Edgar Filing: FORTINET INC

FTNT - 2014.06.30.10Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



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

For the quarterly period ended June 30, 2014



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

For the transition period from to

Commission file number: 001-34511

______________________________________

FORTINET, INC.

(Exact name of registrant as specified in its charter)

______________________________________



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



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

(408) 235-7700

(Registrant’s telephone number, including area code)

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

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

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



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

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

As of July 31, 2014, there were 163,772,825 shares of the registrant’s common stock outstanding.

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FORTINET, INC.

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended June 30, 2014

Table of Contents




		Page

	Part I

Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets as of June 30, 2014 and December 31, 2013	3
	Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2014 and 2013	4
	Condensed Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2014 and 2013	5
	Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2014 and 2013	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	23
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	34
Item 4.	Controls and Procedures	34

	Part II

Item 1.	Legal Proceedings	35
Item 1A.	Risk Factors	35
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	56
Item 5.	Other Information	56
Item 6.	Exhibits	56
	Signatures	57

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Part I

Item 1. Financial Statements

FORTINET, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per share amounts)



	June 30, 2014		December 31, 2013
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	203,947	$	115,873
Short-term investments	354,174		375,497
Accounts receivable—Net of allowance for doubtful accounts and sales returns of $5,005 and $4,605 as of June 30, 2014 and December 31, 2013, respectively	127,825		130,471
Inventory	46,824		48,672
Deferred tax assets	50,984		50,980
Prepaid expenses and other current assets	23,195		14,053
Total current assets	806,949		735,546
PROPERTY AND EQUIPMENT—Net	55,300		36,652
DEFERRED TAX ASSETS	36,531		30,058
LONG-TERM INVESTMENTS	352,473		351,675
GOODWILL	2,824		2,872
OTHER INTANGIBLE ASSETS—Net	3,377		6,841
OTHER ASSETS	7,658		4,820
TOTAL ASSETS	$	1,265,112	$	1,168,464

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	35,848	$	35,599
Accrued liabilities	25,176		27,380
Accrued payroll and compensation	43,705		34,997
Income taxes payable	—		21,421
Deferred revenue	321,359		293,664
Total current liabilities	426,088		413,061
DEFERRED REVENUE	158,843		138,964
INCOME TAXES PAYABLE	36,551		30,208
OTHER LIABILITIES	18,411		471
Total liabilities	639,893		582,704
COMMITMENTS AND CONTINGENCIES (Note 9)
STOCKHOLDERS’ EQUITY:
Common stock, $0.001 par value — 300,000 shares authorized; 163,568 and 161,535 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively	163		161
Additional paid-in capital	507,053		462,644
Accumulated other comprehensive income	1,181		1,092
Retained earnings	116,822		121,863
Total stockholders’ equity	625,219		585,760
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	1,265,112	$	1,168,464

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						Six Months Ended
	June 30, 2014			June 30, 2013			June 30, 2014			June 30, 2013
REVENUE:
Product	$	85,384		$	66,525		$	162,149		$	124,475
Services and other	98,714			80,903			190,898			158,773
Total revenue	184,098			147,428			353,047			283,248
COST OF REVENUE:
Product	37,455			26,948			69,594			49,906
Services and other	20,302			16,760			38,906			32,930
Total cost of revenue	57,757			43,708			108,500			82,836
GROSS PROFIT:
Product	47,929			39,577			92,555			74,569
Services and other	78,412			64,143			151,992			125,843
Total gross profit	126,341			103,720			244,547			200,412
OPERATING EXPENSES:
Research and development	29,938			25,158			58,993			48,492
Sales and marketing	74,817			55,997			142,143			105,973
General and administrative	10,444			8,788			19,454			16,779
Total operating expenses	115,199			89,943			220,590			171,244
OPERATING INCOME	11,142			13,777			23,957			29,168
INTEREST INCOME	1,319			1,337			2,652			2,706
OTHER (EXPENSE) INCOME—Net	(574		)	(100		)	(963		)	115
INCOME BEFORE INCOME TAXES	11,887			15,014			25,646			31,989
PROVISION FOR INCOME TAXES	5,806			6,035			11,172			10,761
NET INCOME	$	6,081		$	8,979		$	14,474		$	21,228
Net income per share attributable to common stockholders (Note 7):
Basic	$	0.04		$	0.06		$	0.09		$	0.13
Diluted	$	0.04		$	0.05		$	0.09		$	0.13
Weighted-average shares outstanding:
Basic	163,161			162,247			162,778			161,767
Diluted	168,345			168,042			168,015			168,033

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						Six Months Ended
	June 30, 2014			June 30, 2013			June 30, 2014			June 30, 2013
Net income	$	6,081		$	8,979		$	14,474		$	21,228
Other comprehensive income (loss)—net of taxes:
Foreign currency translation gains (losses)	1,118			(861		)	101			(1,813		)
Unrealized losses on investments	(21		)	(1,468		)	(19		)	(1,426		)
Tax benefit related to items of other comprehensive income or loss	7			513			7			498
Other comprehensive income (loss)—net of taxes	1,104			(1,816		)	89			(2,741		)
Comprehensive income	$	7,185		$	7,163		$	14,563		$	18,487

See notes to condensed consolidated financial statements.

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FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)



	Six Months Ended
	June 30, 2014			June 30, 2013
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	14,474		$	21,228
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	10,914			7,322
Amortization of investment premiums	4,752			5,889
Stock-based compensation	27,646			20,006
Excess tax benefit from stock-based compensation	(2,443		)	(1,894		)
Other non-cash items—net	3,549			(925		)
Changes in operating assets and liabilities:
Accounts receivable—Net	2,228			(801		)
Inventory	(3,307		)	(16,375		)
Deferred tax assets	(6,470		)	(13,205		)
Prepaid expenses and other current assets	(4,523		)	(258		)
Other assets	159			778
Accounts payable	1,253			14,255
Accrued liabilities	1,544			732
Other liabilities	15,375			(989		)
Accrued payroll and compensation	8,665			2,287
Deferred revenue	47,871			25,943
Income taxes payable	(16,987		)	11,339
Net cash provided by operating activities	104,700			75,332
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of investments	(283,338		)	(275,029		)
Sales of investments	22,864			16,691
Maturities of investments	273,214			176,378
Purchase of property and equipment	(21,022		)	(3,569		)
Payments made in connection with acquisitions—net of cash acquired	(17		)	(5,985		)
Net cash used in investing activities	(8,299		)	(91,514		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock	22,518			15,590
Taxes paid related to net share settlement of equity awards	(5,521		)	—
Excess tax benefit from stock-based compensation	2,443			1,894
Repurchase and retirement of common stock	(27,167		)	—
Net cash (used in) provided by financing activities	(7,727		)	17,484
EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS	(600		)	(809		)
NET INCREASE IN CASH AND CASH EQUIVALENTS	88,074			493
CASH AND CASH EQUIVALENTS—Beginning of period	115,873			122,975
CASH AND CASH EQUIVALENTS—End of period	$	203,947		$	123,468
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes—net	$	31,413		$	11,640
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Liability for purchase of property and equipment and asset retirement obligations	$	6,946		$	1,056
Liability incurred for repurchase of common stock	$	733		$	—

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

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

There have been no material changes to our significant accounting policies as of and for the three and six months ended June 30, 2014. During the first quarter of fiscal 2014, we prospectively modified the expected term calculation used in accounting for stock-based compensation expense and the estimated useful lives of building improvements, and furniture and fixtures.

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

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



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

Effective March 2014, we moved into our new corporate headquarters. The useful life of building improvements placed into service during the three months ended March 31, 2014, in association with our new corporate headquarters is estimated to be 20 years. The useful life of furniture and fixtures now ranges from 3 to 5 years as we placed new furniture and fixtures into service at the new corporate headquarters.

Reclassification—Beginning in the first quarter of 2014, the amounts previously reported as Ratable and other revenue have been combined with the amounts previously reported as Services revenue in the condensed consolidated statements of operations. The combined amounts are now being presented as Services and other revenue in the condensed consolidated statements of operations. The related Cost of revenue and Gross profit, including prior period amounts, have also been combined to conform to the current period presentation. The Ratable and other revenue amounts, including the related

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Cost of revenue and Gross profit amounts, are not material, and the reclassification did not have any impact on our gross margin or net income.

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

2. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

The following table summarizes our investments as of June 30, 2014 and December 31, 2013 (in thousands):



	June 30, 2014
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Corporate debt securities	$	567,252	$	1,313	$	(205	)	$	568,360
Commercial paper	75,154		2		(3		)	75,153
Municipal bonds	37,938		50		(12		)	37,976
Certificates of deposit and term deposits	17,402		2		—			17,404
U.S. government and agency securities	7,749		7		(2		)	7,754
Total available-for-sale securities	$	705,495	$	1,374	$	(222	)	$	706,647



	December 31, 2013
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Corporate debt securities	$	603,185	$	1,506	$	(374	)	$	604,317
Commercial paper	69,356		7		—			69,363
Municipal bonds	38,815		48		(20		)	38,843
Certificates of deposit and term deposits	12,645		3		—			12,648
U.S. government and agency securities	2,000		1		—			2,001
Total available-for-sale securities	$	726,001	$	1,565	$	(394	)	$	727,172

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

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



	June 30, 2014
	Less Than 12 Months					12 Months or Greater					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
Corporate debt securities	$	149,229	$	(204	)	$	1,019	$	(1	)	$	150,248	$	(205	)
Commercial paper	10,884		(3		)	—		—			10,884		(3		)
Municipal bonds	6,215		(10		)	4,018		(2		)	10,233		(12		)
U.S. government and agency securities	1,998		(2		)	—		—			1,998		(2		)
Total available-for-sale securities	$	168,326	$	(219	)	$	5,037	$	(3	)	$	173,363	$	(222	)



	December 31, 2013
	Less Than 12 Months					12 Months or Greater				Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Corporate debt securities	$	182,795	$	(374	)	$	500	$	—	$	183,295	$	(374	)
Commercial paper	7,897		—			—		—		7,897		—
Municipal bonds	14,736		(20		)	—		—		14,736		(20		)
Total available-for-sale securities	$	205,428	$	(394	)	$	500	$	—	$	205,928	$	(394	)

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



	June 30, 2014		December 31, 2013
Due within one year	$	354,174	$	375,497
Due within one to three years	352,473		351,675
Total	$	706,647	$	727,172

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

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

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

Fair Value of Financial Instruments

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table presents the fair value of our financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2014 and December 31, 2013 (in thousands):

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



	June 30, 2014								December 31, 2013
	Aggregate Fair Value		Quoted Prices in Active Markets For Identical Assets		Significant Other Observable Remaining Inputs		Significant Other Unobservable Remaining Inputs		Aggregate Fair Value		Quoted Prices in Active Markets For Identical Assets		Significant Other Observable Remaining Inputs		Significant Other Unobservable Remaining Inputs
			(Level 1)		(Level 2)		(Level 3)				(Level 1)		(Level 2)		(Level 3)
Assets:
Corporate debt securities	$	568,360	$	—	$	568,360	$	—	$	604,317	$	—	$	604,317	$	—
Commercial paper	75,153		—		75,153		—		71,363		—		71,363		—
Municipal bonds	37,976		—		37,976		—		38,843		—		38,843		—
Certificates of deposit and term deposits	17,404		—		17,404		—		12,648		—		12,648		—
Money market funds	21,139		21,139		—		—		5,724		5,724		—		—
U.S. government and agency securities	7,754		1,998		5,756		—		2,001		—		2,001		—
Total	$	727,786	$	23,137	$	704,649	$	—	$	734,896	$	5,724	$	729,172	$	—

Liabilities:
Contingent consideration	$	—	$	—	$	—	$	—	$	1,850	$	—	$	—	$	1,850
Total	$	—	$	—	$	—	$	—	$	1,850	$	—	$	—	$	1,850

Reported as:
Cash equivalents	$	21,139							$	7,724
Short-term investments	354,174								375,497
Long-term investments	352,473								351,675
Total	$	727,786							$	734,896

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

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

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

We have classified the fair value of contingent consideration arising from the acquisition of Coyote Point Systems, Inc. (“Coyote”) (see Note 5), as a Level 3 liability since it is based on a probability-based income approach that includes significant unobservable inputs. The significant unobservable inputs include projected revenues and the percentage probability of occurrence to determine the fair value of the payment. A decrease in the projected revenue during the six months ended June 30, 2014 resulted in no fair value being attributable to the contingent consideration as of June 30, 2014.

The change in the fair value of our contingent consideration liability was as follows (in thousands):



As of December 31, 2013	$1,850
Less change in fair value of contingent consideration	(1,143)
As of March 31, 2014	707
Less change in fair value of contingent consideration	(707)
As of June 30, 2014	$—

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The change in fair value is included in research and development expense in the condensed consolidated statements of operations.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

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

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

We have classified these intangible assets acquired from Coyote as Level 3 assets due to the lack of observable inputs to determine fair value. Significant inputs used in the determination of fair value based on the probability-weighted income approach primarily include internal cash flow projections and discount rates.

As of December 31, 2013, we did not have any assets or liabilities measured at fair value on a nonrecurring basis.

3. INVENTORY

Inventory consisted of the following (in thousands):



	June 30, 2014		December 31, 2013
Raw materials	$	5,284	$	4,319
Finished goods	37,424		40,093
Consigned inventory	4,116		4,260
Inventory	$	46,824	$	48,672

4. PROPERTY AND EQUIPMENT—Net

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



	June 30, 2014			December 31, 2013
Land	$	13,895		$	13,895
Building and building improvements	17,779			610
Evaluation units	26,904			23,442
Computer equipment and software	29,948			23,556
Furniture and fixtures	4,552			1,697
Construction-in-progress	4,332			10,947
Leasehold improvements	7,314			4,303
Total property and equipment	104,724			78,450
Less: accumulated depreciation	(49,424		)	(41,798		)
Property and equipment—net	$	55,300		$	36,652

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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

Depreciation expense was $6.0 million and $3.4 million during the three months ended June 30, 2014 and June 30, 2013, respectively. Depreciation expense was $9.9 million and $6.6 million during the six months ended June 30, 2014 and June 30, 2013, respectively.

5. BUSINESS COMBINATIONS

Coyote Point Systems

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

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

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



Cash and cash equivalents	$	206
Other current assets	501
Finite-lived intangible assets	2,800
Indefinite-lived intangible assets	2,600
Goodwill	2,824
Other assets	88
Total assets acquired	9,019
Current liabilities	1,030
Long-term liabilities	2,004
Total liabilities assumed	3,034
Total purchase price	$	5,985

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

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

6. GOODWILL AND OTHER INTANGIBLE ASSETS—Net

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

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

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



	June 30, 2014
	Gross		Accumulated Amortization		Net
Other intangible assets—net:
Developed technology	$	5,606	$	2,625	$	2,981
Customer relationships	500		104		396
Total other intangible assets—net	$	6,106	$	2,729	$	3,377



	December 31, 2013
	Gross		Accumulated Amortization		Net
Other intangible assets—net:
Developed technology	$	8,971	$	2,568	$	6,403
Customer relationships	500		62		438
Total other intangible assets—net	$	9,471	$	2,630	$	6,841

Amortization expense was $0.5 million and $0.4 million during the three months ended June 30, 2014 and June 30, 2013, respectively. Amortization expense was $1.0 million and $0.7 million for the six months ended June 30, 2014 and June 30, 2013, respectively. The following table summarizes estimated future amortization expense of Other intangible assets—net (in thousands):



	Amount
Years Ending December 31:
2014 (remainder)	$	545
2015	1,091
2016	785
2017	425
2018	425
Thereafter	106
Total	$	3,377

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

7. NET INCOME PER SHARE

Basic net income per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding, plus the dilutive effects of stock options, restricted stock units (“RSUs”), and the employee stock purchase plan (“ESPP”). Potentially 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				Six Months Ended
	June 30, 2014		June 30, 2013		June 30, 2014		June 30, 2013
Numerator:
Net income	$	6,081	$	8,979	$	14,474	$	21,228

Denominator:
Basic shares:
Weighted-average common stock outstanding-basic	163,161		162,247		162,778		161,767
Diluted shares:
Weighted-average common stock outstanding-basic	163,161		162,247		162,778		161,767
Effect of potentially dilutive securities:
Stock options	4,583		5,734		4,753		6,152
RSUs	600		32		462		46
ESPP	1		29		22		68
Weighted-average shares used to compute diluted net income per share	168,345		168,042		168,015		168,033
Net income per share:
Basic	$	0.04	$	0.06	$	0.09	$	0.13
Diluted	$	0.04	$	0.05	$	0.09	$	0.13

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		Six Months Ended
	June 30, 2014	June 30, 2013	June 30, 2014	June 30, 2013
Stock options	4,201	7,472	4,323	7,483
RSUs	593	2,554	1,871	1,804
ESPP	—	—	261	—
	4,794	10,026	6,455	9,287

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

8. DEFERRED REVENUE

Deferred revenue consisted of the following (in thousands):



	June 30, 2014		December 31, 2013
Product	$	4,063	$	2,915
Services and other	476,139		429,713
Total deferred revenue	$	480,202	$	432,628
Reported As:
Current	$	321,359	$	293,664
Non-current	158,843		138,964
Total deferred revenue	$	480,202	$	432,628

9. COMMITMENTS AND CONTINGENCIES

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



	Total		2014 (remainder)		2015		2016		2017		2018		Thereafter
Operating lease commitments	$	34,431	$	4,905	$	7,814	$	6,120	$	5,190	$	3,966	$	6,436
Less: Sublease rental income	876		404		472		—		—		—		—
Operating lease commitments—net	33,555		4,501		7,342		6,120		5,190		3,966		6,436
Purchase commitments	46,379		46,379		—		—		—		—		—
Other contractual commitments	15,987		12,131		2,717		743		396		—		—
Total	$	95,921	$	63,011	$	10,059	$	6,863	$	5,586	$	3,966	$	6,436

Operating Leases—We lease certain facilities under various non-cancelable operating leases, which expire through 2020. The terms of certain operating leases provide for renewal options. Rent expense is recognized using the straight-line method over the term of the lease. Rent expense was $2.4 million during the three months ended June 30, 2014 and June 30, 2013. Rent expense was $5.1 million and $4.7 million during the six months ended June 30, 2014 and June 30, 2013, respectively.

Purchase Commitments and Other Contractual 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 June 30, 2014, we had $46.4 million of open purchase orders with our independent contract manufacturers that may not be cancelable.

In addition to commitments with contract manufacturers, we have open purchase orders and contractual obligations in the ordinary course of business for which we have not received goods or services. As of June 30, 2014, we had $16.0 million in other purchase commitments.

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

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



	Six Months Ended
	June 30, 2014			June 30, 2013
Accrued warranty balance—beginning of the period	$	3,037		$	2,309
Warranty costs incurred	(1,728		)	(1,744		)
Provision for warranty for the period	2,560			2,204
Adjustment related to pre-existing warranties	(415		)	208
Accrued warranty balance—end of the period	$	3,454		$	2,977

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

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

10. STOCKHOLDERS’ EQUITY

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

Employee Stock Options

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



	Three Months Ended		Six Months Ended
	June 30, 2014		June 30, 2014
Expected term in years	4.9		4.9
Volatility	43.3	%	43.3% - 44.5%
Risk-free interest rate	1.7	%	1.7	%
Dividend rate	—		—

There were no stock options granted during the three and six months ended June 30, 2013.

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

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



	Options Outstanding
	Number of Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Life (Years)	Aggregate Intrinsic Value
Balance—December 31, 2013	15,521		$	13.18
Granted	218		21.36
Forfeited	(284	)	23.84
Exercised	(2,082	)	7.32
Balance—June 30, 2014	13,373		14.00
Options vested and expected to vest—June 30, 2014	13,337		$	13.98	2.97	$	152,067
Options exercisable—June 30, 2014	10,952		$	11.97	2.61	$	146,189

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 June 30, 2014, for all in-the-money options. As of June 30, 2014, total compensation expense related to unvested stock options granted to employees but not yet recognized was $28.2 million, net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average period of 1.5 years.

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



	Three Months Ended				Six Months Ended
	June 30, 2014		June 30, 2013		June 30, 2014		June 30, 2013
Weighted-average fair value per share granted	$	8.18	$	—	$	8.58	$	—
Intrinsic value of options exercised	$	16,441	$	3,058	$	31,762	$	29,117
Fair value of options vested	$	4,209	$	5,486	$	8,771	$	16,489

Restricted Stock Units

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



	Restricted Stock Units Outstanding
	Number of Shares		Weighted-Average Grant-Date-Fair Value per Share
Balance—December 31, 2013	4,199		$	22.00
Granted	2,222		21.37
Forfeited	(237	)	21.81
Vested	(791	)	22.55
Balance—June 30, 2014	5,393		$	21.75
RSUs expected to vest—June 30, 2014	5,094		$	21.78

As of June 30, 2014, total compensation expense related to unvested RSUs that were granted to employees and non-employees under the Plan, but not yet recognized, was $112.5 million, net of estimated forfeitures. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 3.0 years.

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

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



	Three Months Ended		Six Months Ended
	June 30, 2014		June 30, 2014
Shares withheld for taxes	86		257
Amount withheld for taxes	$	1,888	$	5,521

No RSUs vested in the three and six months ended June 30, 2013.

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:



	Six Months Ended
	June 30, 2014		June 30, 2013
Expected term in years	0.5		0.5
Volatility	35.9	%	48.0	%
Risk-free interest rate	0.1	%	0.1	%
Dividend rate	—		—

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



	Six Months Ended
	June 30, 2014		June 30, 2013
Weighted-average fair value per share granted	$	5.35	$	7.02
Shares issued under the ESPP	424		329
Weighted-average price per share issued	$	17.18	$	19.91

There were no shares granted or issued under the ESPP during the three months ended June 30, 2014 and June 30, 2013.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Stock-based Compensation Expense

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



	Three Months Ended				Six Months Ended
	June 30, 2014		June 30, 2013		June 30, 2014		June 30, 2013
Cost of product revenue	$	178	$	96	$	291	$	186
Cost of services and other revenue	1,363		1,226		2,692		2,246
Research and development	4,171		3,291		8,053		6,057
Sales and marketing	5,747		4,594		11,493		8,712
General and administrative	3,257		1,500		5,117		2,805
Total stock-based compensation expense	$	14,716	$	10,707	$	27,646	$	20,006

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



	Three Months Ended				Six Months Ended
	June 30, 2014		June 30, 2013		June 30, 2014		June 30, 2013
Stock options	$	4,421	$	5,135	$	9,113	$	10,622
RSUs	9,248		4,357		16,611		7,030
ESPP	1,047		1,215		1,922		2,354
Total stock-based compensation expense	$	14,716	$	10,707	$	27,646	$	20,006

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



	Three Months Ended				Six Months Ended
	June 30, 2014		June 30, 2013		June 30, 2014		June 30, 2013
Income tax benefit associated with stock-based compensation	$	4,247	$	2,794	$	7,813	$	6,381

Share Repurchase Program

On December 6, 2013, our Board of Directors authorized a Share Repurchase Program (“Program”) to repurchase up to $200.0 million of our outstanding common stock through December 31, 2014. Under the Program, share repurchases may be made by us from time to time in privately negotiated transactions or in open market transactions. The Program may be suspended, modified or discontinued at any time without prior notice. During the three and six months ended June 30, 2014, we repurchased 0.7 million and 1.0 million shares of common stock under the Program in open market transactions for an aggregate purchase price of $14.9 million and $22.5 million, respectively. As of June 30, 2014, $138.6 million remains authorized for future share repurchases under the Program.

11. INCOME TAXES

The effective tax rate was 49% for the three months ended June 30, 2014, compared to an effective tax rate of 40% for the three months ended June 30, 2013. The effective tax rate was 44% for the six months ended June 30, 2014, compared to an effective tax of 34% for the six months ended June 30, 2013. The provision for income taxes for the periods presented is comprised of U.S. federal and state taxes, Singapore and other foreign income taxes, and withholding tax, as well as the inclusion of stock compensation benefits and transfer pricing allocations which impact jurisdictional income taxed at various tax rates.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

As of June 30, 2014 and December 31, 2013, unrecognized tax benefits were $35.7 million and $30.2 million, respectively. The total amount of $35.7 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 June 30, 2014, we had accrued approximately $1.4 million for estimated interest related to uncertain tax positions.

12. EMPLOYEE BENEFIT PLANS

Our tax-deferred savings plan, under the 401(k) Plan, allows participating employees to defer a portion of their pre-tax earnings, up to the IRS annual contribution limit. In Canada, we have a Group Registered Retirement Savings Plan program (the “RRSP”) which permits participants to make tax deductible contributions up to the maximum contribution limits under the Income Tax Act. Our board 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) Plans and RRSP for the three months ended June 30, 2014 and June 30, 2013 were $0.6 million and $0.5 million, respectively. Our matching contributions to the 401(k) Plans and RRSP for the six months ended June 30, 2014 and June 30, 2013 were $1.2 million and $1.1 million, respectively.

13. SEGMENT INFORMATION

The following table sets forth revenue by geographic region (in thousands):



	Three Months Ended				Six Months Ended
Revenue	June 30, 2014		June 30, 2013		June 30, 2014		June 30, 2013
Americas:
United States	$	49,672	$	38,815	$	94,465	$	73,603
Other Americas	28,713		21,211		56,352		39,050
Total Americas	78,385		60,026		150,817		112,653
Europe, Middle East, and Africa (“EMEA”)	62,554		50,801		119,197		98,127
Asia Pacific and Japan (“APAC”)	43,159		36,601		83,033		72,468
Total revenue	$	184,098	$	147,428	$	353,047	$	283,248

During the three months and six months ended June 30, 2014, Exclusive Networks Group accounted for 14% of total revenue. During the three and six months ended June 30, 2013, Exclusive Networks Group accounted for 11% and 12% of total revenue, respectively.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



Property and Equipment—Net	June 30, 2014		December 31, 2013
Americas:
United States	$	43,834	$	29,334
Canada	6,828		4,372
Other Americas	29		45
Total Americas	50,691		33,751
EMEA	2,300		1,273
APAC	2,309		1,628
Total property and equipment—net	$	55,300	$	36,652

14. ACCUMULATED OTHER COMPREHENSIVE INCOME

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



	June 30, 2014
	Foreign Currency Translation Gains And Losses		Unrealized Gains And Losses On Investments			Tax Benefit Or Provision Related To Items Of Other Comprehensive Income Or Loss			Total
Balance as of December 31, 2013	$	333	$	1,168		$	(409	)	$	1,092
Other comprehensive income before reclassifications	101		(10		)	4			95
Amounts reclassified from accumulated other comprehensive income	—		(9		)	3			(6		)
Net current-period other comprehensive income	101		(19		)	7			89
Balance as of June 30, 2014	$	434	$	1,149		$	(402	)	$	1,181

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



June 30, 2014
Details About Accumulated Other Comprehensive Income Components	Amount Reclassified From Accumulated Other Comprehensive Income			Affected Line Item In The Statement Where Net Income Is Presented
Unrealized gains on investments	$	(9	)	Other (expense) income—net
Tax provision related to items of other comprehensive income or loss	3			Provision for income taxes
Total reclassification for the period	$	(6	)

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

15. FOREIGN CURRENCY DERIVATIVES

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

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

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



	Buy/Sell	Notional
Currency—As of June 30, 2014
CAD	Buy	$	20,587

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

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

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


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


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


•	expected impact of sales of certain products;


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


•	the impact of our product innovation strategy;


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


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


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


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


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


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


•	expectations regarding spending related to capital expenditures, including improvements and expansion of our new corporate headquarters and other offices and the implementation of our enterprise resource planning system;


•	competition in our market segment;


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


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

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

Business Overview

We provide high performance network security solutions, which enable broad, integrated and high performance protection against advanced security threats while simplifying the IT security infrastructure for enterprises, service providers and governmental entities worldwide. Since inception through June 30, 2014, we had shipped over 1,600,000 appliances via more than 28,000 channel partners to more than 200,000 end-customers worldwide, including a majority of the 2013 Fortune Global 100.

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Our core product line, comprised of FortiGate physical and virtual appliances, ships with a set of broad security and networking capabilities, including firewall, virtual private network (VPN), application control, antivirus, intrusion prevention, Web filtering, vulnerability management, anti-spam, wireless controller, wide area network (WAN) acceleration and native internet protocol version 6 (IPv6) support functionality. Customers select the functions or combination of functions that best meet their specific security requirements - whether that be a high-speed data center firewall (DCFW) at the network core, a next-generation firewall (NGFW) at the edge, or a broad unified threat management (UTM) solution at branch sites. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20 to -100 series, designed for small businesses, FortiGate-200 to -800 series for mid-sized enterprises, to the FortiGate-1000 to -5000 series for large enterprises, telecommunications carriers, and service providers. Our network security platform also includes our FortiGuard security subscription services, which end-customers can subscribe to in order to obtain access to dynamic updates to intrusion prevention, application control, anti-malware, Web filtering, and anti-spam functionality. End-customers can also choose to purchase FortiCare technical support services for our products. End-customers also often use FortiManager and FortiAnalyzer products in conjunction with a FortiGate deployment to provide centralized management, analysis and reporting capabilities. We complement our core FortiGate product line with other appliances and software that offer additional protection from security threats to other critical areas of the enterprise, such as our advanced persistent threats (APTs) sandboxing product, messaging security product, Web application firewalls, databases security product, distributed denial of service attack (DDoS) security product, and endpoint security product for employee computers and mobile devices. Sales of these complementary products and related services represent less than 10% of our total revenue.

Financial Highlights

•

We recorded total revenue of $184.1 million and $353.0 million during the three and six months ended June 30, 2014, respectively. This represents an increase of 25% during each of these periods compared to the same periods last year. Product revenue was $85.4 million and $162.1 million, respectively, an increase of 28% and 30% during the three and six months ended June 30, 2014, respectively, compared to the same periods last year. Services and other revenue was $98.7 million and $190.9 million during the three and six months ended June 30, 2014, respectively, an increase of 22% and 20%, respectively, compared to the same periods last year.


•	Cash, cash equivalents and investments were $910.6 million as of June 30, 2014, an increase of $67.5 million from December 31, 2013.


•	Deferred revenue was $480.2 million as of June 30, 2014, an increase of $47.6 million from December 31, 2013.


•	We generated cash flows from operating activities of $104.7 million during the six months ended June 30, 2014, an increase of 39% compared to the same period last year.


•	We received $20.0 million pursuant to a six year mutual covenant-not-to-sue and release agreement with Palo Alto Networks, Inc. during the six months ended June 30, 2014.


•	We repurchased 1.0 million shares of common stock under our previously-announced Share Repurchase Program for an aggregate purchase price of $22.5 million during the six months ended June 30, 2014.

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

We continue to invest in sales and marketing to expand brand awareness, our global sales team and distribution channels to expand our global reach and sales capacity and meet increasing customer expectations about the quality and functionality of our products, and research and development to strengthen our technology leadership position. We continue to focus on selling to large customers, such as enterprise and service providers. As a result, we experienced increased deal volumes driven by traction in enterprise data center deployments and large enterprise deals.

During the three months ended June 30, 2014, our high-end FortiGate products (FortiGate-1000 to -5000 series) accounted for 40% of billings primarily due to an increase in billings from large enterprise and service provider customers. Our mid-range products (FortiGate-200 to -800 series) accounted for 26% of billings, and our entry-level products (FortiGate-20 to -100 series) accounted for 34% of billings. In prior periods, sales of FortiGate products have generally been balanced across product categories, with some degree of variability from year to year and between quarters.

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During the three and six months ended June 30, 2014, operating expenses increased by 28% and 29%, respectively, compared to the same periods last year. The increase was primarily driven by our accelerated pace of hiring and marketing investments to support our growth as we continued to invest in expanding our sales coverage, marketing capabilities, developing new products and scaling our customer support organization to meet the needs of our growing customer base. Headcount increased to 2,532 as of June 30, 2014 from 2,182 as of June 30, 2013.

Key Financial Metrics

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



	Three Months Ended Or As Of
	June 30, 2014		June 30, 2013
	(in thousands)
Revenue	$	184,098	$	147,428
Deferred revenue	$	480,202	$	389,682
Increase in deferred revenue	$	28,899	$	13,268
Billings (non-GAAP)	$	212,997	$	160,696
Cash, cash equivalents and investments	$	910,594	$	814,410
Net cash provided by operating activities	$	43,798	$	37,221
Free cash flow (non-GAAP)	$	34,094	$	35,186

Deferred revenue. Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue. The majority of our deferred revenue balance consists of the unamortized portion of services revenue from FortiGuard subscription and support service contracts. We monitor our deferred revenue balance because it represents a significant portion of revenue to be recognized in future periods.

Billings (Non-GAAP). We define billings as revenue recognized during a period plus the change in deferred revenue from the beginning to the end of the period less deferred revenue balances acquired from business combinations, if any. We consider billings to be a useful metric for management and investors because billings drive deferred revenue, which is an important indicator of the health and visibility of our business, and has historically, represented a majority of the quarterly revenue that we recognize. There are a number of limitations related to the use of billings versus revenue calculated in accordance with GAAP. First, billings include amounts that have not yet been recognized as revenue. Second, we may calculate billings in a manner that is different from other companies that report similar financial measures. We compensate for these limitations by providing specific information regarding GAAP revenue and evaluating billings together with revenues calculated in accordance with GAAP. 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
	June 30, 2014		June 30, 2013
	(in thousands)
Billings:
Revenue	$	184,098	$	147,428
Add increase in deferred revenue	28,899		13,268
Total billings (Non-GAAP)	$	212,997	$	160,696

Free cash flow (Non-GAAP). Free cash flow is defined as net cash provided by operating activities less capital expenditures. We consider free cash flow to be a liquidity measure that provides useful information to management and

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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 acquisitions, repurchasing shares of our outstanding common stock, and strengthening the balance sheet. Analysis of free cash flow facilitates comparisons of our operating results to competitors’ operating results. A limitation of using free cash flow versus 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 balance from operations for the period because it excludes cash used for capital expenditures. We compensate for this limitation by providing information about our capital expenditures 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
	June 30, 2014			June 30, 2013
	(in thousands)
Free Cash Flow:
Net cash provided by operating activities	$	43,798		$	37,221
Less purchases of property and equipment	(9,704		)	(2,035		)
Free cash flow (Non-GAAP)	$	34,094		$	35,186

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

There have been no material changes to our critical accounting policies and estimates as of and for the three and six months ended June 30, 2014, as compared to the critical accounting policies and estimates described in the Form 10-K.

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

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Results of Operations

Three Months Ended June 30, 2014 and June 30, 2013

Revenue

Three Months Ended

June 30,
2014

June 30,
2013

Amount

% of

Revenue

Amount

% of

Revenue

Change

% Change

(in thousands except percentages)

Revenue: