Edgar Filing: FORTINET INC

10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



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

For the quarterly period ended March 31, 2016



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

For the transition period from to

Commission file number: 001-34511

______________________________________

FORTINET, INC.

(Exact name of registrant as specified in its charter)

______________________________________



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



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

(408) 235-7700

(Registrant’s telephone number, including area code)

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

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

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



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

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

As of April 29, 2016, there were 171,671,224 shares of the registrant’s common stock outstanding.

FORTINET, INC.

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended March 31, 2016

Table of Contents




		Page

	Part I	3

Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets as of March 31, 2016 and December 31, 2015	3
	Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2016 and 2015	4
	Condensed Consolidated Statements of Comprehensive Income (Loss) for the Three Months Ended March 31, 2016 and 2015	5
	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2016 and 2015	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	34
Item 4.	Controls and Procedures	35

	Part II	36
Item 1.	Legal Proceedings	36
Item 1A.	Risk Factors	36
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	59
Item 6.	Exhibits	59
	Signatures	60

Table of Contents

Part I


ITEM 1.	Financial Statements

FORTINET, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited, in thousands, except per share amounts)



	March 31, 2016		December 31, 2015
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	568,008	$	543,277
Short-term investments	384,591		348,074
Accounts receivable—net of reserves for sales returns and doubtful accounts of $6,545 and $6,228 at March 31, 2016 and December 31, 2015, respectively	220,135		259,563
Inventory	78,239		83,868
Prepaid expenses and other current assets	34,728		35,761
Total current assets	1,285,701		1,270,543
LONG-TERM INVESTMENTS	241,888		272,959
DEFERRED TAX ASSETS	131,696		119,216
PROPERTY AND EQUIPMENT—net	115,782		91,067
OTHER INTANGIBLE ASSETS—net	16,457		17,640
GOODWILL	4,692		4,692
OTHER ASSETS	15,305		14,393
TOTAL ASSETS	$	1,811,521	$	1,790,510

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	47,955	$	61,500
Accrued liabilities	33,543		33,028
Accrued payroll and compensation	58,165		61,111
Income taxes payable	9,230		8,379
Deferred revenue	538,449		514,652
Total current liabilities	687,342		678,670
DEFERRED REVENUE	298,739		276,651
INCOME TAX LIABILITIES	65,163		60,624
OTHER LIABILITIES	17,874		19,188
Total liabilities	1,069,118		1,035,133
COMMITMENTS AND CONTINGENCIES (Note 10)
STOCKHOLDERS’ EQUITY:
Common stock, $0.001 par value—300,000 shares authorized; 171,588 and 171,399 shares issued and outstanding at March 31, 2016 and December 31, 2015, respectively	171		171
Additional paid-in capital	718,849		687,658
Accumulated other comprehensive income (loss)	294		(933		)
Retained earnings	23,089		68,481
Total stockholders’ equity	742,403		755,377
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	1,811,521	$	1,790,510

See notes to condensed consolidated financial statements.

Table of Contents

FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited, in thousands, except per share amounts)



	Three Months Ended
	March 31, 2016			March 31, 2015
REVENUE:
Product	$	124,572		$	97,509
Service	160,004			115,377
Total revenue	284,576			212,886
COST OF REVENUE:
Product	49,359			41,368
Service	28,390			22,234
Total cost of revenue	77,749			63,602
GROSS PROFIT:
Product	75,213			56,141
Service	131,614			93,143
Total gross profit	206,827			149,284
OPERATING EXPENSES:
Research and development	44,966			35,816
Sales and marketing	147,403			100,609
General and administrative	19,802			11,961
Restructuring charges	328			—
Total operating expenses	212,499			148,386
OPERATING INCOME (LOSS)	(5,672		)	898
INTEREST INCOME	1,746			1,422
OTHER EXPENSE—net	(1,312		)	(677		)
INCOME (LOSS) BEFORE INCOME TAXES	(5,238		)	1,643
PROVISION FOR (BENEFIT FROM) INCOME TAXES	(1,809		)	83
NET INCOME (LOSS)	$	(3,429	)	$	1,560
Net income (loss) per share (Note 8):
Basic	$	(0.02	)	$	0.01
Diluted	$	(0.02	)	$	0.01
Weighted-average shares outstanding:
Basic	171,745			168,077
Diluted	171,745			173,720

See notes to condensed consolidated financial statements.

Table of Contents

FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(unaudited, in thousands)



	Three Months Ended
	March 31, 2016			March 31, 2015
Net income (loss)	$	(3,429	)	$	1,560
Other comprehensive income:
Unrealized gains on investments	1,888			885
Tax provision related to other items of other comprehensive income	(661		)	(310		)
Other comprehensive income—net of taxes	1,227			575
Comprehensive income (loss)	$	(2,202	)	$	2,135

See notes to condensed consolidated financial statements.

Table of Contents

FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in thousands)



	Three Months Ended
	March 31, 2016			March 31, 2015
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)	$	(3,429	)	$	1,560
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization	10,550			6,353
Amortization of investment premiums	1,497			1,938
Stock-based compensation	30,881			18,880
Other non-cash items—net	(372		)	159
Changes in operating assets and liabilities:
Accounts receivable—net	38,920			23,621
Inventory	(527		)	(6,296		)
Deferred tax assets	(13,141		)	(7,918		)
Prepaid expenses and other current assets	1,029			(1,203		)
Other assets	(911		)	507
Accounts payable	(11,426		)	(11,305		)
Accrued liabilities	300			(3,450		)
Accrued payroll and compensation	(2,945		)	(3,149		)
Other liabilities	(1,332		)	(1,569		)
Deferred revenue	46,106			40,696
Income taxes payable	5,391			5,795
Net cash provided by operating activities	100,591			64,619
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of investments	(115,672		)	(120,991		)
Sales of investments	2,867			6,679
Maturities of investments	108,557			135,363
Purchases of property and equipment	(29,956		)	(4,927		)
Net cash provided by (used in) investing activities	(34,204		)	16,124
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock	17,785			28,955
Taxes paid related to net share settlement of equity awards	(9,441		)	(6,600		)
Repurchase and retirement of common stock	(50,000		)	—
Net cash provided by (used in) financing activities	(41,656		)	22,355
NET INCREASE IN CASH AND CASH EQUIVALENTS	24,731			103,098
CASH AND CASH EQUIVALENTS—Beginning of period	543,277			283,254
CASH AND CASH EQUIVALENTS—End of period	$	568,008		$	386,352
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes—net	$	5,574		$	6,498
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Transfers of evaluation units from inventory to property and equipment	$	6,671		$	3,869
Liability for purchase of property and equipment and asset retirement obligations	$	7,843		$	2,140

See notes to condensed consolidated financial statements.

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 in the United States (“GAAP”) for interim financial information, as well as the instructions to Form 10-Q pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2015, contained in our Annual Report on Form 10-K (the “Form 10-K”) filed with the SEC on February 26, 2016. In the opinion of management, all adjustments, which includes normal recurring adjustments, considered necessary for a fair presentation have been included. All intercompany balances, transactions and cash flows have been eliminated. The results of operations for the three months ended March 31, 2016 are not necessarily indicative of the results for the full year or for any future periods. The condensed consolidated balance sheet as of December 31, 2015 is derived from the audited consolidated financial statements for the year ended December 31, 2015.

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

There have been no material changes to our significant accounting policies as of and for the three months ended March 31, 2016.

Recently Adopted Accounting Standards

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

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

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

Recent Accounting Standards Not Yet Effective

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

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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

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

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

In July 2015, the FASB issued ASU 2015-11—Inventory—Simplifying the Measurement of Inventory, which changes the measurement principle for inventory from the lower of cost or market to lower of cost and net realizable value. ASU 2015-11 applies to entities that measure inventory using a method other than last-in, first-out or the retail inventory method (e.g., first-in, first-out or average cost). ASU 2015-11 will be effective for us beginning on January 1, 2017. We do not expect the impact of ASU 2015-11 on our consolidated financial statements to be significant.

In May 2014, the FASB issued ASU 2014-09—Revenue from Contracts with Customers, which creates a single, joint revenue standard that is consistent across all industries and markets for companies that prepare their financial statements in accordance with GAAP. Under ASU 2014-09, an entity is required to recognize revenue upon the transfer of promised goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to receive in exchange for those goods or services. In July 2015, the FASB decided to delay the effective date of the new revenue standard by one year. In March 2016, the FASB issued ASU 2016-08, which clarifies the implementation guidance on principal versus agent considerations. In April 2016, the FASB issued ASU 2016-10, which clarifies the implementation guidance on identifying performance obligations and licensing. These standards will be effective for us beginning on January 1, 2018, with the option to adopt earlier on January 1, 2017. We are currently evaluating the impact of these new standards on our consolidated financial statements.

2. FINANCIAL INSTRUMENTS AND FAIR VALUE

The following table summarizes our investments as of March 31, 2016 and December 31, 2015 (in thousands):



	March 31, 2016
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Corporate debt securities	$	410,265	$	574	$	(250	)	$	410,589
Commercial paper	75,465		7		(8		)	75,464
Municipal bonds	54,198		53		(7		)	54,244
Certificates of deposit and term deposits ⁽¹⁾	19,847		—		—			19,847
U.S. government and agency securities	66,253		82		—			66,335
Total available-for-sale securities	$	626,028	$	716	$	(265	)	$	626,479

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



	December 31, 2015
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Corporate debt securities	$	438,533	$	30	$	(1,369	)	$	437,194
Commercial paper	66,263		3		(34		)	66,232
Municipal bonds	61,050		12		(40		)	61,022
Certificates of deposit and term deposits ⁽¹⁾	14,897		—		—			14,897
U.S. government and agency securities	41,727		3		(42		)	41,688
Total available-for-sale securities	$	622,470	$	48	$	(1,485	)	$	621,033

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

The following table shows the gross unrealized losses and the related fair values of our investments that have been in a continuous unrealized loss position as of March 31, 2016 and December 31, 2015 (in thousands):



	March 31, 2016
	Less Than 12 Months					12 Months or Greater					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
Corporate debt securities	$	141,018	$	(159	)	$	50,269	$	(91	)	$	191,287	$	(250	)
Commercial paper	16,754		(8		)	—		—			16,754		(8		)
Municipal bonds	12,710		(6		)	1,006		(1		)	13,716		(7		)
Total available-for-sale securities	$	170,482	$	(173	)	$	51,275	$	(92	)	$	221,757	$	(265	)



	December 31, 2015
	Less Than 12 Months					12 Months or Greater					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
Corporate debt securities	$	348,534	$	(1,187	)	$	42,033	$	(182	)	$	390,567	$	(1,369	)
Commercial paper	31,977		(34		)	—		—			31,977		(34		)
Municipal bonds	41,677		(36		)	1,008		(4		)	42,685		(40		)
U.S. government and agency securities	34,703		(42		)	—		—			34,703		(42		)
Total available-for-sale securities	$	456,891	$	(1,299	)	$	43,041	$	(186	)	$	499,932	$	(1,485	)

The contractual maturities of our investments as of March 31, 2016 and December 31, 2015 were as follows (in thousands):



	March 31, 2016		December 31, 2015
Due within one year	$	384,591	$	348,074
Due within one to three years	241,888		272,959
Total	$	626,479	$	621,033

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

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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

The unrealized losses on our available-for-sale securities were caused by fluctuations in market value and interest rates as a result of the economic environment. As the decline in market value are attributable to changes in market conditions and not credit quality, and because we have concluded currently that we neither intend to sell nor is it more likely than not that we will be required to sell these investments prior to a recovery of par value, we do not consider these investments to be other-than temporarily impaired as of March 31, 2016.

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

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

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

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

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

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

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

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Fair Value of Financial Instruments

Assets Measured at Fair Value on a Recurring Basis

The following table presents the fair value of our financial assets measured at fair value on a recurring basis as of March 31, 2016 and December 31, 2015 (in thousands):



	March 31, 2016								December 31, 2015
	Aggregate Fair Value		Quoted Prices in Active Markets For Identical Assets		Significant Other Observable Remaining Inputs		Significant Other Unobservable Remaining Inputs		Aggregate Fair Value		Quoted Prices in Active Markets For Identical Assets		Significant Other Observable Remaining Inputs		Significant Other Unobservable Remaining Inputs
			(Level 1)		(Level 2)		(Level 3)				(Level 1)		(Level 2)		(Level 3)
Assets:
Corporate debt securities	$	410,589	$	—	$	410,589	$	—	$	437,194	$	—	$	437,194	$	—
Commercial paper	82,962		—		82,962		—		69,231		—		69,231		—
Municipal bonds	54,244		—		54,244		—		61,022		—		61,022		—
Certificates of deposit and term deposits	19,847		—		19,847		—		14,897		—		14,897		—
Money market funds	48,599		48,599		—		—		50,030		50,030		—		—
U.S. government and agency securities	66,335		50,326		16,009		—		41,688		25,693		15,995		—
Total	$	682,576	$	98,925	$	583,651	$	—	$	674,062	$	75,723	$	598,339	$	—

Reported as:
Cash equivalents	$	56,097							$	53,029
Short-term investments	384,591								348,074
Long-term investments	241,888								272,959
Total	$	682,576							$	674,062

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

3. INVENTORY

Inventory consisted of the following as of March 31, 2016 and December 31, 2015 (in thousands):



	March 31, 2016		December 31, 2015
Raw materials	$	15,270	$	15,425
Finished goods	62,969		68,443
Inventory	$	78,239	$	83,868

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

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

4. PROPERTY AND EQUIPMENT—net

Property and equipment—net as of March 31, 2016 and December 31, 2015 consisted of the following (in thousands):



	March 31, 2016			December 31, 2015
Land	$	30,321		$	21,683
Building and building improvements	39,454			28,841
Evaluation units	18,413			15,784
Computer equipment and software	49,701			45,632
Furniture and fixtures	10,536			8,901
Construction-in-progress	8,796			8,106
Leasehold improvements	13,182			11,179
Total property and equipment	170,403			140,126
Less: accumulated depreciation	(54,621		)	(49,059		)
Property and equipment—net	$	115,782		$	91,067

During the first quarter of 2016, we purchased certain real property in Union City, California, for cash of $18.5 million to support the growth in our business operations. Of the total cost, we allocated $8.7 million to land and $9.8 million to building.

Depreciation expense was $9.4 million and $6.0 million during the three months ended March 31, 2016 and March 31, 2015, respectively.

5. INVESTMENTS IN PRIVATELY-HELD COMPANIES

Our investments in the equity securities of three privately-held companies totaled $10.3 million as of March 31, 2016 and December 31, 2015. Each of these investments are accounted for as cost-basis investments, as we own less than 20% of the voting securities and do not have the ability to exercise significant influence over operating and financial policies of the respective entities. These investments are carried at historical cost and are recorded as Other assets on our condensed consolidated balance sheet and would be measured at fair value if indicators of impairment exist. As of March 31, 2016, no events have occurred that would adversely affect the carrying value of these investments.

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

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

6. BUSINESS COMBINATIONS

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

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



Purchase Price:
Cash	$	40,914
Estimated fair value of shares withheld for taxes	379
Estimated fair value of earned equity awards assumed by Fortinet	471
Total purchase price	$	41,764

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

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



Cash and cash equivalents	$	3,268
Accounts receivable	8,191
Inventory	11,610
Prepaid expenses and other assets	2,409
Property and equipment	920
Deferred tax assets	18,585
Identifiable intangible assets	19,600
Goodwill	1,868
Total assets acquired	66,451
Deferred revenue	9,800
Accounts payable and accrued liabilities	14,887
Total liabilities assumed	24,687
Total purchase price allocation	$	41,764

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

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



	Estimated Useful Life (in years)	Fair Values
Customer relationships	5	$	12,200
Developed technologies	4	7,200
Trade name	0.5	200
Total		$	19,600

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

7. GOODWILL AND OTHER INTANGIBLE ASSETS—net

Goodwill

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

Other Intangible Assets—net

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



	March 31, 2016
	Weighted-Average Useful Life (in Years)	Gross		Accumulated Amortization		Net
Other intangible assets—net:
Customer relationships	5.0	$	12,200	$	1,830	$	10,370
Developed technologies and other	3.6	11,384		5,297		6,087
Total other intangible assets—net		$	23,584	$	7,127	$	16,457



	December 31, 2015
	Weighted-Average Useful Life (in Years)	Gross		Accumulated Amortization		Net
Other intangible assets—net:
Customer relationships	5.0	$	12,200	$	1,220	$	10,980
Developed technologies and other	3.6	11,384		4,724		6,660
Total other intangible assets—net		$	23,584	$	5,944	$	17,640

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



	Amount
Years:
2016 (remainder)	$	3,417
2017	4,240
2018	4,240
2019	3,340
2020	1,220
Total	$	16,457

8. NET INCOME (LOSS) PER SHARE

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

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



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

Denominator:
Basic shares:
Weighted-average common stock outstanding-basic	171,745			168,077
Diluted shares:
Weighted-average common stock outstanding-basic	171,745			168,077
Effect of potentially dilutive securities:
Stock options	—			3,837
RSUs (including PSUs)	—			1,741
ESPP	—			65
Weighted-average shares used to compute diluted net income per share	171,745			173,720
Net income (loss) per share:
Basic	$	(0.02	)	$	0.01
Diluted	$	(0.02	)	$	0.01

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following potentially dilutive shares of common stock were excluded from the computation of diluted net income (loss) per share for the periods presented, as their effect would have been antidilutive (in thousands):



	Three Months Ended
	March 31, 2016	March 31, 2015
Stock options	6,939	249
RSUs (including PSUs)	10,020	1,333
ESPP	282	169
	17,241	1,751

9. RESTRUCTURING CHARGES

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

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



	Employee Severance and Other Benefits			Contract Terminations and Other Charges			Total
Balance as of December 31, 2015	$	3,689		$	229		$	3,918
Costs incurred	328			—			328
Less cash payments	(1,282		)	(125		)	(1,407		)
Less non-cash charges	(89		)	—			(89		)
Balance as of March 31, 2016	$	2,646		$	104		$	2,750

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

10. COMMITMENTS AND CONTINGENCIES

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



	Total		2016 (remainder)		2017		2018		2019		2020		Thereafter
Operating lease commitments	$	60,677	$	13,411	$	12,897	$	11,036	$	8,734	$	5,945	$	8,654
Inventory purchase commitments	77,530		77,530		—		—		—		—		—
Other contractual commitments and open purchase orders	49,048		41,207		3,461		1,590		930		930		930
Total	$	187,255	$	132,148	$	16,358	$	12,626	$	9,664	$	6,875	$	9,584

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Operating Leases—We lease certain facilities under various non-cancelable operating leases, which expire through 2026. Certain leases require us to pay variable costs such as taxes, maintenance, and insurance. The terms of certain operating leases also provide for renewal options and escalation clauses. Rent expense was $4.6 million and $3.1 million during the three months ended March 31, 2016 and March 31, 2015, respectively. Rent expense is recognized using the straight-line method over the term of the lease.

Inventory Purchase Commitments—Our independent contract manufacturers procure components and build our products based on our forecasts. These forecasts are based on estimates of future demand for our products, which are in turn based on historical trends and an analysis from our sales and marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate component supply, we may issue purchase orders to some of our independent contract manufacturers which may not be cancelable. As of March 31, 2016, we had $77.5 million of open purchase orders with our independent contract manufacturers that may not be cancelable.

Other Contractual Commitments and Open Purchase Orders—In addition to commitments with contract manufacturers, we have open purchase orders and contractual obligations in the ordinary course of business for which we have not received goods or services. As of March 31, 2016, we had $49.0 million in other contractual commitments that may not be cancelable.

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



	Three Months Ended
	March 31, 2016			March 31, 2015
Accrued warranty balance—beginning of the period	$	3,144		$	4,269
Warranty costs incurred	(511		)	(1,095		)
Provision for warranty for the period	377			945
Adjustment related to pre-existing warranties	(353		)	222
Accrued warranty balance—end of the period	$	2,657		$	4,341

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

Indemnification—Under the indemnification provisions of our standard sales contracts, we agree to defend our customers against third-party claims asserting various allegations such as product defects and infringement of certain intellectual property rights, which may include patents, copyrights, trademarks or trade secrets, and to pay judgments entered on such claims. In some contracts, our exposure under these indemnification provisions is limited by the terms of the contracts to certain defined limits, such as the total amount paid by our customer under the agreement. However, certain agreements include covenants, penalties and indemnification provisions including and beyond indemnification for third-party claims of intellectual property infringement and that could potentially expose us to losses in excess of the amount received under the agreement, and in some instances to potential liability that is not contractually limited. To date, there have been no awards under such indemnification provisions.

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

11. STOCKHOLDERS’ EQUITY

Stock-Based Compensation Plans

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

Restricted Stock Units

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



	Restricted Stock Units Outstanding
	Number of Shares		Weighted-Average Grant Date Fair Value per Share
Balance—December 31, 2015	9,257		$	32.97
Granted	2,831		23.87
Forfeited	(441	)	31.94
Vested	(1,014	)	28.45
Balance—March 31, 2016	10,633		$	30.86
RSUs expected to vest—March 31, 2016	9,959		$	30.71

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

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

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



	Three Months Ended
	March 31, 2016		March 31, 2015
Shares withheld for taxes	343		221
Amount withheld for taxes	$	9,441	$	6,600

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Employee Stock Options

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



	Three Months Ended
	March 31, 2016		March 31, 2015
Expected term in years	4.3		4.3
Volatility	43	%	40	%
Risk-free interest rate	1.1	%	1.5	%
Dividend rate	—	%	—	%

The following table summarizes the stock option activity and related information for the periods presented below (in thousands, except exercise prices and contractual life):



	Options Outstanding
	Number of Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Life (Years)	Aggregate Intrinsic Value
Balance—December 31, 2015	6,968		$	20.03
Granted	1,161		23.83
Forfeited	(49	)	35.46
Exercised	(906	)	5.82
Balance—March 31, 2016	7,174		$	22.33
Options vested and expected to vest—March 31, 2016	7,011		$	22.17	3.37	$	65,127
Options exercisable—March 31, 2016	5,107		$	19.71	2.24	$	56,011

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

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



	Three Months Ended
	March 31, 2016		March 31, 2015
Weighted-average fair value per share granted	$	8.68	$	11.17
Intrinsic value of options exercised	19,424		41,003
Fair value of options vested	2,084		3,792

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Employee Stock Purchase Plan

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



	Three Months Ended
	March 31, 2016		March 31, 2015
Expected term in years	0.5		0.5
Volatility	48	%	28	%
Risk-free interest rate	0.4	%	0.1	%
Dividend rate	—	%	—	%

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



	Three Months Ended
	March 31, 2016		March 31, 2015
Weighted-average fair value per share granted	$	7.19	$	7.56
Shares issued under the ESPP	614		427
Weighted-average price per share issued	$	20.49	$	21.34

Stock-based Compensation Expense

Stock-based compensation expense is included in costs and expenses as follows (in thousands):



	Three Months Ended
	March 31, 2016		March 31, 2015
Cost of product revenue	$	326	$	140
Cost of service revenue	2,193		1,632
Research and development	7,355		5,157
Sales and marketing	17,114		9,307
General and administrative	3,893		2,686
Total stock-based compensation expense	$	30,881	$	18,922

The following table summarizes stock-based compensation expense by award type (in thousands):



	Three Months Ended
	March 31, 2016		March 31, 2015
RSUs	$	27,082	$	14,292
Stock options	1,954		3,455
ESPP	1,845		1,175
Total stock-based compensation expense	$	30,881	$	18,922

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



	Three Months Ended
	March 31, 2016		March 31, 2015
Income tax benefit associated with stock-based compensation	$	7,834	$	3,377

Share Repurchase Program

In January 2016, our board of directors approved a new Share Repurchase Program (the “Program”), which authorizes the repurchase of up to $200.0 million of our outstanding common stock through December 31, 2017. Under the Program, share repurchases may be made by us from time to time in privately negotiated transactions or in open market transactions. The Program does not require us to purchase a minimum number of shares, and may be suspended, modified or discontinued at any time without prior notice. In the three months ended March 31, 2016, we repurchased 2.0 million shares of common stock under the Program in open market transactions at an average price of $24.97 per share, for an aggregate purchase price of $50.0 million. As of March 31, 2016, $150.0 million remains available for future share repurchases under the Program.

12. INCOME TAXES

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

As of March 31, 2016 and December 31, 2015, unrecognized tax benefits were $63.4 million and $59.7 million, respectively. The total amount of $62.1 million in unrecognized tax benefits, if recognized, would favorably impact the effective tax rate. It is our policy to classify accrued interest and penalties related to unrecognized tax benefits in the provision for income taxes. As of March 31, 2016, we had accrued $6.7 million for estimated interest related to uncertain tax positions.

We file income tax returns in the U.S. federal jurisdiction, and various U.S. state and foreign jurisdictions. The statute of limitations is open for years that generated state net operating loss carryforwards and after 2009 for state jurisdictions. Additionally, we have foreign net operating losses that have an indefinite life. Generally, we are no longer subject to non-U.S. income tax examinations by tax authorities for tax years prior to 2009. We are no longer subject to examination by U.S. federal tax authorities for tax years prior to 2012. We are currently under examination by U.S federal income tax authorities for the tax years 2012, 2013, and 2014.

13. DEFINED CONTRIBUTION PLANS

Our tax-deferred savings plan under our 401(k) Plan, permits participating employees to defer a portion of their pre-tax earnings. In Canada, we have a Group Registered Retirement Savings Plan program (the “RRSP”), which permits participants to make tax deductible contributions. Our board of directors approved 50% matching contributions on employee contributions up to 4% of each employee’s eligible earnings. Our matching contributions to the 401(k) Plan and RRSP for the three months ended March 31, 2016 and March 31, 2015 were $1.0 million and $0.8 million, respectively.

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

14. SEGMENT AND SIGNIFICANT CUSTOMER INFORMATION

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our chief executive officer. Our chief executive officer reviews financial information presented on a consolidated basis, accompanied by information about revenue by geographic region for purposes of allocating resources and evaluating financial performance. We have one business activity, and there are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Accordingly, we have determined that we have one operating segment, and therefore, one reportable segment.

Revenue by geographic region is based on the billing address of the customer. The following tables set forth revenue and property and equipment—net by geographic region (in thousands):



	Three Months Ended
Revenue	March 31, 2016		March 31, 2015
Americas:
United States	$	75,558	$	58,501
Canada	31,305		20,458
Other Americas	13,183		12,601
Total Americas	120,046		91,560
Europe, Middle East, and Africa (“EMEA”)	105,491		75,664
Asia Pacific (“APAC”)	59,039		45,662
Total revenue	$	284,576	$	212,886



Property and Equipment—net	March 31, 2016		December 31, 2015
Americas:
United States	$	82,885	$	61,064
Other Americas	9,021		8,972
Total Americas	91,906		70,036
EMEA:
France	14,585		13,201
Other EMEA	5,244		3,977
Total EMEA	19,829		17,178
APAC	4,047		3,853
Total property and equipment—net	$	115,782	$	91,067

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



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

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



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

* Represents less than 10%

15. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

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



	March 31, 2016
	Unrealized Losses on Investments			Tax benefit (provision) related to items of other comprehensive income or loss			Total
Beginning balance	$	(1,437	)	$	504		$	(933	)
Other comprehensive income (loss) before reclassifications	1,891			(662		)	1,229
Amounts reclassified from accumulated other comprehensive income (loss)	(3		)	1			(2		)
Net current-period other comprehensive income (loss)	1,888			(661		)	1,227
Ending balance	$	451		$	(157	)	$	294

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



Three Months Ended March 31, 2016
Details about Accumulated Other Comprehensive Income Components	Amount Reclassified from Accumulated Other Comprehensive Income (Loss)			Affected Line Item in the Statement Where Net Income is Presented
Unrealized losses on investments	$	(3	)	Other expense—net
Tax benefit related to items of other comprehensive loss	1			Provision for income taxes
Total reclassification for the period	$	(2	)

16. FOREIGN CURRENCY DERIVATIVES

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

Table of Contents

FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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

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



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

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

17. RELATED PARTY TRANSACTIONS

The son of one member of our board of directors is a partner of an outside law firm that we utilize for certain complex litigation matters. Expenses for legal services provided by the law firm related to matters that arose subsequent to the member joining our board of directors were $0.3 million and $1.9 million in the three months ended March 31, 2016 and March 31, 2015, respectively. Of such amounts, $0.2 million and $0.5 million were incurred under contingent fee arrangements in the three months ended March 31, 2016 and March 31, 2015, respectively. Amounts due and payable to the law firm were $0.4 million and $5.3 million as of March 31, 2016 and December 31, 2015, respectively.

Table of Contents

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

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. These statements include, among other things, statements concerning our expectations regarding:


•	continued growth and market share gains;


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


•	expected impact of sales of certain products;


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


•	the impact of our product innovation strategy;


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


•	growing our sales to enterprise, service provider and government organizations, and the impact of sales to these organizations on our long-term growth, expansion, and operating results;


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


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


•	continued investments in research and development;


•	continued investments in sales and marketing, and the impact of those investments;


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


•	expectations regarding spending related to capital expenditures;


•	competition in our markets;


•	integration of acquired companies and technologies;


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


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


•	other statements regarding our future operations, financial condition and prospects and business strategies.

These forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q and, in particular, the risks discussed under the heading “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q and those discussed in other documents we file with the SEC. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Table of Contents

Business Overview

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

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

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

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

Financial Highlights

•

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


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


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


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


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

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

Table of Contents

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

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

Business Model

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

Key Metrics

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



	Three Months Ended Or As Of
	March 31, 2016		March 31, 2015
	(in thousands)
Revenue	$	284,576	$	212,886
Deferred revenue	$	837,188	$	600,171
Billings (non-GAAP)	$	330,461	$	254,300
Cash, cash equivalents and investments	$	1,194,487	$	1,072,565
Net cash provided by operating activities	$	100,591	$	64,619
Free cash flow (non-GAAP)	$	70,635	$	59,692

Deferred revenue. Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue. The majority of our deferred revenue balance consists of the unrecognized portion of service revenue from FortiGuard security subscription and FortiCare technical support service contracts, which is recognized as revenue ratably

Table of Contents

over the contractual service period. We monitor our deferred revenue balance because it represents a significant portion of revenue to be recognized in future periods.

Billings (Non-GAAP).We define billings as revenue recognized in accordance with GAAP plus the change in deferred revenue from the beginning to the end of the period less any deferred revenue balances acquired from business combination(s) during the period. We consider billings to be a useful metric for management and investors because billings drives future revenue, which is an important indicator of the health and viability of our business. There are a number of limitations related to the use of billings instead of GAAP revenue. First, billings include amounts that have not yet been recognized as revenue. Second, we may calculate billings in a manner that is different from peer companies that report similar financial measures. Management accounts for these limitations by providing specific information regarding GAAP revenue and evaluating billings together with GAAP revenue.

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



	Three Months Ended
	March 31, 2016		March 31, 2015
	(in thousands)
Billings:
Revenue	$	284,576	$	212,886
Add increase in deferred revenue	45,885		41,414
Total billings (Non-GAAP)	$	330,461	$	254,300

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



	Three Months Ended
	March 31, 2016			March 31, 2015
	(in thousands)
Free Cash Flow:
Net cash provided by operating activities	$	100,591		$	64,619
Less purchases of property and equipment	(29,956		)	(4,927		)
Free cash flow (Non-GAAP)	$	70,635		$	59,692

Critical Accounting Policies and Estimates

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

Table of Contents

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

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

Recent Accounting Pronouncements

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

Table of Contents

Results of Operations

Three Months Ended March 31, 2016 and 2015

Revenue



	Three Months Ended
	March 31, 2016				March 31, 2015
	Amount		% of Revenue		Amount		% of Revenue		Change		% Change
	(in thousands, except percentages)
Revenue:
Product	$	124,572	44	%	$	97,509	46	%	$	27,063	28	%
Service	160,004		56		115,377		54		44,627		39
Total revenue	$	284,576	100	%	$	212,886	100	%	$	71,690	34	%
Revenue by geography:
Americas	$	120,046	42	%	$	91,560	43	%	$	28,486	31	%
EMEA	105,491		37		75,664		36		29,827		39
APAC	59,039		21		45,662		21		13,377		29
Total revenue	$	284,576	100	%	$	212,886	100	%	$	71,690	34	%

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

Cost of revenue and gross margin



	Three Months Ended
	March 31, 2016			March 31, 2015			Change			% Change
	(in thousands, except percentages)
Cost of revenue:
Product	$	49,359		$	41,368		$	7,991		19	%
Service	28,390			22,234			6,156			28
Total cost of revenue	$	77,749		$	63,602		$	14,147		22	%
Gross margin:
Product	60.4		%	57.6		%	2.8		%
Service	82.3			80.7			1.6
Total gross margin	72.7		%	70.1		%	2.6		%

Total gross margin increased by 2.6 percentage points in the three months ended March 31, 2016 compared to the same period last year, as both product and service gross margins increased. Product gross margin increased by 2.8 percentage points in the three months ended March 31, 2016 compared to the same period last year. Product gross margin was positively impacted by higher sales of software products such as certain of our virtualized security solutions, as well as improvements in inventory management efficiencies.

Table of Contents

Service gross margin increased in the three months ended March 31, 2016 as compared to the same period last year as we scaled efficiencies resulting from our ability to add to, and charge more for functionality and value in, our FortiGuard security subscription and FortiCare technical support offerings, which yielded more value to our customers and which translated into improved service margins. Cost of service revenue increased by $6.2 million primarily due to a $4.1 million increase in personnel costs related to headcount increases.

Operating expenses



	Three Months Ended								Change		% Change
	March 31, 2016				March 31, 2015
	Amount		% of Revenue		Amount		% of Revenue
	(in thousands, except percentages)
Operating expenses:
Research and development	$	44,966	16	%	$	35,816	17	%	$	9,150	26	%
Sales and marketing	147,403		52		100,609		47		46,794		47
General and administrative	19,802		7		11,961		6		7,841		66
Restructuring charges	328		—		—		—		328		100
Total operating expenses	$	212,499	75	%	$	148,386	70	%	$	64,113	43	%

Research and development

Research and development expense increased by $9.2 million, or 26%, in the three months ended March 31, 2016 compared to the same period last year, primarily due to an increase of $6.9 million in personnel costs as a result of increased headcount to support the development of new products and continued enhancements of our existing products. Depreciation and other occupancy-related costs increased by $1.9 million. We intend to continue to invest in our research and development organization, but expect research and development expense as a percentage of total revenue to remain at a relatively comparable level during the remainder of 2016.

Sales and marketing

Sales and marketing expense increased by $46.8 million, or 47%, in the three months ended March 31, 2016 compared to the same period last year, primarily due to an increase of $35.2 million in personnel costs as we continued to increase our sales and marketing headcount. Marketing-related expenses increased by $5.1 million as we invested significantly in marketing to drive broader market awareness, create a global marketing engine, build broad market lead generation, nurture programs and accelerate pipeline. In addition, we incurred increases in travel expenses of $2.0 million and depreciation and occupancy-related costs of $3.5 million. We intend to continue to make investments in our sales resources and infrastructure and marketing strategy, which are critical to support growth, but expect sales and marketing expense as a percentage of total revenue to slightly decrease during the remainder of 2016.

General and administrative

General and administrative expense increased by $7.8 million, or 66%, in the three months ended March 31, 2016 compared to the same period last year. Personnel costs increased by $4.1 million due to increase in headcount in order to support our expanding business. In addition, we also incurred $3.0 million in expenses related to business process design and reengineering in preparation of implementing a new ERP system. As a percentage of total revenue, we expect general and administrative expense to remain at a relatively comparable level during the remainder of 2016.

Restructuring charges

Restructuring charges of $0.3 million in the three months ended March 31, 2016 primarily relate to the continued restructuring activities related to the acquisition of Meru and reducing our combined cost structure relative to Meru. See Note 9 to the condensed consolidated financial statements for additional details, including types of expenses incurred and the timing of future expenses and cash payments. See also the “Liquidity and Capital Resources” section of this Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Table of Contents

Interest income and other expense—net



	Three Months Ended
	March 31, 2016			March 31, 2015			Change			% Change
	(in thousands, except percentages)
Interest income	$	1,746		$	1,422		$	324		23	%
Other expense—net	(1,312		)	(677		)	(635		)	94

Interest income increased in the three months ended March 31, 2016 compared to the same period last year due to interest earned on higher invested balances of cash, cash equivalents and investments. Interest income varies depending on our average investment balances during the period, types and mix of investments, and market interest rates. The increase in Other expense—net in the three months ended March 31, 2016 as compared to the same period last year was the result of higher foreign currency exchange losses. Other expense—net consisted primarily of foreign exchange and related hedging gains and losses.

Provision for (benefit from) income taxes



	Three Months Ended						Change			% Change
	March 31, 2016			March 31, 2015			Change			% Change
	(in thousands, except percentages)
Provision for (benefit from) income taxes	$	(1,809	)	$	83		$	(1,892	)	*
Effective tax rate (%)	35		%	5		%	30		%	—

* not meaningful

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

Within the next twelve months, we do not believe there will be a decrease in uncertain tax benefits that could significantly impact our effective tax rate.

Table of Contents

Liquidity and Capital Resources



	As of
	March 31, 2016		December 31, 2015
	(in thousands)
Cash and cash equivalents	$	568,008	$	543,277
Investments	626,479		621,033
Total cash, cash equivalents and investments	$	1,194,487	$	1,164,310
Working capital	$	598,359	$	591,873

	Three Months Ended