Edgar Filing: FORTINET INC

Document

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, 2017



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, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth 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
Non-accelerated filer	o	(Do not check if smaller reporting company)	Emerging growth company	o

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If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 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 28, 2017, there were 175,760.937 shares of the registrant’s common stock outstanding.

FORTINET, INC.

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended March 31, 2017

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		Page

	Part I

Item 1.	Financial Statements	1
	Condensed Consolidated Balance Sheets as of March 31, 2017 and December 31, 2016	1
	Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2017 and 2016	2
	Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2017 and 2016	3
	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2017 and 2016	4
	Notes to Condensed Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	30
Item 4.	Controls and Procedures	31

	Part II

Item 1.	Legal Proceedings	32
Item 1A.	Risk Factors	32
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	57
Item 6.	Exhibits	57
	Signatures	58

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Part I


ITEM 1.	Financial Statements

FORTINET, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited, in thousands, except per share amounts)



	March 31, 2017			December 31, 2016
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	823,249		$	709,003
Short-term investments	375,423			376,522
Accounts receivable—Net of reserves for sales returns and doubtful accounts of $11,685 and $11,235 at March 31, 2017 and December 31, 2016, respectively	270,111			312,998
Inventory	104,978			106,887
Prepaid expenses and other current assets	42,321			33,306
Total current assets	1,616,082			1,538,716
LONG-TERM INVESTMENTS	242,333			224,983
DEFERRED TAX ASSETS	199,186			182,745
PROPERTY AND EQUIPMENT—NET	155,476			137,249
OTHER INTANGIBLE ASSETS—NET	22,535			24,828
GOODWILL	14,553			14,553
OTHER ASSETS	17,218			16,867
TOTAL ASSETS	$	2,267,383		$	2,139,941

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	48,689		$	56,732
Accrued liabilities	43,449			35,640
Accrued payroll and compensation	73,204			78,138
Income taxes payable	14,129			13,588
Deferred revenue	677,114			645,342
Total current liabilities	856,585			829,440
DEFERRED REVENUE	420,937			390,007
INCOME TAX LIABILITIES	72,993			68,551
OTHER LIABILITIES	18,619			14,262
Total liabilities	1,369,134			1,302,260
COMMITMENTS AND CONTINGENCIES (Note 9)
STOCKHOLDERS’ EQUITY:
Common stock, $0.001 par value—300,000 shares authorized; 175,443 and 173,078 shares issued and outstanding at March 31, 2017 and December 31, 2016, respectively	175			173
Additional paid-in capital	850,226			800,653
Accumulated other comprehensive loss	(489		)	(765		)
Retained earnings	48,337			37,620
Total stockholders’ equity	898,249			837,681
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	2,267,383		$	2,139,941

See notes to condensed consolidated financial statements.

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FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited, in thousands, except per share amounts)



	Three Months Ended
	March 31, 2017			March 31, 2016
REVENUE:
Product	$	135,253		$	124,572
Service	205,323			160,004
Total revenue	340,576			284,576
COST OF REVENUE:
Product	55,297			49,313
Service	35,267			28,331
Total cost of revenue	90,564			77,644
GROSS PROFIT:
Product	79,956			75,259
Service	170,056			131,673
Total gross profit	250,012			206,932
OPERATING EXPENSES:
Research and development	51,195			44,754
Sales and marketing	170,400			146,103
General and administrative	22,577			19,439
Restructuring charges	430			328
Total operating expenses	244,602			210,624
OPERATING INCOME (LOSS)	5,410			(3,692		)
INTEREST INCOME	2,392			1,746
OTHER INCOME (EXPENSE)—NET	302			(1,312		)
INCOME (LOSS) BEFORE INCOME TAXES	8,104			(3,258		)
BENEFIT FROM INCOME TAXES	(2,613		)	(5,376		)
NET INCOME	$	10,717		$	2,118
Net income per share (Note 7):
Basic	$	0.06		$	0.01
Diluted	$	0.06		$	0.01
Weighted-average shares outstanding:
Basic	174,489			171,745
Diluted	178,278			174,421

See notes to condensed consolidated financial statements.

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FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited, in thousands)



	Three Months Ended
	March 31, 2017		March 31, 2016
Net income	$	10,717	$	2,118
Other comprehensive income:
Change in unrealized loss on investments	425		1,888
Tax provision related to change in unrealized loss on investments	149		661
Other comprehensive income—net of taxes	276		1,227
Comprehensive income	$	10,993	$	3,345

See notes to condensed consolidated financial statements.

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FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in thousands)



	Three Months Ended
	March 31, 2017			March 31, 2016
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	10,717		$	2,118
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	13,493			10,550
Amortization of investment premiums	973			1,497
Stock-based compensation	33,331			28,902
Other non-cash items—net	1,469			(372		)
Changes in operating assets and liabilities:
Accounts receivable—net	42,437			38,920
Inventory	(3,545		)	(527		)
Deferred tax assets	(16,589		)	(16,709		)
Prepaid expenses and other current assets	(8,261		)	1,029
Other assets	653			(911		)
Accounts payable	(8,287		)	(11,426		)
Accrued liabilities	2,923			300
Accrued payroll and compensation	(5,267		)	(2,945		)
Other liabilities	(1,057		)	(1,332		)
Deferred revenue	61,776			46,106
Income taxes payable	4,983			5,391
Net cash provided by operating activities	129,749			100,591
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of investments	(133,006		)	(115,672		)
Sales of investments	6,000			2,867
Maturities of investments	109,207			108,557
Purchases of property and equipment	(13,526		)	(29,956		)
Net cash used in investing activities	(31,325		)	(34,204		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock	29,515			17,785
Taxes paid related to net share settlement of equity awards	(13,693		)	(9,441		)
Repurchase and retirement of common stock	—			(50,000		)
Net cash provided by (used in) financing activities	15,822			(41,656		)
NET INCREASE IN CASH AND CASH EQUIVALENTS	114,246			24,731
CASH AND CASH EQUIVALENTS—Beginning of period	709,003			543,277
CASH AND CASH EQUIVALENTS—End of period	$	823,249		$	568,008
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Liability for purchase of property and equipment	$	18,704		$	7,843
Transfers of evaluation units from inventory to property and equipment	$	5,681		$	6,671

See notes to condensed consolidated financial statements.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Preparation—The unaudited condensed consolidated financial statements of Fortinet, Inc. and its wholly owned subsidiaries (collectively, “we,” “us” or “our”) have been prepared in accordance with 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 (the “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, 2016, contained in our Annual Report on Form 10-K filed with the SEC on March 1, 2017. 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, 2017 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, 2016 is derived from the audited consolidated financial statements for the year ended December 31, 2016.

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, 2017, except for changes to our policies related to inventory and business combinations. For more information, refer to the “Recently Adopted Accounting Standards.”

Recently Adopted Accounting Standards

In January 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) ASU 2017-01—Business Combinations: Clarifying the Definition of a Business, which clarifies the definition of a business to assist organizations with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill and consolidation. We elected to early adopt ASU 2017-01 on a prospective basis beginning on January 1, 2017. The adoption of ASU 2017-01 did not have a material impact on our consolidated financial statements.

In July 2015, the FASB issued ASU 2015-11—Inventory: Simplifying the Measurement of Inventory, which requires entities to measure most inventory at the lower of cost and net realizable value, replacing the former methodology of measuring inventory at the lower of cost or market. We adopted ASU 2015-11 on a prospective basis beginning on January 1, 2017. The adoption of ASU 2015-11 did not have a significant impact on our consolidated financial statements.

Recent Accounting Standards Not Yet Effective

In January 2017, the FASB issued ASU 2017-04—Intangibles - Goodwill and Other: Simplifying the Test for Goodwill Impairment. ASU 2017-04 eliminates Step 2 from the goodwill impairment test which measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. Under ASU 2017-04, an entity should perform its annual or interim goodwill impairment test by comparing the fair value of the reporting unit with its carrying amount, and should recognize an impairment loss for the amount by which the carrying amount exceeds the reporting unit’s fair value, with the loss not exceeding the total amount of goodwill allocated to that reporting unit. ASU 2016-06 will be effective for us beginning on January 1, 2020. Early adoption is permitted for interim or annual goodwill impairment tests performed after January 1, 2017. At adoption, this update will require a prospective approach. We intend to adopt ASU 2017-04 in the fourth quarter of 2017. We do not believe that ASU 2017-04 will have a material impact on our consolidated financial statements.

In October 2016, the FASB issued ASU 2016-16—Income Taxes: —Intra-Entity Transfer of Assets Other Than Inventory, which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

inventory, when the transfer occurs. ASU 2016-06 will be effective for us beginning on January 1, 2018. We are currently evaluating the impact of adopting ASU 2016-16 on our consolidated financial statements.

In June 2016, the FASB issued ASU 2016-13—Financial Instruments—Credit Losses—Measurement of Credit Losses on Financial Instruments, which requires measurement and recognition of expected credit losses for financial assets held. ASU 2016-13 is effective for us beginning on January 1, 2020, with the option to adopt early on January 1, 2019. We are currently evaluating the impact of adopting ASU 2016-13 on our consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02—Leases, which requires the recognition of right-of-use assets and lease liabilities on the consolidated balance sheet for substantially all leases. The new guidance includes a number of optional practical expedients that entities may elect to apply. 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. We currently anticipate to early adopt ASU 2016-02 on January 1, 2018. Our ability to early adopt is dependent on system readiness, including software procured from third-party providers, if any, and the completion of our analysis of information necessary to quantify the impact on the prior period financial statements. Based on our current lease portfolio, we estimate the value of leased assets and liabilities that may be recognized could be at least $50.0 million. We are continuing to evaluate the impact of ASU 2016-02 and our estimate is subject to change. We do not believe that ASU 2016-02 will have a material impact on our consolidated statements of operations.

In May 2014, the FASB issued ASU 2014-09—Revenue from Contracts with Customers, which outlines a single, comprehensive model for entities to use in accounting for revenue arising from contracts with customers. The core principle of ASU 2014-09 is to recognize revenue when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, accordingly, it is possible more judgment and estimates may be required within the revenue recognition process than is required under existing U.S. GAAP, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. The FASB has recently issued several amendments to ASU 2014-09, including clarification on accounting for licenses of intellectual property and identifying performance obligations. ASU 2014-09 will be effective for us beginning January 1, 2018.

The two permitted transition methods under ASU 2014-09 are the full retrospective method, in which case ASU 2014-09 would be applied to each prior reporting period presented and the cumulative effect of applying ASU 2014-09 would be recognized at the earliest period shown, or the modified retrospective method, in which case the cumulative effect of applying ASU 2014-09 would be recognized at the date of initial application. Currently, we are in the process of reviewing our historical contracts to quantify the impact on our consolidated financial statements. Depending on the results of our review, there could be changes to the timing of revenue recognition and certain sales commission and related costs associated with obtaining and fulfilling our customer contracts. These changes may include the acceleration of revenue and associated costs on sales to certain channel partners that are currently accounted for only once the product is sold through to the end-customer. We will be required to capitalize and amortize incremental costs related to obtaining customer contracts, such as sales commission costs. We are also in the process of assessing the appropriate changes to our business processes and upgrading our systems and controls to support recognition and disclosure under ASU 2014-09. We otherwise expect to complete our assessment process, including selecting a transition method for adoption, in the next two quarters of 2017.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

2. FINANCIAL INSTRUMENTS AND FAIR VALUE

The following tables summarize our investments (in thousands):



	March 31, 2017
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Corporate debt securities	$	405,681	$	80	$	(754	)	$	405,007
Commercial paper	110,434		68		(26		)	110,476
U.S. government and agency securities	55,764		2		(89		)	55,677
Municipal bonds	46,227		24		(59		)	46,192
Certificates of deposit and term deposits ⁽¹⁾	404		—		—			404
Total available-for-sale securities	$	618,510	$	174	$	(928	)	$	617,756

	December 31, 2016
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Corporate debt securities	$	379,494	$	43	$	(925	)	$	378,612
Commercial paper	95,110		23		(25		)	95,108
U.S. government and agency securities	64,604		16		(79		)	64,541
Municipal bonds	59,257		3		(235		)	59,025
Certificates of deposit and term deposits ⁽¹⁾	4,219		—		—			4,219
Total available-for-sale securities	$	602,684	$	85	$	(1,264	)	$	601,505

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

The following tables show the gross unrealized losses and the related fair values of our investments that have been in a continuous unrealized loss position (in thousands):



	March 31, 2017
	Less Than 12 Months					12 Months or Greater					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
Corporate debt securities	$	325,615	$	(751	)	$	11,751	$	(3	)	$	337,366	$	(754	)
U.S. government and agency securities	46,388		(89		)	—		—			46,388		(89		)
Municipal bonds	26,833		(59		)	—		—			26,833		(59		)
Commercial paper	31,172		(26		)	—		—			31,172		(26		)
Total available-for-sale securities	$	430,008	$	(925	)	$	11,751	$	(3	)	$	441,759	$	(928	)

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



	December 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	$	311,980	$	(910	)	$	13,541	$	(15	)	$	325,521	$	(925	)
Municipal bonds	52,200		(235		)	—		—			52,200		(235		)
U.S. government and agency securities	33,430		(79		)	—		—			33,430		(79		)
Commercial paper	17,394		(25		)	—		—			17,394		(25		)
Total available-for-sale securities	$	415,004	$	(1,249	)	$	13,541	$	(15	)	$	428,545	$	(1,264	)

The contractual maturities of our investments were as follows (in thousands):



	March 31, 2017		December 31, 2016
Due within one year	$	375,423	$	376,522
Due within one to three years	242,333		224,983
Total	$	617,756	$	601,505

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 comprehensive income. Realized gains and losses on available-for-sale securities are insignificant in the periods presented and are included in Other income (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, 2017.

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.

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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 tables present the fair value of our financial assets measured at fair value on a recurring basis as of March 31, 2017 and December 31, 2016 (in thousands):



	March 31, 2017								December 31, 2016
	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	$	405,007	$	—	$	405,007	$	—	$	378,612	$	—	$	378,612	$	—
Commercial paper	119,965		—		119,965		—		105,097		—		105,097		—
U.S. government and agency securities	55,677		45,222		10,455		—		64,541		52,082		12,459		—
Municipal bonds	46,192		—		46,192		—		59,025		—		59,025		—
Money market funds	21,069		21,069		—		—		38,649		38,649		—		—
Certificates of deposit and term deposits	404		—		404		—		4,219		—		4,219		—
Total	$	648,314	$	66,291	$	582,023	$	—	$	650,143	$	90,731	$	559,412	$	—

Reported as:
Cash equivalents	$	30,558							$	48,638
Short-term investments	375,423								376,522
Long-term investments	242,333								224,983
Total	$	648,314							$	650,143

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the three months ended March 31, 2017.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

3. INVENTORY

Inventory consisted of the following (in thousands):



	March 31, 2017		December 31, 2016
Raw materials	$	16,540	$	18,924
Finished goods	88,438		87,963
Inventory	$	104,978	$	106,887

4. PROPERTY AND EQUIPMENT—NET

Property and equipment—net consisted of the following (in thousands):



	March 31, 2017			December 31, 2016
Computer equipment and software	$	70,048		$	65,323
Building and building improvements	56,373			49,783
Land	44,198			35,079
Leasehold improvements	20,542			18,699
Evaluation units	19,701			20,173
Furniture and fixtures	14,153			13,995
Construction-in-progress	6,201			4,669
Total property and equipment	231,216			207,721
Less: accumulated depreciation	(75,740		)	(70,472		)
Property and equipment—net	$	155,476		$	137,249

Depreciation expense was $11.2 million and $9.4 million for the three months ended March 31, 2017 and March 31, 2016, respectively.

5. INVESTMENTS IN PRIVATELY HELD COMPANIES

Our investments in the equity securities of privately held companies totaled $11.3 million and $10.3 million as of March 31, 2017 and December 31, 2016, respectively. These investments are accounted for as cost-basis investments, as we own less than 20% of the voting securities in each these investments 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 sheets and would be measured at fair value if indicators of impairment existed. As of March 31, 2017, no events have occurred that would adversely affect the carrying value of these investments.

As of March 31, 2017, 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 are not required to be consolidated in our condensed consolidated financial statements.

6. GOODWILL AND OTHER INTANGIBLE ASSETS—NET

Goodwill

As of March 31, 2017, we had goodwill of $14.6 million. There were no impairments to goodwill during the three months ended March 31, 2017 or during previous periods.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Other Intangible Assets—net

The following tables present other intangible assets—net as of March 31, 2017 and December 31, 2016 (in thousands, except years):



	March 31, 2017
	Weighted-Average Useful Life (in Years)	Gross		Accumulated Amortization		Net
Other intangible assets—net:
Finite-lived intangible assets:
Developed technologies and other	3.8	$	23,984	$	10,000	$	13,984
Customer relationships	4.7	14,500		7,549		6,951
		38,484		17,549		20,935

Indefinite-lived intangible assets:
In-process research and development		1,600		—		1,600
Total other intangible assets—net		$	40,084	$	17,549	$	22,535



	December 31, 2016
	Weighted-Average Useful Life (in Years)	Gross		Accumulated Amortization		Net
Other intangible assets—net:
Finite-lived intangible assets:
Developed technologies and other	3.8	$	23,984	$	8,750	$	15,234
Customer relationships	4.7	14,500		6,506		7,994
		38,484		15,256		23,228

Indefinite-lived intangible assets:
In-process research and development		1,600		—		1,600
Total other intangible assets—net		$	40,084	$	15,256	$	24,828

Amortization expense was $2.3 million and $1.2 million during the three months ended March 31, 2017 and March 31, 2016, respectively. The following table summarizes estimated future amortization expense of finite-lived intangible assets—net (in thousands):



	Amount
Years:
2017 (remainder)	$	6,280
2018	6,885
2019	5,406
2020	2,364
Total	$	20,935

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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 restricted stock units (“RSUs”), stock options 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
	March 31, 2017		March 31, 2016
Numerator:
Net income	$	10,717	$	2,118

Denominator:
Basic shares:
Weighted-average common stock outstanding-basic	174,489		171,745
Diluted shares:
Weighted-average common stock outstanding-basic	174,489		171,745
Effect of potentially dilutive securities:
RSUs	2,216		1,020
Stock options	1,523		1,632
ESPP	50		24
Weighted-average shares used to compute diluted net income per share	178,278		174,421
Net income per share:
Basic	$	0.06	$	0.01
Diluted	$	0.06	$	0.01

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
	March 31, 2017	March 31, 2016
RSUs	2,505	6,351
Stock options	1,118	1,559
ESPP	262	282
	3,885	8,192

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

8. RESTRUCTURING CHARGES

In 2016 and 2015, we implemented plans to restructure and further improve efficiencies in our operations due primarily to acquisitions. The remaining restructuring reserve as of March 31, 2017 is included in accrued liabilities on the condensed consolidated balance sheets and is expected to be paid in 2017. Restructuring charges related to these plans consisted primarily of employee severance and other one-time benefits paid in cash and are included in operating expense in the condensed consolidated statements of operations.

Activities related to the restructuring actions are summarized as follows (in thousands):



	Three Months Ended
	March 31, 2017			March 31, 2016
Balance at beginning of period	$	1,151		$	3,918
Costs incurred	430			328
Cash payments	(567		)	(1,407		)
Non-cash items	—			(89		)
Balance at end of period	$	1,014		$	2,750

9. COMMITMENTS AND CONTINGENCIES

The following table summarizes our future principal contractual obligations as of March 31, 2017 (in thousands):



	Total		2017 (remainder)		2018		2019		2020		2021		Thereafter
Operating lease commitments	$	61,354	$	13,083	$	14,401	$	11,972	$	9,497	$	4,088	$	8,313
Inventory purchase commitments	68,846		68,846		—		—		—		—		—
Other contractual commitments and open purchase orders	71,534		60,959		8,402		1,522		560		91		—
Total	$	201,734	$	142,888	$	22,803	$	13,494	$	10,057	$	4,179	$	8,313

Operating Leases—We lease certain facilities under various non-cancelable operating leases, which expire through 2024. 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 $4.5 million and $4.6 million during the three months ended March 31, 2017 and March 31, 2016, 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, 2017, we had $68.8 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, 2017, we had $71.5 million in other contractual commitments that may not be cancelable. We also had other contractual commitments for the purchase of certain real estate properties adjacent to our corporate headquarters amounting to $12.8 million, which we capitalized as part of property and equipment.

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

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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. As required under ASC 450, Contingencies, issued by the FASB, we accrue for contingencies when we believe that a loss is probable and that we can reasonably estimate the amount of any such loss.

In October 2016, we received a letter from the United States Attorney’s Office for the Northern District of California requesting information relating to our compliance with the Trade Agreements Act. This inquiry is ongoing and we are fully cooperating with this inquiry.

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 material awards under such indemnification provisions.

10. STOCKHOLDERS’ EQUITY

Stock-Based Compensation Plans

We have stock-based compensation plans pursuant to which we have granted stock options and RSUs. We also have an ESPP for all eligible employees. As of March 31, 2017, there were a total of 50,087,833 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 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, 2016	9,509		$	31.01
Granted	2,582		37.21
Forfeited	(301	)	33.80
Vested	(1,299	)	27.43
Balance—March 31, 2017	10,491		$	33.04

As of March 31, 2017, total compensation expense related to unvested RSUs that were granted to employees and non-employees under the 2009 Plan, but not yet recognized, was $310.3 million. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 2.9 years.

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.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



	Three Months Ended
	March 31, 2017		March 31, 2016
Shares withheld for taxes	413		343
Amount withheld for taxes	$	13,693	$	9,441

Employee Stock Options

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



	Three months Ended
	March 31, 2017		March 31, 2016
Expected term in years	4.4		4.3
Volatility	36	%	43	%
Risk-free interest rate	1.9	%	1.1	%
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, 2016	6,187		$	23.79
Granted	498		37.24
Forfeited	(46	)	27.24
Exercised	(855	)	14.67
Balance—March 31, 2017	5,784		$	26.27
Options vested and expected to vest—March 31, 2017	5,784		$	26.27	3.4	$	71,951
Options exercisable—March 31, 2017	3,820		$	23.91	2.2	$	56,071

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, 2017, for all in-the-money stock options. As of March 31, 2017, 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 3.0 years.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



	Three Months Ended
	March 31, 2017		March 31, 2016
Weighted-average fair value per share granted	$	12.22	$	8.68
Intrinsic value of options exercised	17,898		19,424
Fair value of options vested	3,395		2,084

Employee Stock Purchase Plan

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



	Three Months Ended
	March 31, 2017		March 31, 2016
Expected term in years	0.5		0.5
Volatility	33	%	48	%
Risk-free interest rate	0.7	%	0.4	%
Dividend rate	—	%	—	%

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



	Three Months Ended
	March 31, 2017		March 31, 2016
Weighted-average fair value per share granted	$	9.28	$	7.19
Shares issued under the ESPP	634		614
Weighted-average price per share issued	$	27.97	$	20.49

Stock-based Compensation Expense

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



	Three Months Ended
	March 31, 2017		March 31, 2016
Cost of product revenue	$	342	$	280
Cost of service revenue	2,310		2,134
Research and development	7,898		7,143
Sales and marketing	19,026		15,815
General and administrative	3,755		3,530
Total stock-based compensation expense	$	33,331	$	28,902

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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
	March 31, 2017		March 31, 2016
RSUs	$	29,041	$	25,103
Stock options	1,845		1,954
ESPP	2,445		1,845
Total stock-based compensation expense	$	33,331	$	28,902

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



	Three Months Ended
	March 31, 2017		March 31, 2016
Income tax benefit associated with stock-based compensation	$	6,645	$	7,321

Share Repurchase Program

In January 2016, our board of directors approved the 2016 Share Repurchase Program (the “2016 Repurchase Program”), which authorizes the repurchase of up to $200.0 million of our outstanding common stock through December 31, 2017. In October 2016, our board of directors authorized the purchase of an additional $100.0 million of shares of our common stock under the 2016 Repurchase Program, increasing our current authorization to $300.0 million through December 31, 2017. Under the 2016 Repurchase Program, share repurchases may be made by us from time to time in privately negotiated transactions or in open market transactions. The 2016 Repurchase 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. There were no shares repurchased under the 2016 Repurchase Program during the three months ended March 31, 2017. As of March 31, 2017, $189.2 million remained available for future share repurchases under the 2016 Repurchase Program.

11. INCOME TAXES

Our effective tax rate was a benefit of (32)% for the three months ended March 31, 2017, compared to an effective tax rate of 165% for the same period last year. The effective tax rates for the periods presented are comprised of U.S. federal and state taxes, withholding taxes and foreign income taxes. The tax rate for the three months ended March 31, 2017 was impacted by the excess tax benefits of $5.5 million on stock options, which was a significant benefit on our income before income taxes. The tax rate for the three months ended March 31, 2016 was also impacted by significant excess tax benefits of $3.6 million on stock options on our loss before income taxes.

As of March 31, 2017 and December 31, 2016, unrecognized tax benefits were $69.4 million and $65.5 million, respectively. The total amount of $67.7 million in unrecognized tax benefits, if recognized, would favorably affect our effective tax rate.

It is our policy to classify accrued interest and penalties related to uncertain tax benefits in the provision for income taxes. As of March 31, 2017 and December 31, 2016, accrued interest and penalties were $10.5 million and $9.5 million, respectively.

As of March 31, 2017, there was no unrecognized tax benefits that we expect would change significantly over the next 12 months.

We file income tax returns in the U.S. federal jurisdiction and in various U.S. state and foreign jurisdictions. Generally, we are no longer subject to U.S. state and 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 income tax authorities for tax years prior to 2012. We are currently under examination by U.S federal income tax authorities for tax years 2012, 2013 and 2014. We have filed a waiver extending the statute of limitations to September 15, 2018 for U.S. federal income tax returns for tax years 2012 and 2013. In addition, the tax authorities in France are examining the inter-company relationship between Fortinet, Inc., Fortinet France and

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Fortinet Singapore. Subsequent to the three months ended March 31, 2017, we received a notice from the French tax authorities that an audit was officially opened for tax years from 2007 to 2015. Our Japan tax audit for tax years 2013, 2014 and 2015 was closed with no material adjustment.

12. 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 our 401(k) Plan and the RRSP for the three months ended March 31, 2017 and March 31, 2016 were $1.3 million and $1.0 million, respectively.

13. 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, 2017		March 31, 2016
Americas:
U.S.	$	90,772	$	75,558
Canada	37,345		31,305
Latin America (“LATAM”)	18,247		13,183
Total Americas	146,364		120,046
Europe, Middle East and Africa (“EMEA”)	126,149		105,491
Asia Pacific (“APAC”)	68,063		59,039
Total revenue	$	340,576	$	284,576



Property and Equipment—net	March 31, 2017		December 31, 2016
Americas:
U.S.	$	111,464	$	96,414
Canada	16,274		12,881
LATAM	475		607
Total Americas	128,213		109,902
EMEA:
France	12,854		13,241
Other EMEA	6,232		6,391
Total EMEA	19,086		19,632
APAC	8,177		7,715
Total property and equipment—net	$	155,476	$	137,249

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



	Three Months Ended
	March 31, 2017		March 31, 2016
Exclusive Networks Group	20	%	19	%
Fine Tec Computers	12	%	*

* Represents less than 10%

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



	March 31, 2017		December 31, 2016
Exclusive Networks Group	22	%	26	%
Fine Tec Computers	15	%	10	%

14. ACCUMULATED OTHER COMPREHENSIVE LOSS

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



	March 31, 2017
	Unrealized losses on investments			Tax provision related to items of other comprehensive income or loss			Total
Beginning balance	$	(1,179	)	$	414		$	(765	)
Other comprehensive income before reclassifications	424			(149		)	275
Amounts reclassified from accumulated other comprehensive loss	1			—			1
Net current-period other comprehensive income	425			(149		)	276
Ending balance	$	(754	)	$	265		$	(489	)

Amounts reclassified from accumulated other comprehensive loss for unrealized losses on investments and tax provision related to items of other comprehensive income or loss are recorded in Other income (expense)—net and in Benefit from income taxes, respectively.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

15. 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 were $0.1 million and $0.3 million during the three months ended March 31, 2017 and March 31, 2016, respectively. Of such amounts, $0.2 million was incurred under contingent fee arrangements in the three months ended March 31, 2016. There were no expenses incurred under contingent fee arrangements during the three months ended March 31, 2017. Amounts due and payable to the law firm were $0.1 million as of March 31, 2017 and December 31, 2016.

16. SUBSEQUENT EVENT

In April 2017, we purchased real estate property in Vancouver, Canada totaling approximately 282,000 square feet for a total cash payment of approximately $85.0 million.

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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 Securities and Exchange Act of 1934 (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 and services;


•	the impact of macro-economic and geopolitical factors on our international sales;


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


•	the impact of our product innovation strategy;


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


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


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


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


•	continued investments in research and development;


•	managing our 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 real estate and other capital expenditures and the impact on free cash flows;


•	competition in our markets;


•	integration of acquired companies and technologies and expectations related to acquisitions;


•	success and expansion of our enterprise resource planning 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;


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


•	adoption of new accounting standards, including those related to revenue recognition and accounting for leases.

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

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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 Securities and Exchange Commission (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.

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 2016 Fortune 100. Our cybersecurity solutions are designed to provide broad, rapid protection against dynamic and sophisticated security threats, while simplifying the information technology (“IT”) and security infrastructure of our end-customers.

The three key areas driving our business are the changing cyber threat landscape, expanding need for regulatory compliance and evolving network security infrastructure. The cyber threat landscape continues to change at a rapid pace, with network attacks continually morphing into vehicles for malware, such as ransomware, and the challenge of having to comply with a variety of constantly changing regulatory requirements. Our end-customers’ infrastructures are rapidly evolving to leverage new technologies such as on-demand cloud and internet on demand, and changing web traffic patterns require end-customers to increase the bandwidth available across their network. These three drivers mean end-customers are constantly evaluating upgrades or deployments of new cybersecurity solutions.

The Fortinet Security Fabric has been developed to provide unified security across the entire network, including network core, endpoints, applications, data centers, access and private and public cloud, and is designed to enable traditionally disparate security devices to work together as an integrated and collaborative whole. It delivers integrated scalability, access control, awareness, security, traffic segmentation, centralized management and orchestration. It is built around an open framework to ensure interoperability and synchronization of intelligence and response, and does so across the distributed network security infrastructure, including both from the cloud and for the cloud. At the core of the Fortinet Security Fabric are our FortiGate physical products and software licenses, which ship with a broad set of security services, including firewall, virtual private network, anti-malware, anti-spam, application control, intrusion prevention, access control, web filtering, traffic and device segmentation and advanced threat protection (“ATP”). Through these security services, our FortiGuard Labs team provides updates using threat research and a global cloud network of data collection and intelligence resources to deliver subscription-based security services to FortiGate appliances and software products. We continually certify the security effectiveness of our security updates through independent test organizations, such as NSS Labs. Our FortiOS operating system provides the foundation for all FortiGate security functions. The latest enhancements to the FortiOS 5.6 offers end-customers the ability to manage security capabilities across their cloud assets’ and software-defined wireless area networks.

Enterprise customers select the form and deployment method 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, an internal segmentation firewall between network zones, a distributed enterprise firewall at branch sites or software- and hardware-based solutions designed for virtualized and cloud environments. Many smaller businesses also tend to deploy unified threat management devices. 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 medium-sized businesses, to the FortiGate-1000 to -7000 series for large enterprises 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 application control, anti-virus, intrusion prevention, web filtering and anti-spam functionality. End-customers may also purchase FortiManager and FortiAnalyzer products in conjunction with a FortiGate deployment to provide enterprise-class centralized management, analysis and reporting capabilities. FortiSIEM provides organizations with a solution for analyzing and managing network security, performance and compliance standards across our and other vendors’ products. Finally, end-customers may purchase FortiCare technical support services for our products and FortiCare professional services to assist in the design, implementation and maintenance of their networks.

We complement our core FortiGate product line with other products and software that offer additional protection from security threats to other critical areas of the enterprise. These products include our FortiMail email security, FortiSandbox ATP, FortiWeb web application firewall and FortiDDoS security appliances, as well as our FortiClient endpoint security software, FortiSIEM software, FortiAP secure wireless access points and FortiSwitch secure switch connectivity products. Our technology also positions us to deliver security to the cloud and for the cloud. Sales of our cloud-related products and services across public, private and hybrid cloud environments continue to grow faster on a percentage basis than other parts of our business.

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Financial Highlights

•

We recorded total revenue of $340.6 million in the three months ended March 31, 2017, an increase of 20% compared to the same period last year. Product revenue was $135.3 million in the three months ended March 31, 2017, an increase of 9% compared to the same period last year. Service revenue was $205.3 million in the three months ended March 31, 2017, an increase of 28% compared to the same period last year.


•	Cash, cash equivalents and investments were $1.44 billion as of March 31, 2017, an increase of $130.5 million, or 10%, from December 31, 2016.


•	Deferred revenue was $1.10 billion as of March 31, 2017, an increase of $62.7 million, or 6%, from December 31, 2016.


•	We generated cash flows from operating activities of $129.7 million in the three months ended March 31, 2017, an increase of $29.2 million, or 29%, compared to the same period last year.

During the three months ended March 31, 2017, our revenue growth was driven by the strength in sales of our products, including FortiGate products, our renewals of service contracts and the sale of our enterprise bundles. Our high-end products accounted for 36% of billings, which reflected strong sales to large enterprises and an increase in large deals. Our mid-range products accounted for 31% of billings, and our entry-level products accounted for 33% of billings. In addition, we continue to see a shift to higher services growth, which reflects our ongoing success in driving higher-priced subscription bundles and metered model business. On a geographic basis, revenue continues to be diversified globally, which remains a key strength of our business.

During the three months ended March 31, 2017, operating expenses increased by $34.0 million, or 16%, as compared to the same period last year. The increase was primarily driven by our investments made to expand our sales coverage, grow our marketing capabilities, develop new products and scale our customer support. We also continued to invest in research and development to strengthen our technology. We believe that continued product innovation has strengthened our technology and resulted in market share gains. Headcount increased by 1% to 4,711 employees and contractors as of March 31, 2017, up from 4,665 as of December 31, 2016.

Business Model

Our sales strategy is based on a distribution model whereby we primarily sell our products, software licenses 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 large service providers and major systems integrators. We also offer our products through Amazon Web Services and Microsoft Azure. While the revenue from such sales are still relatively insignificant, they have increased significantly in recent periods on a percentage basis and are aligned with the networking trends of our customers and the industry as a whole.

Typically, FortiGuard security subscription services and FortiCare technical support services are purchased along with our physical products and software licenses, most frequently as part of a bundle offering that includes hardware and services functionality. We generally invoice at the time of our sale for the total price of the products and security and technical support services, and the invoice is payable within 30 to 90 days. We also invoice certain software licenses and services on a monthly basis.

We generally recognize product revenue up front, and recognize revenue for the sale of new and the renewal of existing FortiGuard security subscription services and FortiCare technical support services contracts ratably. We recognize revenue for certain software licenses up front as product revenue and, to a lesser extent, recognize other software licenses over the term of the agreement as services revenue. We recognize the security and support revenue over the service period, which is typically one to three years, but 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 has contributed to our positive cash flow from operations.

Our approach to network security is defined by our Security Processing Unit (“SPU”) hardware architecture. The SPU includes three lines of proprietary Applications-Specific Integrated Circuits (“ASICs”), content processor, network processor and the system on a chip. The ASICs are designed for highly efficient execution of computationally intensive tasks such as policy enforcement, threat detection and encryption. As such ASIC based solutions can run many security applications simultaneously without a significant reduction in performance.

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Key Metrics

We monitor a number of key 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, 2017		March 31, 2016
	(in thousands)
Revenue	$	340,576	$	284,576
Deferred revenue	$	1,098,051	$	837,188
Billings (non-GAAP)	$	403,278	$	330,461
Cash, cash equivalents and investments	$	1,441,005	$	1,194,487
Net cash provided by operating activities	$	129,749	$	100,591
Free cash flow (non-GAAP)	$	116,223	$	70,635

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 over the contractual service period. We monitor our deferred revenue balance, growth and the mix of short-term and long-term deferred revenue because it represents a significant portion of revenue to be recognized in future periods. Deferred revenue was $1.10 billion as of March 31, 2017, an increase of $62.7 million, or 6%, from December 31, 2016.

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 drive 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 and are impacted by the term of security and support agreements. Second, we may calculate billings in a manner that is different from peer companies that report similar financial measures.

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, 2017		March 31, 2016
	(in thousands)
Billings:
Revenue	$	340,576	$	284,576
Add change in deferred revenue	62,702		45,885
Total billings (non-GAAP)	$	403,278	$	330,461

Free cash flow (non-GAAP). We define free cash flow as net cash provided by operating activities minus capital expenditures such as purchases of real estate and other property and equipment. We believe 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 capital expenditures, can be used for strategic opportunities, including investing in our business, making strategic acquisitions, repurchasing outstanding common stock and strengthening the balance sheet. However, free cash flow is not intended to represent our residual cash flow available for discretionary expenditures, since we may have other non-discretionary expenditures that are not deducted from the measure. A limitation of using free cash flow rather than the GAAP

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measure of net cash provided by operating activities 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” and by presenting cash flow from investing and financing activities in our reconciliation of free cash flows. In addition, it is important to note that other companies, including companies in our industry, may not use free cash flow, may calculate free cash flow in a different manner than we do or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of free cash flows as a comparative measure. 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, 2017			March 31, 2016
	(in thousands)
Free Cash Flow:
Net cash provided by operating activities	$	129,749		$	100,591
Less purchases of property and equipment	(13,526		)	(29,956		)
Free cash flow (non-GAAP)	$	116,223		$	70,635
Net cash used in investing activities	$	(31,325	)	$	(34,204	)
Net cash provided by (used in) financing activities	$	15,822		$	(41,656	)

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. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable 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 were no material changes to our critical accounting policies and estimates as of and for the three months ended March 31, 2017, as compared to the critical accounting policies and estimates described in our Annual Report on Form 10-K filed with the SEC on March 1, 2017 (the “Form 10-K”).

Recent Accounting Pronouncements

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

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Results of Operations

Three Months Ended March 31, 2017 and March 31, 2016

Revenue



	Three Months Ended
	March 31, 2017				March 31, 2016
	Amount		% of Revenue		Amount		% of Revenue		Change		% Change
	(in thousands, except percentages)
Revenue:
Product	$	135,253	40	%	$	124,572	44	%	$	10,681	9	%
Service	205,323		60		160,004		56		45,319		28
Total revenue	$	340,576	100	%	$	284,576	100	%	$	56,000	20	%
Revenue by geography:
Americas	$	146,364	43	%	$	120,046	42	%	$	26,318	22	%
Europe, Middle East and Africa	126,149		37		105,491		37		20,658		20
Asia Pacific	68,063		20		59,039		21		9,024		15
Total revenue	$	340,576	100	%	$	284,576	100	%	$	56,000	20	%

Total revenue increased by $56.0 million, or 20%, during the three months ended March 31, 2017 compared to the same period last year. On a geographic basis, we continued to experience diversification globally. Revenue from all our regions grew, with the Americas contributing the largest portion of our revenue growth both on an absolute dollar and on a percentage basis. Product revenue increased by $10.7 million, or 9%, in the three months ended March 31, 2017 compared to the same period last year. The increase in product revenue was primarily driven by the strength in sales of our FortiGate products and our enterprise bundles. Service revenue increased by $45.3 million, or 28%, in the three months ended March 31, 2017 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. We continued to see the shift from product revenue to higher-margin, recurring service revenue, which reflected our ongoing success in driving sales of enterprise bundles.

Cost of revenue and gross margin



	Three Months Ended
	March 31, 2017			March 31, 2016			Change			% Change
	(in thousands, except percentages)
Cost of revenue:
Product	$	55,297		$	49,313		$	5,984		12	%
Service	35,267			28,331			6,936			25
Total cost of revenue	$	90,564		$	77,644		$	12,920		17	%
Gross margin:
Product	59.1		%	60.4		%	(1.3		)%
Service	82.8			82.3			0.5
Total gross margin	73.4		%	72.7		%	0.7		%

Total gross margin increased by 0.7 percentage points in the three months ended March 31, 2017 compared to the same period last year. Product gross margin decreased by 1.3 percentage points in the three months ended March 31, 2017

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compared to the same period last year. The decrease in product gross margin was primarily due to higher inventory reserves and other charges.

Service gross margin increased by 0.5 percentage points in the three months ended March 31, 2017 as compared to the same period last year, as we scaled efficiencies resulting from an increased mix of higher-margin service revenue. Cost of service revenue increased by $6.9 million and was comprised primarily of personnel costs.

Operating expenses



	Three Months Ended								Change		% Change
	March 31, 2017				March 31, 2016
	Amount		% of Revenue		Amount		% of Revenue
	(in thousands, except percentages)
Operating expenses:
Research and development	$	51,195	15	%	$	44,754	16	%	$	6,441	14	%
Sales and marketing	170,400		50		146,103		51		24,297		17
General and administrative	22,577		7		19,439		7		3,138		16
Restructuring charges	430		—		328		—		102		31
Total operating expenses	$	244,602	72	%	$	210,624	74	%	$	33,978	16	%

Research and development

Research and development expense increased by $6.4 million, or 14%, in the three months ended March 31, 2017 compared to the same period last year, primarily due to an increase of $4.5 million in personnel costs as a result of increased headcount to support the development of new products and continued enhancements of our existing products. Historically, we have refreshed our ASICs on a three- to four-year cycle and the refreshes have demonstrated significant performance improvements. 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 2017.

Sales and marketing

Sales and marketing expense increased by $24.3 million, or 17%, in the three months ended March 31, 2017 compared to the same period last year, primarily due to an increase of $19.4 million in personnel costs as we continued to increase our sales and marketing headcount. In addition, amortization expense increased by $1.5 million related to intangible assets acquired from AccelOps, Inc. (“AccelOps”). As a percentage of total revenue, sales and marketing expense decreased as we focused on scaling our investments in our sales force and marketing programs. 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 decrease during the remainder of 2017.

General and administrative

General and administrative expense increased by $3.1 million, or 16%, in the three months ended March 31, 2017 compared to the same period last year. Personnel costs increased by $1.7 million as we continued to increase headcount. In addition, litigation settlement expense increased by $1.6 million. We also incurred expense of $1.1 million due to third-party costs related to the preparation and implementation of the new revenue recognition standards. As a percentage of total revenue, we expect general and administrative expense to increase during the remainder of 2017 as we continue to implement the new revenue recognition standard.

Restructuring

Restructuring expenses of $0.4 million in the three months ended March 31, 2017 primarily relate to our restructuring activities to improve operating efficiencies due to the acquisition of AccelOps and certain other activities. Restructuring charges of $0.3 million during the three months ended March 31, 2016 primarily related to continued restructuring activities related to the acquisition of Meru Networks, Inc. (“Meru”) and reducing our combined cost structure relative to Meru. See Note 8 of the

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notes to our condensed consolidated financial statements for additional details, including the types of expenses incurred and cash payments made. See also the “Liquidity and Capital Resources” below.

Interest income and other income (expense)—net



	Three Months Ended
	March 31, 2017		March 31, 2016			Change		% Change
	(in thousands, except percentages)
Interest income	$	2,392	$	1,746		$	646	37	%
Other income (expense)—net	302		(1,312		)	1,614		(123	)

Interest income increased by $0.6 million, or 37%, during the three months ended March 31, 2017 as 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 income (expense)—net in the three months ended March 31, 2017 as compared to the same period last year was the result of higher foreign currency exchange gains.

Benefit from income taxes



	Three Months Ended						Change			% Change
	March 31, 2017			March 31, 2016			Change			% Change
	(in thousands, except percentages)
Benefit from income taxes	$	(2,613	)	$	(5,376	)	$	2,763		(51	)%
Effective tax rate (%)	(32		)%	165.0		%	(197		)%	—

Our effective tax rate was a benefit of (32)% for the three months ended March 31, 2017, compared to an effective tax rate of 165% for the same period last year. The effective tax rates for the periods presented are comprised of U.S. federal and state taxes, withholding taxes and foreign income taxes. The tax rate for the three months ended March 31, 2017 is impacted by the excess tax benefits of $5.5 million on stock options, which was a significant benefit on our income before income taxes. The tax rate for the three months ended March 31, 2016 was also impacted by significant excess tax benefits of $3.6 million on stock options on our loss before income taxes.

Within the next 12 months, we do not believe there will be a decrease in uncertain tax benefits that could significantly impact our effective tax rate.

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Liquidity and Capital Resources



	As of
	March 31, 2017			December 31, 2016
	(in thousands)
Cash and cash equivalents	$	823,249		$	709,003
Investments	617,756			601,505
Total cash, cash equivalents and investments	$	1,441,005		$	1,310,508
Working capital	$	759,497		$	709,276

	Three Months Ended
	March 31, 2017			March 31, 2016
	(in thousands)
Cash provided by operating activities	$	129,749		$	100,591
Cash used in investing activities	(31,325		)	(34,204		)
Cash provided by (used in) financing activities	15,822			(41,656		)
Net increase in cash and cash equivalents	$	114,246		$	24,731

Liquidity and capital resources may be impacted by our operating activities, as well as by our business acquisitions, real estate and other capital expenditures, stock repurchases, proceeds associated with stock option exercises and issuances of common stock under our employee stock purchase plan (the “ESPP”), payment of taxes in connection with the net settlement of equity awards and investments in strategic relationships that we have made or may make in the future. As of March 31, 2017, $189.2 million remained available for future share repurchase under our 2016 Repurchase Program (the “2016 Repurchase Program”). In recent years we have received significant capital resources as a result of the exercise of stock options. We expect proceeds in future years to be impacted by the increased mix of restricted stock units (“RSUs”) granted versus stock options and also to vary based on our share price. In April 2017, we purchased a real estate in Vancouver, Canada for approximately $85.0 million which will affect our free cash flows in the second quarter of 2017. We expect our free cash flows to improve in the second half of 2017.

As of March 31, 2017, our cash, cash equivalents and investments of $1.44 billion were invested primarily in corporate debt securities, commercial paper, U.S. government and agency securities, municipal bonds, money market funds, certificates of deposit and term deposits. It is our investment policy to invest excess cash in a manner that preserves capital, provides liquidity and maximizes return without significantly increasing risk.

As of March 31, 2017, $599.5 million of our cash and investments were held by our international subsidiaries and are therefore not immediately available to fund domestic operations unless the cash is repatriated. While we do not intend to do so, should this amount be repatriated, most of it would be subject to U.S. federal income tax that would be partially offset by foreign tax credits. We do not enter into investments for trading or speculative purposes.

We believe that our existing cash and cash equivalents will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced products and services offerings, the costs to ensure access to adequate manufacturing capacity, the continuing market acceptance of our products and our investments in real estate through purchases or long-term leases. Historically, we have required capital principally to fund our working capital needs, capital expenditures, share repurchases and acquisition activities. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition would be adversely affected.

Operating Activities

Cash generated by operating activities is our primary source of liquidity. It is primarily comprised of net income, as adjusted for non-cash items, and changes in operating assets and liabilities. Non-cash adjustments consist primarily of stock-based compensation, depreciation of property and equipment and amortization of intangible assets.

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Our operating activities during the three months ended March 31, 2017 provided $129.7 million in cash as a result of our continued growth in the sales of FortiGuard security subscriptions and FortiCare support contracts, as well as product sales, and the ability to successfully manage our working capital. The increase in sales of our FortiGuard security subscription and FortiCare technical supports to new and existing customers was reflected in the increase in our deferred revenue. We continued to see the shift from product revenue to higher-margin, recurring service revenue. For example, our total revenue grew 20% during the three months ended March 31, 2017 compared to the same period last year, while our total deferred revenue balance grew 31% during the three months ended March 31, 207 compared to the same period last year.

Our operating activities during the three months ended March 31, 2016 provided $100.6 million in cash as a result of our continued growth in billings and our ability to successfully manage our working capital. Changes in operating assets and liabilities primarily resulted from an increase in payments received from customers, which was partially offset by an increase in payments to vendors.

Investing Activities

The changes in cash flows from investing activities primarily relate to timing of purchases, maturities and sales of investments and purchases of property and equipment. Historically, in making a lease versus purchase decision related to our larger facilities, we have elected to purchase the facility. We expect to make similar decisions in the future.

During the three months ended March 31, 2017, cash used for investing activities was primarily due to the $13.5 million we spent on capital expenditures and $17.8 million due to purchases, net of maturities, of our investments.

During the three months ended March 31, 2016, cash used for investing activities was primarily due to the $30.0 million we spent on capital expenditures, including our purchase of certain real property in Union City, California for total cash of $18.5 million. Cash outflows due to sales and maturities of our investments, net of purchases, amounted to $4.2 million.

Financing Activities

The changes in cash flows from financing activities primarily relate to proceeds from the issuance of common stock under our equity incentive plan and the ESPP, taxes paid related to net share settlement of equity awards, excess tax benefit from stock-based compensation and repurchase and retirement of common stock.

During the three months ended March 31, 2017, cash used for financing activities was $15.8 million, proceeds from the issuance of common stock, net of tax withholding.

During the three months ended March 31, 2016, cash used for financing activities was $41.7 million, primarily due to $50.0 million used to repurchase our common stock. This was partially offset by $8.3 million of proceeds from the issuance of common stock, net of taxes paid, related to withholding upon issuance of RSUs.

Contractual Obligations and Commitments

There were no material changes outside the ordinary course of business during the three months ended March 31, 2017 to the contractual obligations and commitments disclosed in Management’s Discussion and Analysis of Financial Condition and Results of Operations, set forth in Part II, Item 7, of the Form 10-K. See Note 9 to the notes to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information regarding contractual obligations and commitments.

Off-Balance Sheet Arrangements

As of March 31, 2017, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

There were no material changes in our market risk during the three months ended March 31, 2017 compared to the disclosures in Part II, Item 7A of the Form 10-K.

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ITEM 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) under the Exchange Act) as of March 31, 2017. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Based on that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective as of March 31, 2017 to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) under the Exchange Act) during the three months ended March 31, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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Part II

ITEM 1. Legal Proceedings

We are subject to various claims, complaints and legal actions that arise from time to time in the normal course of business. We accrue for contingencies when we believe that a loss is probable and that we can reasonably estimate the amount of any such loss. There can be no assurance that existing or future legal proceedings arising in the ordinary course of business or otherwise will not have a material adverse effect on our business, consolidated financial position, results of operations or cash flows.

ITEM 1A. Risk Factors