10-Q
Table of Contents

 
 
 
 
 
 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 FORM 10-Q 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2015
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from              to             
Commission file number: 001-34511
______________________________________
 FORTINET, INC.
(Exact name of registrant as specified in its charter)
______________________________________

Delaware
77-0560389
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
899 Kifer Road
Sunnyvale, California
94086
(Address of principal executive offices)
(Zip Code)
(408) 235-7700
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 (“Exchange Act”) during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x  No  o 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. 
Large accelerated filer
x
 
 
Accelerated filer
o
Non-accelerated filer
o
(Do not check if smaller reporting company)
 
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  o     No  x
As of October 30, 2015, there were 172,264,048 shares of the registrant’s common stock outstanding.



FORTINET, INC.
QUARTERLY REPORT ON FORM 10-Q
For the Quarter Ended September 30, 2015
Table of Contents
 
 
 
 
 
 
Page
 
 
 
 
Part I
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Part II
 
 
 
 
 


 

Table of Contents

Part I

Item 1. Financial Statements
FORTINET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except per share amounts)
 
 
September 30,
2015
 
December 31,
2014
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
540,712

 
$
283,254

Short-term investments
367,446

 
436,766

Accounts receivable—net of sales returns reserve and allowance for doubtful accounts of $5,488 and $6,204 as of September 30, 2015 and December 31, 2014, respectively
174,111

 
184,741

Inventory
80,650

 
69,477

Deferred tax assets
47,304

 
41,484

Prepaid expenses and other current assets
41,517

 
31,143

Total current assets
1,251,740

 
1,046,865

LONG-TERM INVESTMENTS
261,506

 
271,724

PROPERTY AND EQUIPMENT—net
83,372

 
58,919

DEFERRED TAX ASSETS
72,003

 
31,080

GOODWILL
4,260

 
2,824

OTHER INTANGIBLE ASSETS—net
18,967

 
2,832

OTHER ASSETS
15,325

 
10,530

TOTAL ASSETS
$
1,707,173

 
$
1,424,774

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
48,793

 
$
49,947

Accrued liabilities
29,831

 
29,016

Accrued payroll and compensation
47,915

 
45,875

Income taxes payable
5,477

 
2,689

Deferred revenue
471,118

 
368,929

Total current liabilities
603,134

 
496,456

DEFERRED REVENUE
235,793

 
189,828

INCOME TAXES PAYABLE
56,906

 
45,139

OTHER LIABILITIES
15,954

 
17,385

Total liabilities
911,787

 
748,808

COMMITMENTS AND CONTINGENCIES (Note 11)


 


STOCKHOLDERS’ EQUITY:
 
 
 
Common stock, $0.001 par value — 300,000 shares authorized; 172,402 and 166,443 shares issued and outstanding as of September 30, 2015 and December 31, 2014, respectively
172

 
166

Additional paid-in capital
671,138

 
562,504

Accumulated other comprehensive loss
(90
)
 
(349
)
Retained earnings
124,166

 
113,645

Total stockholders’ equity
795,386

 
675,966

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
1,707,173

 
$
1,424,774

See notes to condensed consolidated financial statements.


3
Table of Contents

FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share amounts)
 
 
Three Months Ended
 
Nine Months Ended
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
REVENUE:
 
 
 
 
 
 
 
Product
$
119,737

 
$
87,731

 
$
332,023

 
$
249,880

Service
140,331

 
105,617

 
380,716

 
296,515

Total revenue
260,068

 
193,348

 
712,739

 
546,395

COST OF REVENUE:
 
 
 
 
 
 
 
Product
46,167

 
35,636

 
134,932

 
105,230

Service
25,534

 
21,249

 
69,869

 
60,155

Total cost of revenue
71,701

 
56,885

 
204,801

 
165,385

GROSS PROFIT:
 
 
 
 
 
 
 
Product
73,570

 
52,095

 
197,091

 
144,650

Service
114,797

 
84,368

 
310,847

 
236,360

Total gross profit
188,367

 
136,463

 
507,938

 
381,010

OPERATING EXPENSES:
 
 
 
 
 
 
 
Research and development
42,110

 
30,790

 
115,315

 
89,783

Sales and marketing
120,994

 
80,433

 
333,531

 
222,576

General and administrative
21,220

 
9,789

 
51,199

 
29,243

Restructuring charges
5,883

 
—

 
5,883

 
—

Total operating expenses
190,207

 
121,012

 
505,928

 
341,602

OPERATING INCOME (LOSS)
(1,840
)
 
15,451

 
2,010

 
39,408

INTEREST INCOME
1,333

 
1,339

 
4,119

 
3,991

OTHER EXPENSE—net
(653
)
 
(1,005
)
 
(2,160
)
 
(1,968
)
INCOME (LOSS) BEFORE INCOME TAXES
(1,160
)
 
15,785

 
3,969

 
41,431

PROVISION FOR (BENEFIT FROM) INCOME TAXES
(9,329
)
 
11,729

 
(6,552
)
 
22,901

NET INCOME
$
8,169

 
$
4,056

 
$
10,521

 
$
18,530

Net income per share (Note 8):
 
 
 
 
 
 
 
Basic
$
0.05

 
$
0.02

 
$
0.06

 
$
0.11

Diluted
$
0.05

 
$
0.02

 
$
0.06

 
$
0.11

Weighted-average shares outstanding:
 
 
 
 
 
 
 
Basic
171,648

 
164,294

 
169,898

 
163,289

Diluted
177,897

 
169,727

 
175,963

 
168,735

See notes to condensed consolidated financial statements.


4
Table of Contents

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Net income
$
8,169

 
$
4,056

 
$
10,521

 
$
18,530

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

 
(432
)
 
—

 
(333
)
Unrealized gains (losses) on investments
337

 
(977
)
 
400

 
(993
)
Tax benefit (provision) related to items of other comprehensive income or loss
(118
)
 
342

 
(141
)
 
348

Other comprehensive income (loss)—net of taxes
219

 
(1,067
)
 
259

 
(978
)
Comprehensive income
$
8,388

 
$
2,989

 
$
10,780

 
$
17,552


See notes to condensed consolidated financial statements.




5
Table of Contents

FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
10,521

 
$
18,530

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
22,206

 
16,519

Amortization of investment premiums
5,770

 
6,680

Stock-based compensation
67,001

 
42,313

Excess tax benefit from stock-based compensation
—

 
(4,325
)
Other non-cash items—net
2,681

 
3,801

Changes in operating assets and liabilities, net of assets acquired and liabilities assumed in business acquisitions:
 
 
 
Accounts receivable—net
20,923

 
13,140

Inventory
(12,427
)
 
(11,095
)
Deferred tax assets
(28,297
)
 
(12,186
)
Prepaid expenses and other current assets
(7,806
)
 
(2,781
)
Other assets
(264
)
 
(159
)
Accounts payable
(9,842
)
 
3,806

Accrued liabilities
(3,296
)
 
2,818

Accrued payroll and compensation
(1,895
)
 
5,651

Other liabilities
(1,232
)
 
14,350

Deferred revenue
136,193

 
68,006

Income taxes payable
13,753

 
(3,850
)
Net cash provided by operating activities
213,989

 
161,218

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of investments
(329,687
)
 
(388,808
)
Sales of investments
35,384

 
27,282

Maturities of investments
364,256

 
371,837

Purchases of property and equipment
(29,013
)
 
(26,802
)
Payments made in connection with business acquisitions—net of cash acquired
(38,025
)
 
(17
)
Net cash provided by (used in) investing activities
2,915

 
(16,508
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
63,543

 
40,529

Taxes paid related to net share settlement of equity awards
(22,989
)
 
(8,506
)
Excess tax benefit from stock-based compensation
—

 
4,325

Repurchase and retirement of common stock
—

 
(38,235
)
Net cash provided by (used in) financing activities
40,554

 
(1,887
)
EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS
—

 
(600
)
NET INCREASE IN CASH AND CASH EQUIVALENTS
257,458

 
142,223

CASH AND CASH EQUIVALENTS—Beginning of period
283,254

 
115,873

CASH AND CASH EQUIVALENTS—End of period
$
540,712

 
$
258,096

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid for income taxes—net
$
15,272

 
$
38,755

NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Transfers of evaluation units from inventory to property and equipment
$
13,695

 
$
9,073

Liability for purchase of property and equipment and asset retirement obligations
$
2,243

 
$
4,710

Liability incurred for repurchase of common stock
$
—

 
$
379

Equity awards assumed in connection with business acquisition
$
471

 
$
—

See notes to condensed consolidated financial statements.

6
Table of Contents

FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Preparation—The unaudited condensed consolidated financial statements of Fortinet, Inc. and its wholly-owned subsidiaries (collectively, “we,” “us” or “our”) have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) for interim financial information as well as the instructions to Form 10-Q pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2014, contained in our Annual Report on Form 10-K (“Form 10-K”) filed with the SEC on March 2, 2015. In the opinion of management, all adjustments, which includes normal recurring adjustments, considered necessary for a fair presentation have been included. All intercompany balances, transactions and cash flows have been eliminated. The results of operations for the three and nine months ended September 30, 2015 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, 2014 is derived from the audited consolidated financial statements for the year ended December 31, 2014.

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.

In the third quarter of 2014, we reevaluated the selected functional currency of our international subsidiaries due to the nature of our business operations and recorded the cumulative impact of the reevaluation of the functional currency in the consolidated statement of operations. Subsequently, the remeasurement of the assets and liabilities of all international subsidiaries has been recorded in the consolidated statement of operations prospectively. The impact of this reevaluation was not material for 2014 or any of our previously issued financial statements.

There have been no material changes to our significant accounting policies as of and for the three and nine months ended September 30, 2015, except for the inclusion of policies related to business combinations and restructuring charges.

Business combinations—We include the results of operations of the businesses that we acquire as of the respective dates of acquisition. We allocate the fair value of the purchase price of our business acquisitions to the tangible assets acquired, liabilities assumed, and intangible assets acquired, based on their estimated fair values. The excess of the purchase price over the fair values of these identifiable assets and liabilities is recorded as goodwill. Additional information existing as of the acquisition date but unknown to us may become known during the remainder of the measurement period, not to exceed 12 months from the acquisition date, which may result in changes to the amounts and allocations recorded.

Restructuring charges—We recognize liability for exit and disposal activities when the liability is incurred. Our restructuring charges consist of one-time termination benefits related to the reduction of our workforce, contract-termination costs, such as lease exit costs, and other costs. Liabilities for costs associated with a restructuring activity are measured at fair value and are recognized when the liability is incurred. One-time termination benefits are expensed at the date we notify the employee, unless the employee must provide future service, in which case the benefits are expensed ratably over the future service period. A liability for contract-termination costs represents a liability for costs to terminate a contract before the end of its term and is recognized at fair value when we terminate the contract in accordance with the contract terms, which is usually done by giving written notice to the counterparty within the notification period specified by the contract or by otherwise negotiating a termination with the counterparty. A liability for costs that will continue to be incurred under a contract for its remaining term without economic benefit to the entity is recognized at the cease-use date. Costs to terminate a lease before the end of its term are recognized when the property is vacated. Other costs primarily consist of asset write-offs and consulting fees, which are expensed when incurred.

We continually evaluate the adequacy of the remaining liabilities under our restructuring initiatives. Although we believe that these estimates accurately reflect the costs of our restructuring plans, actual results may differ and thereby require us to record an additional provision or reverse a portion of such a provision.





7
Table of Contents
FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



Recent Accounting Pronouncements

In September 2015, the Financial Accounting Standards Board (“FASB“) issued Accounting Standards Update 2015-16—Simplifying the Accounting for Measurement-Period Adjustments (“ASU 2015-16”).  ASU 2015-16 eliminates the requirement for an acquirer in a business combination to account for measurement-period adjustments retrospectively.  Instead, acquirers must recognize measurement-period adjustments during the period in which they determine the amounts, including the effect on earnings of any amounts they would have recorded in previous periods if the accounting had been completed at the acquisition date.  ASU 2015-16 will be effective for us beginning on January 1, 2016.

In July 2015, the FASB issued Accounting Standards Update 2015-11—Inventory—Simplifying the Measurement of Inventory (Topic 330) (“ASU 2015-11”). ASU 2015-11 changes the measurement principle for inventory from the lower of cost or market to lower of cost and net realizable value. It applies to entities that measure inventory using a method other than last-in, first-out or the retail inventory method (e.g., first-in first-out, average cost). ASU 2015-11 will be effective for us beginning on January 1, 2017. We do not expect the impact of ASU 2015-11 on our consolidated financial statements to be significant.

In May 2014, the FASB issued Accounting Standards Update No. 2014-09—Revenue from Contracts with Customers (Topic 606) (“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 GAAP. Under ASU 2014-09, an entity is required to recognize revenue upon the transfer of promised goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to receive in exchange for those goods or services. In July 2015, the FASB decided to delay the effective date of the new revenue standard by one year. As such, ASU 2014-09 will be effective for us beginning on January 1, 2018, with the option to adopt earlier on January 1, 2017. We are currently evaluating the impact of ASU 2014-09 on our consolidated financial statements.






8
Table of Contents
FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



2. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

The following table summarizes our investments as of September 30, 2015 and December 31, 2014 (in thousands):
 
September 30, 2015
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
485,236

 
$
265

 
$
(470
)
 
$
485,031

Commercial paper
59,936

 
6

 
(10
)
 
59,932

Municipal bonds
59,251

 
71

 
(7
)
 
59,315

Certificates of deposit and term deposits (1)
8,668

 
—

 
—

 
8,668

U.S. government and agency securities
16,001

 
5

 
—

 
16,006

Total available-for-sale securities
$
629,092

 
$
347

 
$
(487
)
 
$
628,952

 
December 31, 2014
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
589,526

 
$
365

 
$
(875
)
 
$
589,016

Commercial paper
51,156

 
3

 
(4
)
 
51,155

Municipal bonds
39,745

 
15

 
(39
)
 
39,721

Certificates of deposit and term deposits (1)
22,854

 
—

 
—

 
22,854

U.S. government and agency securities
5,749

 
1

 
(6
)
 
5,744

Total available-for-sale securities
$
709,030

 
$
384

 
$
(924
)
 
$
708,490


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

The following table shows the gross unrealized losses and the related fair values of our investments that have been in a continuous unrealized loss position as of September 30, 2015 and December 31, 2014 (in thousands):

 
September 30, 2015
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
Corporate debt securities
$
217,790

 
$
(370
)
 
$
37,622

 
$
(100
)
 
$
255,412

 
$
(470
)
Commercial paper
16,720

 
(10
)
 
—

 
—

 
16,720

 
(10
)
Municipal bonds
10,302

 
(4
)
 
1,012

 
(3
)
 
11,314

 
(7
)
Total available-for-sale securities
$
244,812

 
$
(384
)
 
$
38,634

 
$
(103
)
 
$
283,446

 
$
(487
)











9
Table of Contents
FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



 
December 31, 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
$
317,011

 
$
(858
)
 
$
6,011

 
$
(17
)
 
$
323,022

 
$
(875
)
Commercial paper
8,185

 
(4
)
 
—

 
—

 
8,185

 
(4
)
Municipal bonds
26,684

 
(39
)
 
—

 
—

 
26,684

 
(39
)
U.S. government and agency securities
4,745

 
(6
)
 
—

 
—

 
4,745

 
(6
)
Total available-for-sale securities
$
356,625

 
$
(907
)
 
$
6,011

 
$
(17
)
 
$
362,636

 
$
(924
)

The contractual maturities of our investments as of September 30, 2015 and December 31, 2014 were as follows (in thousands):
 
 
September 30,
2015
 
December 31,
2014
Due within one year
$
367,446

 
$
436,766

Due within one to three years
261,506

 
271,724

Total
$
628,952

 
$
708,490


Available-for-sale securities are reported at fair value, with unrealized gains and losses, net of tax, included as a separate component of stockholders’ equity and in total comprehensive income. Realized gains and losses on available-for-sale securities are included in Other expense—net in our condensed consolidated statements of operations. Realized gains and losses from the sale of available-for-sale securities were not significant in any period presented.

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 is 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 September 30, 2015.

 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

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



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.

Fair Value of Financial Instruments

Assets Measured at Fair Value on a Recurring Basis

The following table presents the fair value of our financial assets measured at fair value on a recurring basis as of September 30, 2015 and December 31, 2014 (in thousands):
 
 
September 30, 2015
 
December 31, 2014
 
 
Aggregate
Fair
Value
 
Quoted
Prices in
Active
Markets For
Identical
Assets
 
Significant
Other
Observable
Inputs
 
Aggregate
Fair
Value
 
Quoted
Prices in
Active
Markets For
Identical
Assets
 
Significant
Other
Observable
Inputs
 
 
 
 
(Level 1)
 
(Level 2)
 
 
 
(Level 1)
 
(Level 2)
 
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
$
485,031

 
$
—

 
$
485,031

 
$
589,016

 
$
—

 
$
589,016

 
Commercial paper
61,932

 
—

 
61,932

 
51,155

 
—

 
51,155

 
Municipal bonds
59,315

 
—

 
59,315

 
39,721

 
—

 
39,721

 
Certificates of deposit and term deposits
8,668

 
—

 
8,668

 
22,854

 
—

 
22,854

 
Money market funds
81,683

 
81,683

 
—

 
13,311

 
13,311

 
—

 
U.S. government and agency securities
16,006

 
2,002

 
14,004

 
5,744

 
1,998

 
3,746

 
Total
$
712,635

 
$
83,685

 
$
628,950

 
$
721,801

 
$
15,309

 
$
706,492

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reported as:
 
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
$
83,683

 
 
 
 
 
$
13,311

 
 
 
 
 
Short-term investments
367,446

 
 
 
 
 
436,766

 
 
 
 
 
Long-term investments
261,506

 
 
 
 
 
271,724

 
 
 
 
 
Total
$
712,635

 
 
 
 
 
$
721,801

 
 
 
 
 

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the period ended September 30, 2015.


3. INVENTORY

Inventory consisted of the following as of September 30, 2015 and December 31, 2014 (in thousands):
 
 
September 30,
2015
 
December 31,
2014
Raw materials
$
13,594

 
$
10,617

Finished goods
67,056

 
58,860

Total inventory
$
80,650

 
$
69,477


Inventory includes finished goods held by distributors where revenue is recognized on a sell-through basis of $1.5 million and $1.2 million as of September 30, 2015 and December 31, 2014, respectively. Inventory also includes raw materials at contract manufacturers of $4.2 million and $4.8 million as of September 30, 2015 and December 31, 2014, respectively.


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



4. PROPERTY AND EQUIPMENT—net

Property and equipment—net consisted of the following as of September 30, 2015 and December 31, 2014 (in thousands):
 
 
September 30,
2015
 
December 31,
2014
Land
$
21,685

 
$
13,895

Building and building improvements
22,283

 
20,166

Evaluation units
40,984

 
31,474

Computer equipment and software
43,658

 
31,821

Furniture and fixtures
7,054

 
5,096

Construction-in-progress
10,248

 
3,902

Leasehold improvements
9,070

 
7,998

Total property and equipment
154,982

 
114,352

Less: accumulated depreciation
(71,610
)
 
(55,433
)
Property and equipment—net
$
83,372

 
$
58,919


Depreciation expense was $7.5 million and $5.4 million during the three months ended September 30, 2015 and September 30, 2014, respectively. Depreciation expense was $20.3 million and $15.3 million during the nine months ended September 30, 2015 and September 30, 2014, respectively.


5. INVESTMENTS IN PRIVATELY-HELD COMPANIES

As of September 30, 2015, we had invested a total of $10.3 million in the equity securities of three privately-held companies. Each of these investments is accounted for as a cost-basis investment, as we own less than 20% of the voting securities and do not have the ability to exercise significant influence over operating and financial policies of the 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.

During the nine months ended September 30, 2015, no events have occurred that would adversely affect the carrying value of these investments.



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



6. BUSINESS COMBINATIONS

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

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

Purchase Price:
 
Cash
$
40,914

Estimated fair value of shares withheld for taxes
379

Estimated fair value of earned equity awards assumed by Fortinet
471

Total purchase price
$
41,764


We accounted for this transaction as a business combination. We expensed acquisition-related costs of $1.7 million in general and administrative expenses. The total purchase price was allocated to Meru’s identifiable tangible and intangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date. The total purchase price was allocated using the information currently available. As a result, we may continue to adjust the estimated purchase price allocation as and when additional information is available.

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

Cash and cash equivalents
$
3,268

Accounts receivable
8,316

Inventory
11,854

Prepaid expenses and other assets
2,409

Property and equipment
983

Deferred tax assets
18,585

Identifiable intangible assets
19,600

Goodwill
1,436

Total assets acquired
66,451

Deferred revenue
9,800

Accounts payable and accrued liabilities
14,887

Total liabilities assumed
24,687

Total purchase price allocation
$
41,764



The goodwill of $1.4 million represents the premium we paid over the fair value of the net tangible liabilities assumed and identified intangible assets acquired, due primarily to Meru’s assembled workforce. The goodwill recorded as part of the Meru acquisition is not deductible for U.S. federal income tax purposes.

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

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



 
Estimated Useful Life (in years)
 
Fair Values
Customer relationships
5
 
$
12,200

Developed technologies
4
 
7,200

Trade name
0.5
 
200

Total
 
 
$
19,600


The amortization expense of customer relationships and trade name is amortized on a straight-line basis and is recorded in sales and marketing expenses. The amortization expense of developed technologies is amortized on a straight-line basis and is recorded in cost of product revenue.

Upon acquisition, Meru became our wholly-owned subsidiary. The results of operations of Meru have been included in our consolidated statements of operations from the acquisition date. Revenue and net loss of Meru from July 8, 2015 through September 30, 2015 were $12.0 million and $9.6 million, respectively.

The unaudited financial information below summarizes the combined results of Fortinet and Meru on a pro forma basis, after giving effect to the acquisition of Meru on July 8, 2015, as though the business combination occurred on January 1, 2014. The pro forma financial information is presented for informational purposes and is not indicative of the results of operations that would have been achieved if the acquisition had taken place at the beginning of each of the periods presented. The following pro forma financial information for all periods presented includes purchase accounting adjustments for amortization charges from acquired intangible assets, depreciation of acquired property, plant and equipment, stock-based compensation and related tax effects (in thousands):

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Pro forma revenue
$
261,199

 
$
218,363

 
$
750,442

 
$
615,581

Pro forma income (loss) from operations
$
(5,968
)
 
$
11,194

 
$
(15,368
)
 
$
20,768

Pro forma net income (loss)
$
4,959

 
$
572

 
$
(2,619
)
 
$
4,173

Pro forma net income (loss) per basic
$
0.03

 
$
—

 
$
(0.02
)
 
$
0.03

Pro forma net income (loss) per diluted
$
0.03

 
$
—

 
$
(0.01
)
 
$
0.02



7. GOODWILL AND OTHER INTANGIBLE ASSETS—net

Goodwill

There were no impairments to goodwill during the three and nine months ended September 30, 2015. The following table presents the changes in the carrying amount of goodwill (in thousands):

 
Amount
Balance—December 31, 2014
$
2,824

Addition due to business acquisition
1,436

Balance—September 30, 2015
$
4,260


Other Intangible Assets—net
During the three months ended June 30, 2015, we reassessed the fair value and the remaining useful life of the developed technologies and customer relationship acquired from the Coyote Point business acquisition. Based on this reassessment, we determined a decrease in the projected cash flow and that the remaining net book value of the developed technologies and customer relationships were impaired. As a result, we recorded an impairment charge of $1.6 million associated with these assets. The impairment charge is included within cost of product revenue and sales and marketing in the condensed consolidated statements of operations.

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




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

 
 
 
September 30, 2015
 
Weighted Average Useful Life (in years)
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
 
 
Customer relationships
5.0
 
$
12,200

 
$
610

 
$
11,590

Developed technologies
3.6
 
11,184

 
3,907

 
7,277

Trade names
0.5
 
200

 
100

 
100

Total other intangible assets—net
 
 
$
23,584

 
$
4,617

 
$
18,967


 
 
 
December 31, 2014
 
Weighted Average Useful Life (in years)
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
 
 
Developed technologies
3.6
 
$
5,606

 
$
3,128

 
$
2,478

Customer relationships
6.0
 
500

 
146

 
354

Total other intangible assets—net
 
 
$
6,106

 
$
3,274

 
$
2,832


Amortization expense was $1.3 million and $0.2 million for the three months ended September 30, 2015 and September 30, 2014, respectively. Amortization expense was $1.9 million and $1.2 million for the nine months ended September 30, 2015 and September 30, 2014, respectively. The following table summarizes estimated future amortization expense of other intangible assets—net (in thousands):

 
Amount
2015 (remainder)
$
1,327

2016
4,600

2017
4,240

2018
4,240

2019
3,340

Thereafter
1,220

Total
$
18,967



8. NET INCOME PER SHARE

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


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



A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per share is as follows (in thousands, except per share amounts):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Numerator:
 
 
 
 
 
 
 
Net income
$
8,169

 
$
4,056

 
$
10,521

 
$
18,530

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Basic shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding—basic
171,648

 
164,294

 
169,898

 
163,289

Diluted shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding—basic
171,648

 
164,294

 
169,898

 
163,289

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Stock options
3,451

 
4,405

 
3,669

 
4,728

RSUs (including PSUs)
2,742

 
993

 
2,335

 
692

ESPP
56

 
35

 
61

 
26

Weighted-average shares used to compute diluted net income per share
177,897

 
169,727

 
175,963

 
168,735

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.05

 
$
0.02

 
$
0.06

 
$
0.11

Diluted
$
0.05

 
$
0.02

 
$
0.06

 
$
0.11


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 anti-dilutive (in thousands):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Stock options
265

 
3,023

 
271

 
4,101

RSUs (including PSUs)
1,331

 
696

 
1,026

 
879

ESPP
209

 
226

 
126

 
133

 
1,805

 
3,945

 
1,423

 
5,113



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



9. DEFERRED REVENUE

Deferred revenue consisted of the following as of September 30, 2015 and December 31, 2014 (in thousands):
 
 
September 30,
2015
 
December 31,
2014
Product
$
6,134

 
$
4,642

Service
700,777

 
554,115

Total deferred revenue
$
706,911

 
$
558,757

Reported as:
 
 
 
Current
$
471,118

 
$
368,929

Non-current
235,793

 
189,828

Total deferred revenue
$
706,911

 
$
558,757



10. RESTRUCTURING CHARGES

In connection with the acquisition of Meru, during the third quarter of 2015, we initiated planned cost reduction and restructuring activities to improve our cost structure and operational efficiencies. We estimate that we will incur $6.3 million of restructuring charges, consisting of severance and other one-time benefits, contract terminations and other charges. We incurred $5.9 million of restructuring charges during the three months ended September 30, 2015 which are included in operating expense in the condensed consolidated statements of operations. These charges are primarily related to severance and other one-time benefits to be paid in cash. We expect the remainder of the amount to be incurred during the fourth quarter of 2015 and in 2016.

The following table provides a summary of restructuring activity as of September 30, 2015 (in thousands):

 
Employee Severance and Other Benefits
 
Contract Terminations and Other Charges
 
Total
Balance as of December 31, 2014
$
—

 
$
—

 
$
—

Costs incurred
5,469

 
414

 
5,883

Less cash payments
(1,858
)
 
(62
)
 
(1,920
)
Less non-cash charges
(219
)
 
(191
)
 
(410
)
Balance as of September 30, 2015
$
3,392

 
$
161

 
$
3,553


Cash payments for the restructuring activities are expected to be made through fiscal year 2017, primarily relating to severance and other one-time benefits. The short-term portion of the restructuring reserve of $2.7 million is included in accrued liabilities and the remaining long-term portion of $0.9 million is included in other liabilities on the condensed balance sheet as of September 30, 2015.


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



11. COMMITMENTS AND CONTINGENCIES

The following table summarizes our future principal contractual obligations as of September 30, 2015 (in thousands):

 
Total
 
2015 (remainder)
 
2016
 
2017
 
2018
 
2019
 
Thereafter
Operating lease commitments
$
56,775

 
$
4,167

 
$
15,679

 
$
10,879

 
$
8,404

 
$
7,053

 
$
10,593

Inventory purchase commitments
75,984

 
73,038

 
2,946

 
—

 
—

 
—

 
—

Other contractual commitments and open purchase orders
38,072

 
26,233

 
7,995

 
2,149

 
751

 
609

 
335

Total
$
170,831

 
$
103,438

 
$
26,620


$
13,028


$
9,155


$
7,662


$
10,928


Operating Leases—We lease certain facilities under various non-cancelable operating leases, which expire through 2025. In addition to the amounts above, certain leases require us to pay variable costs such as taxes, maintenance, insurance, and asset retirement obligations. The terms of certain operating leases also provide for renewal options and escalation clauses. Rent expense was $3.7 million and $2.6 million during the three months ended September 30, 2015 and 2014, respectively. Rent expense was $9.7 million and $7.7 million during the nine months ended September 30, 2015 and 2014, respectively. Rent expense is recognized using the straight-line method over the term of the lease.
    
Inventory Purchase —Our independent contract manufacturers procure certain inventory items 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 analysis, 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 September 30, 2015, we had $76.0 million of open purchase orders with our independent contract manufacturers.
 
Other Contractual Commitments and Open Purchase Orders —In addition to commitments with contract manufacturers, we have other contractual commitments and open purchase orders in the ordinary course of business for which we have not received goods or services. As of September 30, 2015, we had $38.1 million in other contractual commitments and open purchase orders.

Warranties—Accrued warranty activities are summarized as follows (in thousands):
 
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
Accrued warranty balance—beginning of the period
$
4,269

 
$
3,037

Warranty costs incurred
(3,413
)
 
(2,597
)
Provision for warranty for the period, including warranty liabilities assumed in connection with a business acquisition
3,638

 
3,786

Adjustment related to pre-existing warranties
(94
)
 
(540
)
Accrued warranty balance—end of the period
$
4,400

 
$
3,686


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

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



our estimates, if any, which could result in the need to adjust the liability and record additional expenses. We have not recorded any significant accrual for loss contingencies associated with such legal proceedings; determined that a significant unfavorable outcome is probable or reasonably possible; or determined that the amount or range of any possible loss is reasonably estimable.

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


12. STOCKHOLDERS’ EQUITY

Stock-Based Compensation Plans

Our stock-based compensation plans include the 2000 Stock Plan (the “2000 Plan”), the 2008 Stock Plan (the “2008 Plan”), the 2009 Equity Incentive Plan (the “2009 Plan”), 2011 Employee Stock Purchase Plan (the “ESPP”) and equity plans assumed through the Meru acquisition. Under these plans, we have granted (or, in the case of acquired plans, assumed) stock options and RSUs, including PSUs.

In connection with the Meru acquisition, we assumed and exchanged Meru’s outstanding RSUs with an estimated fair value of $2.0 million. Of the total estimated fair value, $0.5 million relating to earned equity awards was allocated to the purchase price and the remainder relating to future services is being recognized over the remaining service period. No new equity awards can be granted under the assumed plans. As of September 30, 2015, RSUs representing 42,332 shares of common stock were outstanding under the awards assumed through the acquisition of Meru.

As of September 30, 2015, there were a total of 41,362,003 shares of common stock available for grant under our stock-based compensation plans.

Employee Stock Options

The following table summarizes the weighted-average assumptions relating to our employee stock options:
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Expected term in years
4.3

 
4.9

 
4.3

 
4.9

Volatility
37
%
 
41
%
 
38
%
 
43
%
Risk-free interest rate
1.6
%
 
1.6
%
 
1.5
%
 
1.7
%
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):
 

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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, 2014
10,702

 
$
14.98

 
 
 
 
Granted
656

 
41.02

 
 
 
 
Forfeited
(123
)
 
26.69

 
 
 
 
Exercised
(4,016
)
 
11.38

 
 
 
 
Balance—September 30, 2015
7,219

 
$
19.16

 
 
 
 
Options vested and expected to vest—September 30, 2015
7,155

 
$
18.97

 
2.8
 
$
169,925

Options exercisable—September 30, 2015
6,021

 
$
16.40

 
2.2
 
$
157,064


The aggregate intrinsic value represents the pre-tax difference between the exercise price of stock options and the quoted market price of our common stock on September 30, 2015, for all in-the-money options. As of September 30, 2015, total compensation expense related to unvested stock options granted to employees but not yet recognized was $14.0 million. This expense is expected to be amortized on a straight-line basis over a weighted-average period of 2.6 years.  

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Weighted-average fair value per share granted
$
15.89

 
$
9.13

 
$
13.60

 
$
8.76

Intrinsic value of options exercised
40,132

 
17,728

 
103,170

 
49,490

Fair value of options vested
2,491

 
4,393

 
9,001

 
13,163


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, 2014
6,291

 
$
22.93

Granted and assumed through business acquisition
5,385

 
40.01

Forfeited
(675
)
 
27.80

Vested
(1,776
)
 
22.35

Balance—September 30, 2015
9,225

 
$
32.66

RSUs expected to vest—September 30, 2015
7,899

 
$
32.90


As of September 30, 2015, total compensation expense related to unvested RSUs that were granted to employees and non-employees, but not yet recognized, was $291.4 million. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 3.1 years.


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



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

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Shares withheld for taxes
245

 
124

 
590

 
381

Amount withheld for taxes
$
11,628

 
$
2,985

 
$
22,989

 
$
8,506


Performance Stock Units

We have granted PSUs to certain of our executive officers and employees. PSUs granted to executive officers are based on the achievement of the market-based vesting conditions during the performance period, the final settlement of the PSUs will range between 0% and 150% of the target shares underlying the PSUs based on a specified objective formula approved by our Compensation Committee. The PSUs entitle our executive officers to receive a number of shares of our common stock based on the performance of our stock price over a two- or three-year period as compared to the NASDAQ Composite index for the same periods. PSUs granted to our employees who are not executive officers are based on the achievement of personal- and company-based performance vesting conditions during the performance period. The final settlement of these PSUs will range between 50% to 150% of the target shares underlying the PSUs based on specified objective formula approved by our Compensation Committee. The PSUs entitle such employees to receive a number of shares of our common stock based on a one year performance period, and vest equally in the second and third years. There were no PSUs granted during the three months ended September 30, 2015 and September 30, 2014.

The following table summarizes the weighted-average assumptions relating to our PSUs granted to our executive officers:
 
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
Expected term in years
3.0

 
3.0

Volatility
38
%
 
47
%
Risk-free interest rate
1.1
%
 
0.9
%
Dividend rate
—
%
 
—
%

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

 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
Shares granted to executive officers and employees
206

 
120

Weighted-average fair value per share granted
$
34.86

 
$
21.21


As of September 30, 2015, total compensation expense related to unvested PSUs that were granted to certain of our executive officers and employees, but not yet recognized, was $6.4 million. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 2.1 years.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)




Employee Stock Purchase Plan

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Expected term in years
0.5

 
0.5

 
0.5

 
0.5

Volatility
32
%
 
32
%
 
31
%
 
34
%
Risk-free interest rate
0.2
%
 
0.1
%
 
0.1
%
 
0.1
%
Dividend rate
—
%
 
—
%
 
—
%
 
—
%

Additional information related to the ESPP is provided below (in thousands, except per share amounts):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Weighted-average fair value per share granted
$
11.42

 
$
6.03

 
$
8.23

 
$
5.91

Shares issued under the ESPP
337

 
346

 
764

 
770

Weighted-average price per share issued
$
28.05

 
$
19.38

 
$
24.30

 
$
18.17


Stock-based Compensation Expense

Stock-based compensation expense is included in costs and expenses as follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Cost of product revenue
$
291

 
$
60

 
$
641

 
$
351

Cost of service revenue
1,849

 
1,522

 
5,141

 
4,214

Research and development
6,663

 
4,505

 
17,361

 
12,558

Sales and marketing
13,904

 
7,397

 
34,482

 
18,890

General and administrative
3,612

 
1,183

 
9,376

 
6,300

Total stock-based compensation expense
$
26,319

 
$
14,667

 
$
67,001

 
$
42,313


The following table summarizes stock-based compensation expense by award type (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Stock options
$
2,669

 
$
4,282

 
$
9,141

 
$
13,395

RSUs (including PSUs)
21,996

 
9,275

 
53,674

 
25,886

ESPP
1,654

 
1,110

 
4,186

 
3,032

Total stock-based compensation expense
$
26,319

 
$
14,667

 
$
67,001

 
$
42,313


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


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



 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Income tax benefit associated with stock-based compensation
$
5,224

 
$
4,225

 
$
12,867

 
$
11,821


Share Repurchase Program

In December 2013, our Board of Directors (“Board”) authorized a Share Repurchase Program (“Program”) to repurchase up to $200.0 million of our outstanding common stock through December 31, 2014. Under the Program, share repurchases may be made by us from time to time in privately negotiated transactions or in open market transactions. The Program does not require us to purchase a minimum number of shares, and may be suspended, modified or discontinued at any time without prior notice. In October 2014, our Board extended the share repurchase authorization under the Program through December 31, 2015. During the three and nine months ended September 30, 2015, there were no shares repurchased under the Program. As of September 30, 2015, $122.5 million remains available for future share repurchases under the Program.

13. INCOME TAXES

We recognized a tax benefit of $9.3 million and a tax expense of $11.7 million on pretax net loss of $1.2 million and pretax net income of $15.8 million during the three months ended September 30, 2015 and 2014, respectively. The effective tax rate was 804% for the three months ended September 30, 2015, compared to an effective tax rate of 74% for the same period last year. The effective tax rate was a benefit of 165% for the nine months ended September 30, 2015, compared to an effective tax rate of 55% for the same period last year. The benefit for income taxes for the periods presented is comprised of U.S. federal and state taxes, Singapore and other foreign income taxes, withholding tax, and transfer pricing allocations which impact jurisdictional income taxed at various tax rates. The decrease in the tax provision and change in effective tax rate was primarily due to the decrease in profitability before income taxes and additional tax benefits related to discrete items, such as the increase of the prior year's federal research and development credit and the release of previously unrecognized tax benefits. The effective tax rate for the three months ended September 30, 2015 also reflected a tax benefit due to a recent U.S. Tax Court opinion based on which we recognized the tax benefit due to the exclusion of the stock-based compensation from intercompany charges in prior periods.

As of September 30, 2015 and December 31, 2014, unrecognized tax benefits were $55.8 million and $44.2 million, respectively. The total amount of $54.6 million in unrecognized tax benefits, if recognized, would favorably impact the effective tax rate. It is our policy to classify accrued interest and penalties related to unrecognized tax benefits in the provision for income taxes. As of September 30, 2015, we had accrued $5.0 million for estimated interest related to uncertain tax positions.

We file income tax returns in the U.S. federal jurisdiction, and various U.S. state and foreign jurisdictions. The statute of limitations is open for years that generated state net operating loss carryforwards and after 2009 for state jurisdictions. Additionally, we have foreign net operating losses that have an indefinite life. Generally, we are no longer subject to non-U.S. income tax examinations by tax authorities for tax years prior to 2008. We are no longer subject to examination by U.S. federal tax authorities for tax years prior to 2011, and we are currently subject to examination by U.S federal income tax authorities for tax year 2012.


14. 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 approved 50% matching contributions on employee contributions up to 4% of each employee’s eligible earnings. Our matching contributions to the 401(k) Plan and RRSP during the three months ended September 30, 2015 and September 30, 2014 were $0.9 million and $0.7 million, respectively. Our matching contributions to the 401(k) Plan and RRSP during the nine months ended September 30, 2015 and September 30, 2014 were $2.7 million and $1.9 million, respectively.



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



15. 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.

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



Revenue by geographic region is based on the billing address of the customer. The following table sets forth revenue (in thousands):
 
 
Three Months Ended
 
Nine Months Ended
Revenue
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Americas:
 
 
 
 
 
 
 
United States
$
72,767

 
$
50,329

 
$
202,491

 
$
144,794

Canada
26,027

 
21,104

 
72,676

 
59,837

Other Americas
14,371

 
10,785

 
38,151

 
28,404

Total Americas
113,165

 
82,218

 
313,318

 
233,035

Europe, Middle East, and Africa (“EMEA”)
91,740

 
66,157

 
250,808

 
185,354

Asia Pacific (“APAC”)
55,163

 
44,973

 
148,613

 
128,006

Total revenue
$
260,068

 
$
193,348

 
$
712,739

 
$
546,395


The following table sets forth property and equipment by geographic region as of September 30, 2015 and December 31, 2014 (in thousands):

 
 
 
 
Property and Equipment—net
September 30,
2015
 
December 31,
2014
Americas:
 
 
 
United States
$
58,372

 
$
46,116

Canada
7,811

 
6,054

Other Americas
1,853

 
875

Total Americas
68,036

 
53,045

EMEA:
 
 
 
France
9,369

 
2,052

Other EMEA
2,236

 
1,204

Total EMEA
11,605

 
3,256

APAC
3,731

 
2,618

Total property and equipment—net
$
83,372

 
$
58,919


The following customers, each of which is a distributor, accounted for 10% or more of our revenue:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Exclusive Networks Group
17
%
 
15
%
 
17
%
 
14
%
Fin Tec Computers
*

 
11
%
 
*

 
*

* Represents less than 10%


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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 net accounts receivable:
 
September 30,
2015
 
December 31,
2014
Exclusive Networks Group
19
%
 
18
%
Ingram Micro
11
%
 
*

Fin Tec Computer
10
%
 
*

* Represents less than 10%


16. ACCUMULATED OTHER COMPREHENSIVE LOSS

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

 
Unrealized Gains (Losses) on Investments
 
Tax benefit (provision) related to items of other comprehensive income or loss
 
Total
Beginning balance as of December 31, 2014
$
(540
)
 
$
191

 
$
(349
)
Other comprehensive income before reclassifications
407

 
(143
)
 
264

Amounts reclassified from accumulated other comprehensive loss
(7
)
 
2

 
(5
)
Net current-period other comprehensive income
400

 
(141
)
 
259

Ending balance as of September 30, 2015
$
(140
)
 
$
50

 
$
(90
)

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

Nine Months Ended September 30, 2015
Details about Accumulated Other Comprehensive Loss Components
 
Amount Reclassified from Accumulated Other Comprehensive Loss
 
Affected Line Item in the Statement Where Net Income is Presented
Unrealized gains on investments
 
$
(7
)
 
Other expense—net
Tax provision related to items of other comprehensive income
 
2

 
Provision for (benefit from)income taxes
Total reclassification for the period
 
$
(5
)
 
 


17. 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”), the Euro (“EUR”), and the British Pound (“GBP”). To help protect against significant fluctuations in value and the volatility of future cash flows caused by changes in currency exchange rates, we engage in foreign currency risk management activities, including forward contracts, to hedge balance sheet items denominated in CAD. We do not use these contracts for speculative or trading purposes. All of the derivative instruments are with high quality financial institutions and we monitor the creditworthiness of these parties. These contracts typically have maturities of one month. We record changes in the fair value of forward exchange contracts related to balance sheet accounts as Other expense—net in the condensed consolidated statement of operations.


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



Additionally, independent of any hedging activities, fluctuations in foreign currency exchange rates may cause us to recognize transaction gains and losses in Other expense—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 EUR and GBP could adversely impact our operating expenses in the future.

The notional amount of our forward exchange contract to hedge balance sheet accounts were (in thousands):

 
Buy/Sell
 
Notional
Currency—As of September 30, 2015
 
 
 
CAD
Sell
 
$
9,653

 
 
 
 
Currency—As of December 31, 2014
 
 
 
CAD
Buy
 
$
6,879

 
 
 
 

As of September 30, 2015, the fair value of the forward exchange contract was not material.


18. RELATED PARTY TRANSACTIONS

The son of one member of our Board of Directors (“Board”) is a partner in an outside law firm that we utilize for certain complex litigation matters. Expenses for legal services provided by the law firm related to matters that arose subsequent to the member joining our Board were $0.9 million each for the three months ended September 30, 2015 and September 30, 2014, respectively. Expenses for legal services provided by the law firm related to matters that arose subsequent to the member joining our Board were $3.7 million and $1.7 million for the nine months ended September 30, 2015 and September 30, 2014, respectively. Amounts due and payable to the law firm were $1.4 million and $1.3 million as of September 30, 2015 and December 31, 2014, respectively.


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