as of September 30, 2014.

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



9
Table of Contents

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




Fair Value of Financial Instruments

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table presents the fair value of our financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2014 and December 31, 2013 (in thousands):
 
 
September 30, 2014
 
 
 
December 31, 2013
 
 
 
Aggregate
Fair
Value
 
Quoted
Prices in
Active
Markets For
Identical
Assets
 
Significant
Other
Observable
Remaining
Inputs
 
Significant
Other
Unobservable
Remaining
Inputs
 
Aggregate
Fair
Value
 
Quoted
Prices in
Active
Markets For
Identical
Assets
 
Significant
Other
Observable
Remaining
Inputs
 
Significant
Other
Unobservable
Remaining
Inputs
 
 
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
 
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
$
587,244

 
$
—

 
$
587,244

 
$
—

 
$
604,317

 
$
—

 
$
604,317

 
$
—

Commercial paper
58,253

 
—

 
58,253

 
—

 
71,363

 
—

 
71,363

 
—

Municipal bonds
33,277

 
—

 
33,277

 
—

 
38,843

 
—

 
38,843

 
—

Certificates of deposit and term deposits
21,144

 
—

 
21,144

 
—

 
12,648

 
—

 
12,648

 
—

Money market funds
20,125

 
20,125

 
—

 
—

 
5,724

 
5,724

 
—

 
—

U.S. government and agency securities
5,745

 
1,998

 
3,747

 
—

 
2,001

 
—

 
2,001

 
—

Total
$
725,788

 
$
22,123

 
$
703,665

 
$
—

 
$
734,896

 
$
5,724

 
$
729,172

 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Contingent consideration
$
—

 
$
—

 
$
—

 
$
—

 
$
1,850

 
$
—

 
$
—

 
$
1,850

Total
$
—

 
$
—

 
$
—

 
$
—

 
$
1,850

 
$
—

 
$
—

 
$
1,850

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reported as:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
$
20,125

 
 
 
 
 
 
 
$
7,724

 
 
 
 
 
 
Short-term investments
402,495

 
 
 
 
 
 
 
375,497

 
 
 
 
 
 
Long-term investments
303,168

 
 
 
 
 
 
 
351,675

 
 
 
 
 
 
Total
$
725,788

 
 
 
 
 
 
 
$
734,896

 
 
 
 
 
 

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

We classify items within Level 2 if the investments are valued using model driven valuations using observable inputs such as quoted market prices, benchmark yields, reported trades, broker/dealer quotes or alternative pricing sources with reasonable levels of price transparency. Investments are held by custodians who obtain investment prices from a third-party pricing provider that incorporates standard inputs in various asset price models.

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the three and nine months ended September 30, 2014.

We classified the fair value of contingent consideration arising from the acquisition of Coyote Point Systems, Inc. (“Coyote”) (see Note 5), as a Level 3 liability since it is based on a probability-based income approach that includes significant unobservable inputs. The significant unobservable inputs include projected revenues and the percentage probability of occurrence to determine the fair value of the payment.


10
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FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)




The change in the fair value of our contingent consideration liability was as follows (in thousands):
As of December 31, 2013
$1,850
Less change in fair value of contingent consideration
(1,143)
As of March 31, 2014
707
Less change in fair value of contingent consideration
(707)
As of September 30, 2014
$—

Decreases in the projected revenues of Coyote following the acquisition resulted in reductions to the fair value of the contingent consideration and the changes are included in research and development expense in the condensed consolidated statements of operations.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

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

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

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


3. INVENTORY

Inventory consisted of the following (in thousands):
 
 
September 30,
2014
 
December 31,
2013
Raw materials
$
5,922

 
$
4,319

Finished goods
40,370

 
40,093

Consigned inventory
5,052

 
4,260

Inventory
$
51,344

 
$
48,672


 

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




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

 
$
13,895

Building and building improvements
17,546

 
610

Evaluation units
29,181

 
23,442

Computer equipment and software
31,010

 
23,556

Furniture and fixtures
4,655

 
1,697

Construction-in-progress
5,326

 
10,947

Leasehold improvements
7,595

 
4,303

Total property and equipment
109,208

 
78,450

Less: accumulated depreciation
(52,396
)
 
(41,798
)
Property and equipment—net
$
56,812

 
$
36,652


Beginning in the first quarter of 2014, we reclassified certain fixed assets between categories in the table above to better reflect the nature of these fixed assets. Prior period amounts have also been reclassified to conform to the current period presentation. The impact of the reclassification is not material.

Depreciation expense was $5.4 million and $3.8 million during the three months ended September 30, 2014 and September 30, 2013, respectively. Depreciation expense was $15.3 million and $10.4 million during the nine months ended September 30, 2014 and September 30, 2013, respectively.



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




5. BUSINESS COMBINATIONS

Coyote Point Systems

On March 21, 2013, we acquired all of the outstanding equity securities of Coyote, a provider of application delivery, load balancing and acceleration solutions, for $6.0 million in cash. The acquisition also included a contingent obligation for up to $5.5 million in future earn-out payments to former stockholders of Coyote, if specified future operational objectives, service conditions and financial results are met within two years of the acquisition date. As of September 30, 2014, we have estimated that no contingent earn-out payment thresholds will be met.

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

The following table summarizes the fair value of assets acquired and liabilities assumed (in thousands):

Cash and cash equivalents
$
206

Other current assets
501

Finite-lived intangible assets
2,800

Indefinite-lived intangible assets
2,600

Goodwill
2,824

Other assets
88

Total assets acquired
9,019

Current liabilities
1,030

Long-term liabilities
2,004

Total liabilities assumed
3,034

Total purchase price
$
5,985


Of the total acquired identified intangible assets, we allocated $2.3 million to developed technology, $0.5 million to customer relationships, and $2.6 million to in-process research and development (“IPR&D”) as of the acquisition date. Identified finite-lived intangible assets consist of developed technology and customer relationships that are being amortized as cost of revenue and sales and marketing expense, respectively, ratably on a straight-line basis, each over an estimated useful life of six years. The goodwill of $2.8 million represents the premium we paid over the fair value of the net tangible liabilities assumed and identified intangible assets acquired, due primarily to acquire developed and in-process technology. None of the goodwill recognized as a result of the acquisition is deductible for income tax purposes. The financial results of this acquisition were considered immaterial for purposes of pro-forma financial disclosures. During the three months ended September 30, 2013, we completed the development of technology associated with the IPR&D projects, and started amortizing this developed technology as cost of revenue ratably on a straight-line basis over an estimated remaining useful life of approximately five years.



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




6. GOODWILL AND OTHER INTANGIBLE ASSETS—Net

We recorded $2.8 million of goodwill from the acquisition of Coyote. There were no impairments to goodwill during the three and nine months ended September 30, 2014.

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

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

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

 
$
2,877

 
$
2,729

Customer relationships
500

 
125

 
375

Total other intangible assets—net
$
6,106

 
$
3,002

 
$
3,104


 
December 31, 2013
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
Developed technology
$
8,971

 
$
2,568

 
$
6,403

Customer relationships
500

 
62

 
438

Total other intangible assets—net
$
9,471

 
$
2,630

 
$
6,841


Amortization expense was $0.2 million and $0.4 million during the three months ended September 30, 2014 and September 30, 2013, respectively. Amortization expense was $1.2 million and $1.1 million for the nine months ended September 30, 2014 and September 30, 2013, respectively. The following table summarizes estimated future amortization expense of Other intangible assets—net (in thousands):

 
Amount
Years Ending December 31:
 
2014 (remainder)
$
273

2015
1,091

2016
785

2017
425

2018
425

Thereafter
105

Total
$
3,104



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




7. NET INCOME PER SHARE

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

A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per share is as follows (in thousands, except per share amounts):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Numerator:
 
 
 
 
 
 
 
Net income
$
4,056

 
$
11,029

 
$
18,530

 
$
32,257

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Basic shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding-basic
164,294

 
162,906

 
163,289

 
162,150

Diluted shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding-basic
164,294

 
162,906

 
163,289

 
162,150

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Stock options
4,405

 
5,525

 
4,728

 
5,844

RSUs
993

 
213

 
692

 
50

ESPP
35

 
22

 
26

 
10

Weighted-average shares used to compute diluted net income per share
169,727

 
168,666

 
168,735

 
168,054

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.02

 
$
0.07

 
$
0.11

 
$
0.20

Diluted
$
0.02

 
$
0.07

 
$
0.11

 
$
0.19


The following weighted-average shares of common stock were excluded from the computation of diluted net income per share for the periods presented, as their effect would have been antidilutive (in thousands):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Stock options
3,023

 
6,640

 
4,101

 
7,364

RSUs
696

 
1,416

 
879

 
2,383

ESPP
226

 
407

 
133

 
399

 
3,945

 
8,463

 
5,113

 
10,146



15
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FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)




8. DEFERRED REVENUE

Deferred revenue consisted of the following (in thousands):
 
 
September 30,
2014
 
December 31,
2013
Product
$
2,685

 
$
2,915

Services and other
497,327

 
429,713

Total deferred revenue
$
500,012

 
$
432,628

Reported As:
 
 
 
Current
$
329,132

 
$
293,664

Non-current
170,880

 
138,964

Total deferred revenue
$
500,012

 
$
432,628



9. COMMITMENTS AND CONTINGENCIES

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

 
Total
 
2014 (remainder)
 
2015
 
2016
 
2017
 
2018
 
Thereafter
Operating lease commitments
$
39,575

 
$
2,495

 
$
9,411

 
$
7,590

 
$
6,649

 
$
5,467

 
$
7,963

Less: Sublease rental income
642

 
193

 
449

 
—

 
—

 
—

 
—

Operating lease commitments—net
38,933

 
2,302

 
8,962

 
7,590

 
6,649

 
5,467

 
7,963

Purchase commitments
76,355

 
53,006

 
23,349

 
—

 
—

 
—

 
—

Other contractual commitments
24,176

 
19,530

 
3,592

 
813

 
241

 
—

 
—

Total
$
139,464

 
$
74,838

 
$
35,903

 
$
8,403

 
$
6,890

 
$
5,467

 
$
7,963


Operating Leases—We lease certain facilities under various non-cancelable operating leases, which expire through 2024. The terms of certain operating leases provide for renewal options. Rent expense is recognized using the straight-line method over the term of the lease. Rent expense was $2.6 million and $2.4 million during the three months ended September 30, 2014 and September 30, 2013, respectively. Rent expense was $7.7 million and $7.1 million during the nine months ended September 30, 2014 and September 30, 2013, respectively.
    
Purchase Commitments and Other Contractual Commitments—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, 2014, we had $76.4 million of open purchase orders with our independent contract manufacturers that may not be cancelable.
 
In addition to commitments with contract manufacturers, we have open purchase orders and contractual obligations in the ordinary course of business for which we have not received goods or services. As of September 30, 2014, we had $24.2 million in other purchase commitments.


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




Warranties—Accrued warranty activities are summarized as follows (in thousands):

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

 
$
2,309

Warranty costs incurred
(2,597
)
 
(2,670
)
Provision for warranty for the period
3,786

 
3,134

Adjustment related to pre-existing warranties
(540
)
 
274

Accrued warranty balance—end of the period
$
3,686

 
$
3,047


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

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


10. STOCKHOLDERS’ EQUITY

Employee Stock Options

The following table summarizes the weighted-average assumptions relating to our employee stock options for the periods presented below:
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Expected term in years
4.9

 
4.6

 
4.9

 
4.6

Volatility
40.7
%
 
47.8
%
 
43.1
%
 
47.8
%
Risk-free interest rate
1.6
%
 
1.2
%
 
1.7
%
 
1.2
%
Dividend rate
—

 
—

 
—

 
—




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




The following table summarizes the stock option activity and related information for the periods presented below (in thousands, except exercise prices and contractual life):
 
 
Options Outstanding
 
Number
of Shares
 
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Life (Years)
 
Aggregate
Intrinsic
Value
Balance—December 31, 2013
15,521

 
$
13.18

 
 
 


Granted
320

 
22.36

 
 
 
 
Forfeited
(390
)
 
24.15

 
 
 
 
Exercised
(3,216
)
 
8.25

 
 
 
 
Balance—September 30, 2014
12,235

 
14.37

 
 
 
 
Options vested and expected to vest—September 30, 2014
12,205

 
$
14.35

 
2.82
 
$
136,230

Options exercisable—September 30, 2014
10,244

 
$
12.59

 
2.48
 
$
131,847


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, 2014, for all in-the-money options. As of September 30, 2014, total compensation expense related to unvested stock options granted to employees but not yet recognized was $22.9 million, net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average period of 1.47 years.  

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Weighted-average fair value per share granted
$
9.13

 
$
8.61

 
$
8.76

 
$
8.61

Intrinsic value of options exercised
$
17,728

 
$
7,880

 
$
49,490

 
$
36,997

Fair value of options vested
$
4,393

 
$
5,063

 
$
13,163

 
$
21,553


Restricted Stock Units

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

 
Restricted Stock Units Outstanding
 
Number of Shares
 
Weighted-Average Grant-Date-Fair Value per Share
Balance—December 31, 2013
4,199

 
$
22.00

Granted
3,359

 
22.44

Forfeited
(342
)
 
21.85

Vested
(1,197
)
 
22.31

Balance—September 30, 2014
6,019

 
$
22.27

RSUs expected to vest—September 30, 2014
5,699

 
$
22.27



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)




As of September 30, 2014, total compensation expense related to unvested RSUs that were granted to employees and non-employees under our 2009 Equity Incentive Plan, but not yet recognized, was $128.3 million, net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 3.02 years.

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Shares withheld for taxes
124

 
45

 
381

 
45

Amount withheld for taxes
$
2,985

 
$
966

 
$
8,506

 
$
966


Employee Stock Purchase Plan

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Expected term in years
0.5

 
0.5

 
0.5

 
0.5

Volatility
31.9
%
 
35.1
%
 
34.1
%
 
44.0
%
Risk-free interest rate
0.1
%
 
0.1
%
 
0.1
%
 
0.1
%
Dividend rate
—

 
—

 
—

 
—


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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Weighted-average fair value per share granted
$
6.03

 
$
5.04

 
$
5.91

 
$
6.11

Shares issued under the ESPP
346

 
344

 
770

 
672

Weighted-average price per share issued
$
19.38

 
$
17.90

 
$
18.17

 
$
18.88


Stock-based Compensation Expense

Stock-based compensation expense is included in costs and expenses as follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Cost of product revenue
$
60

 
$
91

 
$
351

 
$
277

Cost of services and other revenue
1,522

 
1,297

 
4,214

 
3,543

Research and development
4,505

 
3,548

 
12,558

 
9,605

Sales and marketing
7,397

 
5,215

 
18,890

 
13,927

General and administrative
1,183

 
1,627

 
6,300

 
4,432

Total stock-based compensation expense
$
14,667

 
$
11,778

 
$
42,313

 
$
31,784



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




The following table summarizes stock-based compensation expense by award type (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Stock options
$
4,282

 
$
5,180

 
$
13,395

 
$
15,801

RSUs
9,275

 
5,408

 
25,886

 
12,439

ESPP
1,110

 
1,190

 
3,032

 
3,544

Total stock-based compensation expense
$
14,667

 
$
11,778

 
$
42,313

 
$
31,784


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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Income tax benefit associated with stock-based compensation
$
4,225

 
$
3,176

 
$
11,821

 
$
9,557


Share Repurchase Program

On December 6, 2013, our Board of Directors (“Board”) authorized a Share Repurchase Program (“Program”) to repurchase up to $200.0 million of our outstanding common stock through December 31, 2014. Under the Program, share repurchases may be made by us from time to time in privately negotiated transactions or in open market transactions. The Program may be suspended, modified or discontinued at any time without prior notice. During the three and nine months ended September 30, 2014, we repurchased 0.4 million and 1.4 million shares of common stock under the Program in open market transactions for an aggregate purchase price of $10.7 million and $33.2 million, respectively. As of September 30, 2014, $127.9 million remained authorized for future share repurchases under the Program.


11. INCOME TAXES

The effective tax rate was 74% for the three months ended September 30, 2014, compared to an effective tax rate of 40% for the three months ended September 30, 2013. The effective tax rate was 55% for the nine months ended September 30, 2014, compared to an effective tax of 36% for the nine months ended September 30, 2013. The provision for income taxes for the periods presented is comprised of U.S. federal and state taxes, Singapore and other foreign income taxes, withholding tax, discrete taxes resulting from an increase in tax reserves, as well as the inclusion of stock compensation benefits and transfer pricing allocations which impact jurisdictional income taxed at various tax rates.

As of September 30, 2014 and December 31, 2013, unrecognized tax benefits were $39.4 million and $30.2 million, respectively. The total amount of $39.4 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, 2014, we had accrued approximately $1.6 million for estimated interest related to uncertain tax positions.


12. DEFINED CONTRIBUTION PLANS

Our tax-deferred savings plan, under the 401(k) Plan, allows participating employees to defer a portion of their pre-tax earnings, up to the IRS annual contribution limit. In Canada, we have a Group Registered Retirement Savings Plan program (the “RRSP”) which permits participants to make tax deductible contributions up to the maximum contribution limits under the Income Tax Act. Our Board approved 50% matching contributions on employee contributions up to 4% of each employee’s

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




eligible earnings. Our matching contributions to the 401(k) Plans and RRSP for the three months ended September 30, 2014 and September 30, 2013 were $0.7 million and $0.6 million, respectively. Our matching contributions to the 401(k) Plans and RRSP for the nine months ended September 30, 2014 and September 30, 2013 were $1.9 million and $1.6 million, respectively.


13. SEGMENT AND SIGNIFICANT CUSTOMER INFORMATION

The following table sets forth revenue by geographic region (in thousands):
 
 
Three Months Ended
 
Nine Months Ended
Revenue
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Americas:
 
 
 
 
 
 
 
United States
$
50,329

 
$
40,654

 
$
144,794

 
$
114,257

Other Americas
31,889

 
24,794

 
88,241

 
63,844

Total Americas
82,218

 
65,448

 
233,035

 
178,101

Europe, Middle East, and Africa (“EMEA”)
66,157

 
51,373

 
185,354

 
149,500

Asia Pacific and Japan (“APAC”)
44,973

 
37,878

 
128,006

 
110,346

Total revenue
$
193,348

 
$
154,699

 
$
546,395

 
$
437,947



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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Exclusive Networks Group
15
%
 
11
%
 
14
%
 
11
%
Fine Tec Computer
11
%
 
—

 
—

 
—



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

 
September 30,
2014
 
December 31,
2013
Exclusive Networks Group
13
%
 
13
%
Fine Tec Computer
15
%
 
—



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




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

Property and Equipment—Net
September 30,
2014
 
December 31,
2013
Americas:
 
 
 
United States
$
45,234

 
$
29,334

Canada
5,884

 
4,372

Other Americas
411

 
45

Total Americas
51,529

 
33,751

EMEA
2,221

 
1,273

APAC
3,062

 
1,628

Total property and equipment—net
$
56,812

 
$
36,652



14. ACCUMULATED OTHER COMPREHENSIVE INCOME

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

 
September 30, 2014
 
Foreign Currency Translation Gains And Losses
 
Unrealized Gains And Losses On Investments
 
Tax Benefit Or Provision Related To Items Of Other Comprehensive Income Or Loss
 
Total
Balance as of December 31, 2013
$
333

 
$
1,168

 
$
(409
)
 
$
1,092

Other comprehensive income before reclassifications
(333
)
 
(984
)
 
345

 
(972
)
Amounts reclassified from accumulated other comprehensive income
—

 
(9
)
 
3

 
(6
)
Net current-period other comprehensive income
(333
)
 
(993
)
 
348

 
(978
)
Balance as of September 30, 2014
$
—

 
$
175

 
$
(61
)
 
$
114


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

September 30, 2014
Details About Accumulated Other Comprehensive Income Components
 
Amount Reclassified From Accumulated Other Comprehensive Income
 
Affected Line Item In The Statement Where Net Income Is Presented
Unrealized gains on investments
 
$
(9
)
 
Other expense—net
Tax provision related to items of other comprehensive income or loss
 
3

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



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




15. FOREIGN CURRENCY DERIVATIVES

Foreign Currency Derivatives—Our sales contracts are primarily denominated in U.S. dollars and therefore substantially all of our revenue is not subject to foreign currency translation risk. However, a substantial portion of our operating expenses incurred outside the U.S. are denominated in foreign currencies and are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Canadian dollar (“CAD”). To help protect against significant fluctuations in value and the volatility of future cash flows caused by changes in currency exchange rates, we engage in foreign currency risk management activities, including forward contracts, to hedge balance sheet items denominated in CAD. We do not use these contracts for speculative or trading purposes. All of the derivative instruments are with high quality financial institutions and we monitor the creditworthiness of these parties. These contracts typically have maturities of one month. We record changes in the fair value of forward exchange contracts related to balance sheet accounts as Other (expense) income—net in the consolidated statement of operations.

Additionally, independent of any hedging activities, fluctuations in foreign currency exchange rates may cause us to recognize transaction gains and losses in Other (expense) income—net in our condensed consolidated statements of operations. Our hedging activities are intended to reduce, but not eliminate, the impact of currency exchange rate movements. As our hedging activities are relatively short-term in nature and are focused on CAD, long-term material changes in the value of the U.S. dollar against other foreign currencies, such as the GBP and EUR could adversely impact our operating expenses in the future.

The notional amount of forward exchange contracts to hedge balance sheet accounts as of September 30, 2014 and December 31, 2013 were (in thousands):

 
Buy/Sell
 
Notional
Currency—As of September 30, 2014
 
 
 
CAD
Buy
 
$
13,242

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



16. SUBSEQUENT EVENT

On October 17, 2014, our Board extended the share repurchase authorization under the Program through December 31, 2015. As of October 17, 2014, $124.9 million remained authorized for future share repurchases under the Program.



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ITEM 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. These statements include, among other things, statements concerning our expectations regarding:
 
•
variability in sales in certain product categories from year to year and between quarters;

•
expected impact of certain acquisitions and investments in strategic relationships;

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

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

•
our ability to meet increasing customer expectations about the quality and functionality of our products;
 
•
trends in revenue, costs of revenue, and gross margin;
 
•
trends in our operating expenses, including personnel costs, research and development expense, sales and marketing expense and general and administrative expense, and expectations regarding these expenses as a percentage of total revenue;

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

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

•
expectations regarding spending related to capital expenditures;
•
competition in our markets;
 
•
the sufficiency of our existing cash, cash equivalents and investments to meet our cash needs for at least the next 12 months;

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

Business Overview

We provide high performance network security solutions, which enable broad, integrated and high performance protection against advanced security threats while simplifying the IT security infrastructure for enterprises, service providers and governmental entities worldwide, including the majority of the Fortune Global 100.
Our core product platform is the FortiGate physical and virtual appliance, which ships with a set of broad security services, including firewall, virtual private network (VPN), application control, intrusion prevention, Web filtering and advanced threat protection (ATP). These security services are enabled by FortiGuard which provides extensive threat research and a global cloud network to deliver protection services to each FortiGate. FortiGate also has extensive networking capability

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such as switching, routing, native internet protocol version 6 (IPv6) and different modes of deployment. FortiManager provides central management and the FortiAnalyzer provides reporting and analytics. The FortiGate platform can be extended to provide enhanced capabilities. For example, it can be used as a Wireless Controller for Access Points. An external sandbox can also be attached for local ATP analysis.

Customers select the functions or combination of functions that best meet their specific security requirements such as a high-speed data center firewall (DCFW) at the network core, a next-generation firewall (NGFW) at the edge, or a broad unified threat management (UTM) solution at branch sites. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20 to -100 series, designed for small businesses, FortiGate-200 to -800 series for mid-sized enterprises, to the FortiGate-1000 to -5000 series for large enterprises, telecommunications carriers, and service providers. Our network security platform 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, and anti-spam functionality. End-customers can also choose to purchase FortiCare technical support services for our products. End-customers also often use FortiManager and FortiAnalyzer products in conjunction with a FortiGate deployment to provide centralized management, 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 our FortiSandbox ATP messaging security product, Web application firewalls, databases security product, distributed denial of service attack (DDoS) security product, and endpoint security product for employee computers and mobile devices. Sales of these complementary products and related services represent less than 10% of our total revenue.

Financial Highlights

•
We recorded total revenue of $193.3 million and $546.4 million during the three and nine months ended September 30, 2014, respectively, an increase of 25% during each of these periods compared to the same periods last year. Product revenue was $87.7 million and $249.9 million during the three and nine months ended September 30, 2014, respectively, an increase of 26% and 29%, respectively, compared to the same periods last year. Services and other revenue was $105.6 million and $296.5 million during the three and nine months ended September 30, 2014, respectively, an increase of 24% and 22%, respectively, compared to the same periods last year.

•
Cash, cash equivalents and investments were $963.8 million as of September 30, 2014, an increase of $120.7 million from December 31, 2013.

•
Deferred revenue was $500.0 million as of September 30, 2014, an increase of $67.4 million from December 31, 2013.

•
We generated cash flows from operating activities of $161.2 million during the nine months ended September 30, 2014, an increase of 60% compared to the same period last year.

•
We received $20.0 million pursuant to a six year mutual covenant-not-to-sue and release agreement with Palo Alto Networks, Inc. in January 2014.

•
We repurchased 1.4 million shares of common stock under our previously-announced Share Repurchase Program for an aggregate purchase price of $33.2 million during the nine months ended September 30, 2014.

Revenue grew as a result of our focus on growth and our strategy to invest in our marketing and increase sales capacity during the three and nine months ended September 30, 2014. We also continued to gain traction with several recently introduced FortiGate products, including demand for certain of our high speed, low latency next-generation enterprise data center security products.

We continue to invest in sales and marketing to expand brand awareness and our global sales team and distribution channels to expand our global reach and sales capacity. We continue to focus on selling to large customers, such as enterprise and service providers. As a result, we experienced increased deal volumes driven by traction in enterprise data center deployments and large enterprise deals.

During the three months ended September 30, 2014, our revenue growth was primarily driven by greater sales volume in our FortiGate product family due to increased demand across all product categories, particularly from our entry-level and mid-range products, including our recently introduced FortiGate 300D and 500D enterprise security appliances. Sales of entry-level products (FortiGate-20 to -100 series) and mid-range products (FortiGate-200 to -800 series) increased compared to the

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same period last year. During the nine months ended September 30, 2014, our revenue growth was primarily driven by an increase in the sale of our high-end products, including our recently introduced FortiGate 1500D and 3700D enterprise security appliances.

During the three and nine months ended September 30, 2014, operating expenses increased by 31% and 30%, respectively, compared to the same periods last year. The increase was primarily driven by our accelerated pace of hiring and marketing investments to support our growth as we continued to invest in expanding our sales coverage, marketing capabilities, developing new products and scaling our customer support organization to meet the needs of our growing customer base. Headcount increased to 2,721 as of September 30, 2014 from 2,238 as of September 30, 2013.


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Key Financial Metrics

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

 
Three Months Ended Or As Of
 
September 30,
2014
 
September 30,
2013
 
(in thousands)
Revenue
$
193,348

 
$
154,699

Deferred revenue
$
500,012

 
$
400,173

Increase in deferred revenue
$