Document
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 June 30, 2017
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 Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x  No  o 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. 

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



Table of Contents

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  o     No  x
As of July 27, 2017, there were 175,835,328 shares of the registrant’s common stock outstanding.



FORTINET, INC.
QUARTERLY REPORT ON FORM 10-Q
For the Quarter Ended June 30, 2017
Table of Contents
 
 
 
 
 
 
Page
 
 
 
 
Part I
 
 
 
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
 
Part II
 
 
 
 
Item 1.
Item 1A.
Item 2.
Item 6.
 


 

Table of Contents

Part I

ITEM 1.
Financial Statements
FORTINET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except per share amounts)
 
 
June 30,
2017
 
December 31,
2016
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
853,137

 
$
709,003

Short-term investments
354,187

 
376,522

Accounts receivable—Net of reserves for sales returns and doubtful accounts of $11,855 and $11,235 at June 30, 2017 and December 31, 2016, respectively

274,476

 
312,998

Inventory
86,439

 
106,887

Prepaid expenses and other current assets
36,395

 
33,306

Total current assets
1,604,634

 
1,538,716

LONG-TERM INVESTMENTS
257,622

 
224,983

DEFERRED TAX ASSETS
207,029

 
182,745

PROPERTY AND EQUIPMENT—NET
238,513

 
137,249

OTHER INTANGIBLE ASSETS—NET
20,328

 
24,828

GOODWILL
14,553

 
14,553

OTHER ASSETS
18,012

 
16,867

TOTAL ASSETS
$
2,360,691

 
$
2,139,941

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
42,171

 
$
56,732

Accrued liabilities
41,185

 
35,640

Accrued payroll and compensation
80,307

 
78,138

Income taxes payable
15,184

 
13,588

Deferred revenue
706,672

 
645,342

Total current liabilities
885,519

 
829,440

DEFERRED REVENUE
454,799

 
390,007

INCOME TAX LIABILITIES
81,718

 
68,551

OTHER LIABILITIES
16,516

 
14,262

Total liabilities
1,438,552

 
1,302,260

COMMITMENTS AND CONTINGENCIES (Note 9)


 


STOCKHOLDERS’ EQUITY:
 
 
 
Common stock, $0.001 par value—300,000 shares authorized; 175,735 and 173,078 shares issued and outstanding at June 30, 2017 and December 31, 2016, respectively
175

 
173

Additional paid-in capital
880,142

 
800,653

Accumulated other comprehensive loss
(523
)
 
(765
)
Retained earnings
42,345

 
37,620

Total stockholders’ equity
922,139

 
837,681

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
2,360,691

 
$
2,139,941

See notes to condensed consolidated financial statements.


1
Table of Contents

FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share amounts)
 
 
Three Months Ended
 
Six Months Ended
June 30,
2017
 
June 30,
2016
 
June 30,
2017
 
June 30,
2016
REVENUE:
 
 
 
 
 
 
 
Product
$
142,705

 
$
136,641

 
$
277,958

 
$
261,213

Service
220,764

 
174,750

 
426,087

 
334,754

Total revenue
363,469

 
311,391

 
704,045

 
595,967

COST OF REVENUE:
 
 
 
 
 
 
 
Product
60,787

 
52,788

 
116,084

 
102,101

Service
34,865

 
31,715

 
70,132

 
60,046

Total cost of revenue
95,652

 
84,503

 
186,216

 
162,147

GROSS PROFIT:
 
 
 
 
 
 
 
Product
81,918

 
83,853

 
161,874

 
159,112

Service
185,899

 
143,035

 
355,955

 
274,708

Total gross profit
267,817

 
226,888

 
517,829

 
433,820

OPERATING EXPENSES:
 
 
 
 
 
 
 
Research and development
51,159

 
45,502

 
102,354

 
90,256

Sales and marketing
166,337

 
162,694

 
336,737

 
308,797

General and administrative
21,911

 
22,184

 
44,488

 
41,623

Restructuring charges
(90
)
 
553

 
340

 
881

Total operating expenses
239,317

 
230,933

 
483,919

 
441,557

OPERATING INCOME (LOSS)
28,500

 
(4,045
)
 
33,910

 
(7,737
)
INTEREST INCOME
3,163

 
1,705

 
5,555

 
3,451

OTHER INCOME (EXPENSE)—NET
1,243

 
(1,350
)
 
1,545

 
(2,662
)
INCOME (LOSS) BEFORE INCOME TAXES
32,906

 
(3,690
)
 
41,010

 
(6,948
)
PROVISION FOR (BENEFIT FROM) INCOME TAXES
9,873

 
(2,302
)
 
7,260

 
(7,678
)
NET INCOME (LOSS)

$
23,033

 
$
(1,388
)
 
$
33,750

 
$
730

Net income (loss) per share (Note 8):
 
 
 
 
 
 
 
Basic
$
0.13

 
$
(0.01
)
 
$
0.19

 
$
—

Diluted
$
0.13

 
$
(0.01
)
 
$
0.19

 
$
—

Weighted-average shares outstanding:
 
 
 
 
 
 
 
Basic
175,741

 
172,075

 
175,118

 
171,910

Diluted
179,701

 
172,075

 
178,993

 
175,360

See notes to condensed consolidated financial statements.


2
Table of Contents

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

 
Three Months Ended
 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
 
June 30,
2017
 
June 30,
2016
Net income (loss)
$
23,033

 
$
(1,388
)
 
$
33,750

 
$
730

Other comprehensive income (loss):
 
 
 
 
 
 
 
Change in unrealized gains (losses) on investments
(91
)
 
662

 
334

 
2,549

Tax provision (benefit) related to change in unrealized gains (losses) on investments
(57
)
 
232

 
92

 
892

Other comprehensive income (loss)
(34
)
 
430

 
242

 
1,657

Comprehensive income (loss)
$
22,999

 
$
(958
)
 
$
33,992

 
$
2,387


See notes to condensed consolidated financial statements.




3
Table of Contents

FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
33,750

 
$
730

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
27,492

 
21,841

Amortization of investment premiums
1,447

 
2,794

Stock-based compensation
68,422

 
59,249

Other non-cash items—net
1,705

 
1,192

Changes in operating assets and liabilities:
 
 
 
Accounts receivable—net
37,902

 
2,022

Inventory
9,752

 
(8,019
)
Deferred tax assets
(24,376
)
 
(27,120
)
Prepaid expenses and other current assets
(3,223
)
 
2,442

Other assets
722

 
(2,409
)
Accounts payable
(19,880
)
 
(130
)
Accrued liabilities
1,755

 
(6,426
)
Accrued payroll and compensation
1,565

 
8,679

Other liabilities
(2,677
)
 
(2,858
)
Deferred revenue
125,402

 
111,082

Income taxes payable
14,762

 
5,463

Net cash provided by operating activities
274,520

 
168,532

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of investments
(270,463
)
 
(230,855
)
Sales of investments
9,995

 
7,366

Maturities of investments
247,187

 
219,131

Purchases of property and equipment
(99,888
)
 
(44,399
)
Payments made in connection with business acquisition, net of cash acquired
—

 
(20,660
)
Net cash used in investing activities
(113,169
)
 
(69,417
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
41,832

 
22,972

Taxes paid related to net share settlement of equity awards
(25,895
)
 
(17,358
)
Repurchase of common stock
(33,154
)
 
(50,000
)
Payments of debt assumed in connection with business acquisition
—

 
(1,626
)
Net cash used in financing activities
(17,217
)
 
(46,012
)
NET INCREASE IN CASH AND CASH EQUIVALENTS
144,134

 
53,103

CASH AND CASH EQUIVALENTS—Beginning of period
709,003

 
543,277

CASH AND CASH EQUIVALENTS—End of period
$
853,137

 
$
596,380

NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Liability for purchase of property and equipment
$
22,197

 
$
7,617

Transfers of evaluation units from inventory to property and equipment
$
11,087

 
$
11,449

Liability incurred in connection with business acquisition
$
—

 
$
1,513

See notes to condensed consolidated financial statements.

4
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 (the “SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2016, contained in our Annual Report on Form 10-K filed with the SEC on March 1, 2017. In the opinion of management, all adjustments, which includes normal recurring adjustments, considered necessary for a fair presentation have been included. All intercompany balances, transactions and cash flows have been eliminated. The results of operations for the three and six months ended June 30, 2017 are not necessarily indicative of the results for the full year or for any future periods. The condensed consolidated balance sheet as of December 31, 2016 is derived from the audited consolidated financial statements for the year ended December 31, 2016.

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain amounts in prior periods have been reclassified to conform with current period presentation.

There have been no material changes to our significant accounting policies as of and for the three and six months ended June 30, 2017, except for changes to our policies related to business combinations. For more information, refer to the “Recently Adopted Accounting Standards.”

Recently Adopted Accounting Standards

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

Recent Accounting Standards Not Yet Effective

In May 2017, the FASB issued ASU 2017-09—Compensation - Stock Compensation to clarify when to account for a change to the terms or conditions of a share-based payment award as a modification. Under ASU 2017-09, modifications accounting is required only if the fair value, the vesting conditions or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. ASU 2017-09 is effective prospectively for us beginning on January 1, 2018. We do not believe ASU 2017-09 will have a material impact on our consolidated financial statements.

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


5
Table of Contents
FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



In October 2016, the FASB issued ASU 2016-16—Income Taxes: —Intra-Entity Transfer of Assets Other Than Inventory, which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. ASU 2016-16 will be effective for us beginning on January 1, 2018. We are currently evaluating the impact of adopting ASU 2016-16 on our consolidated financial statements.

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

In February 2016, the FASB issued ASU 2016-02—Leases, which requires the recognition of right-of-use assets and lease liabilities on the consolidated balance sheet for substantially all leases. The new guidance includes a number of optional practical expedients that entities may elect to apply. The new guidance will also require significant additional disclosures about the amount, timing and uncertainty of cash flows from leases. This new guidance will be effective for us beginning on January 1, 2019, using a modified retrospective approach. We currently anticipate to early adopt ASU 2016-02 on January 1, 2018. Our ability to early adopt is dependent on system readiness, including software procured from third-party providers, if any, and the completion of our analysis of information necessary to quantify the impact on the prior period financial statements. Based on our current lease portfolio, we currently estimate that the value of leased assets and liabilities that may be recognized to be at least $40.0 million. Previously, we had estimated the amount could be at least $50.0 million. We are continuing to evaluate the impact of ASU 2016-02 and our estimate is subject to change. We do not believe that ASU 2016-02 will have a material impact on our consolidated statements of operations. We expect to expand our disclosures in the footnotes to include more details on our leases, significant judgments and lease-related amounts recognized in the financial statements.

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

The two permitted transition methods under ASU 2014-09 are the full retrospective method, in which case ASU 2014-09 would be applied to each prior reporting period presented and the cumulative effect of applying ASU 2014-09 would be recognized at the earliest period shown, or the modified retrospective method, in which case the cumulative effect of applying ASU 2014-09 would be recognized at the date of initial application. We have substantially completed our analysis of historical contracts and believe that the quantitative impact on revenue in our consolidated financial statements is not material. We expect the pattern of revenue recognition from the sales of our FortiGate and other appliances, FortiGuard security subscription services and FortiCare technical support services to be substantially unchanged on an ongoing basis. Further, we do not expect that the acceleration of revenue and associated cost of sales to certain channel partners, which are currently accounted for only once the product is sold through to the end-customer, to have a significant impact upon adoption. We expect to select the transition method for adoption in the third quarter of 2017.

Under ASU 2014-09, we will be required to capitalize and amortize incremental costs related to obtaining customer contracts, such as sales commission costs related to service contracts. Under current U.S. GAAP, we expense all sales commissions when incurred. Our quantitative analysis of the impact of the change in accounting for sales commissions, including the various components of our current and future compensation plans and the key assumptions associated with the amortization term, is in progress. We believe that the amortization of incremental commission costs of obtaining customer contracts is likely to have a material impact on our financial statements.

We expect to expand our financial statement disclosures which may include more details on our disaggregation of revenue, performance obligations, contract balances, costs to obtain a contract, as well as any significant judgments. We are in the process of assessing the appropriate changes to our business processes, upgrading our systems and developing new controls

6
Table of Contents
FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



to support recognition and disclosure under ASU 2014-09. Reviews are ongoing which may alter our conclusions and the anticipated financial impact. We will continue to assess the impact of ASU 2014-09 until the adoption date.

2. FINANCIAL INSTRUMENTS AND FAIR VALUE

The following tables summarize our investments (in thousands):
 
 
June 30, 2017
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
429,112

 
$
78

 
$
(736
)
 
$
428,454

Commercial paper
87,464

 
1

 
(26
)
 
87,439

U.S. government and agency securities
50,283

 
—

 
(127
)
 
50,156

Municipal bonds
45,390

 
21

 
(56
)
 
45,355

Term deposit (1)
405

 
—

 
—

 
405

Total available-for-sale securities
$
612,654

 
$
100

 
$
(945
)
 
$
611,809

 
 
 
 
 
 
 
 
 
December 31, 2016
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
379,494

 
$
43

 
$
(925
)
 
$
378,612

Commercial paper
95,110

 
23

 
(25
)
 
95,108

U.S. government and agency securities
64,604

 
16

 
(79
)
 
64,541

Municipal bonds
59,257

 
3

 
(235
)
 
59,025

Certificates of deposit and term deposits (1)
4,219

 
—

 
—

 
4,219

Total available-for-sale securities
$
602,684

 
$
85

 
$
(1,264
)
 
$
601,505

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

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

 
June 30, 2017
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
Corporate debt securities
$
346,768

 
$
(708
)
 
$
14,738

 
$
(28
)
 
$
361,506

 
$
(736
)
U.S. government and agency securities
47,668

 
(127
)
 
—

 
—

 
47,668

 
(127
)
Municipal bonds
24,032

 
(56
)
 
—

 
—

 
24,032

 
(56
)
Commercial paper
42,050

 
(26
)
 
—

 
—

 
42,050

 
(26
)
Total available-for-sale securities
$
460,518

 
$
(917
)
 
$
14,738

 
$
(28
)
 
$
475,256

 
$
(945
)


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




 
December 31, 2016
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
Corporate debt securities
$
311,980

 
$
(910
)
 
$
13,541

 
$
(15
)
 
$
325,521

 
$
(925
)
Municipal bonds
52,200

 
(235
)
 
—

 
—

 
52,200

 
(235
)
U.S. government and agency securities
33,430

 
(79
)
 
—

 
—

 
33,430

 
(79
)
Commercial paper
17,394

 
(25
)
 
—

 
—

 
17,394

 
(25
)
Total available-for-sale securities
$
415,004

 
$
(1,249
)
 
$
13,541

 
$
(15
)
 
$
428,545

 
$
(1,264
)

The contractual maturities of our investments were as follows (in thousands):
 
 
June 30,
2017
 
December 31,
2016
Due within one year
$
354,187

 
$
376,522

Due between one and three years
257,622

 
224,983

Total
$
611,809

 
$
601,505


Available-for-sale securities are reported at fair value, with unrealized gains and losses and the related tax impact included as a separate component of stockholders’ equity and in comprehensive income (loss). Realized gains and losses on available-for-sale securities are insignificant in the periods presented and are included in Other income (expense)—net in our condensed consolidated statements of operations. We use the specific identification method to determine the cost basis of investments sold.

The unrealized losses on our available-for-sale securities were caused by fluctuations in market value and interest rates as a result of the economic environment. As the decline in market value are attributable to changes in market conditions and not credit quality, and because we have concluded currently that we neither intend to sell nor is it more likely than not that we will be required to sell these investments prior to a recovery of par value, we do not consider these investments to be other-than temporarily impaired as of June 30, 2017.

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

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

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

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

We measure the fair value of money market funds and certain U.S. government and agency securities using quoted prices in active markets for identical assets. The fair value of all other financial instruments was based on quoted prices for similar assets in active markets, or model driven valuations using significant inputs derived from or corroborated by observable market data.
 
We classify investments within Level 1 if quoted prices are available in active markets for identical securities.
 
We classify items within Level 2 if the investments are valued using model driven valuations using observable inputs such as quoted market prices, benchmark yields, reported trades, broker/dealer quotes or alternative pricing sources with

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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 tables present the fair value of our financial assets measured at fair value on a recurring basis as of June 30, 2017 and December 31, 2016 (in thousands):
 
 
June 30, 2017
 
December 31, 2016
 
Aggregate
Fair
Value
 
Quoted
Prices in
Active
Markets For
Identical
Assets
 
Significant
Other
Observable
Remaining
Inputs
 
Significant
Other
Unobservable
Remaining
Inputs
 
Aggregate
Fair
Value
 
Quoted
Prices in
Active
Markets For
Identical
Assets
 
Significant
Other
Observable
Remaining
Inputs
 
Significant
Other
Unobservable
Remaining
Inputs
 
 
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
 
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
$
428,454

 
$
—

 
$
428,454

 
$
—

 
$
378,612

 
$
—

 
$
378,612

 
$
—

Commercial paper
106,915

 
—

 
106,915

 
—

 
105,097

 
—

 
105,097

 
—

U.S. government and agency securities
50,156

 
44,706

 
5,450

 
—

 
64,541

 
52,082

 
12,459

 
—

Municipal bonds
45,355

 
—

 
45,355

 
—

 
59,025

 
—

 
59,025

 
—

Money market funds
18,997

 
18,997

 
—

 
—

 
38,649

 
38,649

 
—

 
—

Certificates of deposit and term deposits (1)
55,758

 
—

 
55,758

 
—

 
59,479

 
—

 
59,479

 
—

Total
$
705,635

 
$
63,703

 
$
641,932

 
$
—

 
$
705,403

 
$
90,731

 
$
614,672

 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reported as:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
$
93,826

 
 
 
 
 
 
 
$
103,898

 
 
 
 
 
 
Short-term investments
354,187

 
 
 
 
 
 
 
376,522

 
 
 
 
 
 
Long-term investments
257,622

 
 
 
 
 
 
 
224,983

 
 
 
 
 
 
Total
$
705,635

 
 
 
 
 
 
 
$
705,403

 
 
 
 
 
 

(1) Subsequent to the issuance of our consolidated financial statements as of and for the year ended December 31, 2016, we determined that $55.3 million in 30-day term deposits, included within cash and cash equivalents in the consolidated balance sheet as of December 31, 2016, should have also been included as Level 2 investments in the fair value hierarchy table for financial assets and financial liabilities measured at fair value on a recurring basis. Accordingly, we have corrected the above table as of December 31, 2016, the effect of which is immaterial to the financial statements as a whole. 

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the six months ended June 30, 2017.




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3. INVENTORY

Inventory consisted of the following (in thousands):
 
 
June 30,
2017
 
December 31,
2016
Raw materials
$
13,265

 
$
18,924

Finished goods
73,174

 
87,963

Inventory
$
86,439

 
$
106,887


4. PROPERTY AND EQUIPMENT—NET

Property and equipment—net consisted of the following (in thousands):
 
 
June 30,
2017
 
December 31,
2016
Building and building improvements
$
133,641

 
$
49,783

Computer equipment and software
72,131

 
65,323

Land
59,203

 
35,079

Leasehold improvements
20,169

 
18,699

Evaluation units
19,600

 
20,173

Furniture and fixtures
14,531

 
13,995

Construction-in-progress
1,077

 
4,669

Total property and equipment
320,352

 
207,721

Less: accumulated depreciation
(81,839
)
 
(70,472
)
Property and equipment—net
$
238,513

 
$
137,249


In April 2017, we purchased certain real estate in Burnaby, Canada for $84.8 million. The purchase was accounted for under the asset acquisition method. The cost of the assets acquired was allocated to land and buildings based on their relative fair values. The amounts allocated to land and buildings were $12.7 million and $72.1 million, respectively.

Depreciation expense was $11.8 million and $9.0 million during the three months ended June 30, 2017 and June 30, 2016, respectively. Depreciation expense was $23.0 million and $18.4 million during the six months ended June 30, 2017 and June 30, 2016, respectively.

5. INVESTMENTS IN PRIVATELY HELD COMPANIES

Our investments in the equity securities of privately held companies totaled $12.1 million and $10.3 million as of June 30, 2017 and December 31, 2016, respectively. These investments are accounted for as cost-basis investments, as we own less than 20% of the voting securities in each of these investments and do not have the ability to exercise significant influence over operating and financial policies of the respective entities. These investments are carried at historical cost and are recorded as other assets on our condensed consolidated balance sheets and would be measured at fair value if indicators of impairment existed. As of June 30, 2017, no events have occurred that would adversely affect the carrying value of these investments.

As of June 30, 2017, we determined that we had a variable interest in these privately held companies. However, we determined that we were not the primary beneficiary as we did not have the power to direct their activities that most significantly affect their economic performance. The variable interest entities are not required to be consolidated in our condensed consolidated financial statements.

6.     BUSINESS COMBINATION

On June 7, 2016, we completed our acquisition of AccelOps, Inc. (“AccelOps”), a provider of network security monitoring and analytics solutions, for total cash consideration of $22.1 million, net of cash received. This acquisition extended

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



the Fortinet Security Fabric by enhancing our network security visibility, security data analytics and threat intelligence across multi-vendor solutions.

The acquisition of AccelOps was accounted as a business combination in accordance with ASC Topic 805 “Business Combinations” issued by the FASB, and we used our best estimates and assumptions to assign fair value to the tangible and intangible assets acquired and liabilities assumed at the acquisition date. We included acquisition-related costs of $0.3 million in general and administrative expenses. The total purchase price was allocated to AccelOps’ identifiable tangible and intangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date. The acquisition also included a contingent obligation for up to $4.0 million in future earn out payments to certain former stockholders of AccelOps if specified future financial targets are met, none of which were met.

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

Cash and cash equivalents
$
171

Accounts receivable
1,126

Prepaid expenses and other assets
430

Property and equipment
203

Deferred tax assets
3,435

Finite-lived intangible assets
14,900

Indefinite-lived intangible assets in process research and development
1,600

Goodwill
9,861

Total assets acquired
31,726

Deferred revenue
4,400

Accounts payable and accrued liabilities
3,348

Other liabilities
1,694

Total liabilities assumed
9,442

Total purchase price allocation
$
22,284


Finite-lived intangible assets consist of developed technology, customer relationships and other intangible assets. AccelOps’ technology provides a software solution to manage security, performance and compliance from a single platform. The acquired developed technologies include software patents, know-how, process and designs. The value of customer relationships is attributable to the generation of a consistent income source and the avoidance of costs associated with creating new customer relationships.

The estimated useful life and fair values of the acquired finite-lived intangible assets were as follows (in thousands, except for estimated useful life):
 
Estimated Useful Life (in years)
 
Fair Values
Developed technologies
4
 
$
12,400

Customer relationships
3
 
2,300

Other
2
 
200

Total
 
 
$
14,900


The developed technologies and other are amortized on a straight-line basis. The amortization expense of developed technologies and other intangibles are recorded in cost of revenue. The amortization expense of customer relationships is amortized on an accelerated basis and is recorded in sales and marketing expenses.

Indefinite-lived intangible assets consist of in-process research and development, which will begin to be amortized upon completion of development.


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The goodwill of $9.9 million represents the amount of the purchase price in excess of the fair value of the net tangible liabilities assumed and intangible assets acquired, including AccelOps’ assembled workforce. The goodwill recorded as part of the AccelOps acquisition is not deductible for U.S. federal income tax purposes.

7. GOODWILL AND OTHER INTANGIBLE ASSETS—NET

Goodwill

As of June 30, 2017, we had goodwill of $14.6 million. There were no impairments to goodwill during the three and six months ended June 30, 2017 or during prior periods.

Other Intangible Assets—net

The following tables present other intangible assets—net as of June 30, 2017 and December 31, 2016 (in thousands, except years):

 
June 30, 2017
 
Weighted-Average Useful Life (in Years)
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
 
 
Finite-lived intangible assets:
 
 
 
 
 
 
 
Developed technologies and other
3.8
 
$
23,984

 
$
11,250

 
$
12,734

Customer relationships
4.7
 
14,500

 
8,506

 
5,994

 
 
 
38,484

 
19,756

 
18,728

 
 
 
 
 
 
 
 
Indefinite-lived intangible assets:
 
 
 
 
 
 
 
In-process research and development
 
 
1,600

 
—

 
1,600

Total other intangible assets—net
 
 
$
40,084

 
$
19,756

 
$
20,328


 
December 31, 2016
 
Weighted-Average Useful Life (in Years)
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
 
 
Finite-lived intangible assets:
 
 
 
 
 
 
 
Developed technologies and other
3.8
 
$
23,984

 
$
8,750

 
$
15,234

Customer relationships
4.7
 
14,500

 
6,506

 
7,994

 
 
 
38,484

 
15,256

 
23,228

 
 
 
 
 
 
 
 
Indefinite-lived intangible assets:
 
 
 
 
 
 
 
In-process research and development
 
 
1,600

 
—

 
1,600

Total other intangible assets—net
 
 
$
40,084

 
$
15,256

 
$
24,828



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



Amortization expense was $2.2 million and $2.3 million during the three months ended June 30, 2017 and June 30, 2016, respectively. Amortization expense was $4.5 million and $3.5 million during the six months ended June 30, 2017 and June 30, 2016, respectively. The following table summarizes estimated future amortization expense of finite-lived intangible assets—net (in thousands):

 
Amount
Years:
 
2017 (remainder)
$
4,074

2018
6,885

2019
5,406

2020
2,363

Total
$
18,728


8. NET INCOME (LOSS) PER SHARE

Basic net income (loss) per share is computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding, plus the dilutive effects of restricted stock units (“RSUs”), stock options and the employee stock purchase plan (“ESPP”). Dilutive shares of common stock are determined by applying the treasury stock method. For the three months ended June 30, 2016, we incurred a net loss and, therefore, the effect of dilutive shares were not included in the computation of dilutive net loss per share as the effect was antidilutive.

A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income (loss) per share is as follows (in thousands, except per share amounts):
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
 
June 30,
2017
 
June 30,
2016
Numerator:
 
 
 
 
 
 
 
Net income (loss)
$
23,033

 
$
(1,388
)
 
$
33,750

 
$
730

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Basic shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding-basic
175,741

 
172,075

 
175,118

 
171,910

Diluted shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding-basic
175,741

 
172,075

 
175,118

 
171,910

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
RSUs
2,441

 
—

 
2,328

 
1,580

Stock options
1,488

 
—

 
1,506

 
1,796

ESPP
31

 
—

 
41

 
74

Weighted-average shares used to compute diluted net income (loss) per share
179,701

 
172,075

 
178,993

 
175,360

Net income (loss) per share:
 
 
 
 
 
 
 
Basic
$
0.13

 
$
(0.01
)
 
$
0.19

 
$
—

Diluted
$
0.13

 
$
(0.01
)
 
$
0.19

 
$
—



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



The following weighted-average shares of common stock were excluded from the computation of diluted net income (loss) per share for the periods presented, as their effect would have been antidilutive (in thousands):
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
 
June 30,
2017
 
June 30,
2016
RSUs
1,158

 
10,577

 
1,831

 
4,715

Stock options
1,124

 
7,058

 
1,121

 
1,182

ESPP
—

 
554

 
131

 
141

 
2,282

 
18,189

 
3,083

 
6,038


9. COMMITMENTS AND CONTINGENCIES

The following table summarizes our future principal contractual obligations as of June 30, 2017 (in thousands):

 
Total
 
2017 (remainder)
 
2018
 
2019
 
2020
 
2021
 
Thereafter
Operating lease commitments
$
46,907

 
$
7,099

 
$
11,296

 
$
8,668

 
$
7,283

 
$
4,122

 
$
8,439

Inventory purchase commitments
67,237

 
65,905

 
1,332

 
—

 
—

 
—

 
—

Other contractual commitments and open purchase orders
63,228

 
53,250

 
7,057

 
2,278

 
533

 
110

 
—

Total
$
177,372

 
$
126,254

 
$
19,685


$
10,946


$
7,816


$
4,232


$
8,439


Operating Leases—We lease certain facilities under various non-cancelable operating leases, which expire through 2026. Certain leases require us to pay variable costs such as taxes, maintenance, and insurance. The terms of certain operating leases also provide for renewal options and escalation clauses. Rent expense was $3.9 million and $4.6 million during the three months ended June 30, 2017 and June 30, 2016, respectively. Rent expense was $8.4 million and $8.5 million during the six months ended June 30, 2017 and June 30, 2016, respectively. Rent expense is recognized using the straight-line method over the term of the lease.
    
Inventory Purchase Commitments—Our independent contract manufacturers procure components and build our products based on our forecasts. These forecasts are based on estimates of future demand for our products, which are in turn based on historical trends and an analysis from our sales and marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate component supply, we may issue purchase orders to some of our independent contract manufacturers which may not be cancelable. As of June 30, 2017, we had $67.2 million of open purchase orders with our independent contract manufacturers that may not be cancelable.

Other Contractual Commitments and Open Purchase Orders—In addition to commitments with contract manufacturers, we have open purchase orders and contractual obligations in the ordinary course of business for which we have not received goods or services. As of June 30, 2017, we had $63.2 million in other contractual commitments that may not be cancelable. We also had other contractual commitments for the purchase of certain real estate adjacent to our corporate headquarters amounting to $12.1 million, which we capitalized as part of property and equipment.

Litigation—We are involved in disputes, litigation, and other legal actions. For lawsuits where we are the defendant, we are in the process of defending these litigation matters, and while there can be no assurances and the outcome of these matters is currently not determinable, we currently believe that there are no existing claims or proceedings that are likely to have a material adverse effect on our financial position. There are many uncertainties associated with any litigation and these actions or other third-party claims against us may cause us to incur costly litigation fees, including contingent legal fees with related parties, costs and substantial settlement charges, and possibly subject us to damages and other penalties. In addition, the resolution of any intellectual property litigation may require us to make royalty payments, which could adversely affect our gross margins in future periods. If any of those events were to occur, our business, financial condition, results of operations, and cash flows could be adversely affected. The actual liability in any such matters may be materially different from our estimates, if any, which could result in the need to adjust the liability and record additional expenses. As required under ASC 450, Contingencies, issued by the FASB, we accrue for contingencies when we believe that a loss is probable and that we can reasonably estimate the amount of any such loss.

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

Indemnification—Under the indemnification provisions of our standard sales contracts, we agree to defend our customers against third-party claims asserting various allegations such as product defects and infringement of certain intellectual property rights, which may include patents, copyrights, trademarks or trade secrets, and to pay judgments entered on such claims. In some contracts, our exposure under these indemnification provisions is limited by the terms of the contracts

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



to certain defined limits, such as the total amount paid by our customer under the agreement. However, certain agreements include covenants, penalties and indemnification provisions including and beyond indemnification for third-party claims of intellectual property infringement and that could potentially expose us to losses in excess of the amount received under the agreement, and in some instances to potential liability that is not contractually limited. To date, there have been no material awards under such indemnification provisions.

10. STOCKHOLDERS’ EQUITY

Stock-Based Compensation Plans

We have stock-based compensation plans pursuant to which we have granted stock options and RSUs. We also have an ESPP for all eligible employees. As of June 30, 2017, there were a total of 50,222,634 shares of common stock available for grant under our stock-based compensation plans.

Restricted Stock Units

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

 
Restricted Stock Units Outstanding
 
Number of Shares
 
Weighted-Average Grant Date Fair Value per Share
Balance—December 31, 2016
9,509

 
$
31.01

Granted
3,132

 
37.38

Forfeited
(645
)
 
33.73

Vested
(2,246
)
 
28.24

Balance—June 30, 2017
9,750

 
$
33.63


As of June 30, 2017, total compensation expense related to unvested RSUs granted to employees and non-employees under the 2009 Plan, but not yet recognized, was $288.2 million. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 2.8 years.

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

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

 
 
 
Six Months Ended
 
 
 
 
 
June 30,
2017
 
June 30,
2016
Shares withheld for taxes
 
 
 
 
725

 
590

Amount withheld for taxes
 
 
 
 
$
25,895

 
$
17,358









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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



Employee Stock Options

The following table summarizes the weighted-average assumptions relating to our employee stock options:
 
 
Three months Ended
 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
 
June 30,
2017
 
June 30,
2016
Expected term in years
4.4

 
4.3

 
4.4

 
4.3

Volatility
34
%
 
39
%
 
36
%
 
43
%
Risk-free interest rate
1.9
%
 
1.2
%
 
1.9
%
 
1.1
%
Dividend rate
—
%
 
—
%
 
—
%
 
—
%

The following table summarizes the stock option activity and related information for the periods presented below (in thousands, except exercise prices and contractual life):
 
 
Options Outstanding
 
Number
of Shares
 
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Life (Years)
 
Aggregate
Intrinsic
Value
Balance—December 31, 2016
6,187

 
$
23.79

 
 
 


Granted
512

 
37.29

 
 
 
 
Forfeited
(82
)
 
29.88

 
 
 
 
Exercised
(1,368
)
 
17.52

 
 
 
 
Balance—June 30, 2017
5,249

 
$
26.65

 
 
 
 
Options vested and expected to vest—June 30, 2017
5,249

 
$
26.65

 
3.4
 
$
58,943

Options exercisable—June 30, 2017
3,478

 
$
24.38

 
2.1
 
$
46,541


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, 2017, for all in-the-money stock options. As of June 30, 2017, total compensation expense related to unvested stock options granted to employees but not yet recognized was $17.5 million. This expense is expected to be amortized on a straight-line basis over a weighted-average period of 2.8 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,
2017
 
June 30,
2016
 
June 30,
2017
 
June 30,
2016
Weighted-average fair value per share granted
$
12.18

 
$
10.92

 
$
12.22

 
$
8.90

Intrinsic value of options exercised
9,003

 
6,829

 
26,901

 
26,253

Fair value of options vested
1,733

 
793

 
5,128

 
2,876


Employee Stock Purchase Plan

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


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
Expected term in years
0.5

 
0.5

Volatility
33
%
 
48
%
Risk-free interest rate
0.7
%
 
0.4
%
Dividend rate
—
%
 
—
%

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

 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
Weighted-average fair value per share granted
$
9.28

 
$
7.19

Shares issued under the ESPP
634

 
614

Weighted-average price per share issued
$
27.97

 
$
20.49


Stock-based Compensation Expense

Stock-based compensation expense is included in costs and expenses as follows (in thousands):
 
Three Months Ended
 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
 
June 30,
2017
 
June 30,
2016
Cost of product revenue
$
383

 
$
298

 
$
725

 
$
578

Cost of service revenue
2,473

 
2,123

 
4,783

 
4,257

Research and development
8,253

 
7,458

 
16,151

 
14,601

Sales and marketing
19,745

 
16,990

 
38,771

 
32,805

General and administrative
4,237

 
3,478

 
7,992

 
7,008

Total stock-based compensation expense
$
35,091

 
$
30,347

 
$
68,422

 
$
59,249


The following table summarizes stock-based compensation expense by award type (in thousands):
 
Three Months Ended
 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
 
June 30,
2017
 
June 30,
2016
RSUs
$
30,862

 
$
26,799

 
$
59,903

 
$
51,902

Stock options
1,925

 
1,592

 
3,770

 
3,546

ESPP
2,304

 
1,956

 
4,749

 
3,801

Total stock-based compensation expense
$
35,091

 
$
30,347

 
$
68,422

 
$
59,249


Total income tax benefit associated with stock-based compensation that is recognized in the condensed consolidated statements of operations is as follows (in thousands):
 
Three Months Ended
 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
 
June 30,
2017
 
June 30,
2016
Income tax benefit associated with stock-based compensation
$
7,743

 
$
7,416

 
$
14,389

 
$
14,737


2016 Share Repurchase Program


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In January 2016, our board of directors approved the 2016 Share Repurchase Program (the “2016 Repurchase Program”), which authorizes the repurchase of up to $200.0 million of our outstanding common stock through December 31, 2017. In October 2016, our board of directors authorized the purchase of an additional $100.0 million of shares of our common stock under the 2016 Repurchase Program, increasing our current authorization to $300.0 million through December 31, 2017. Under the 2016 Repurchase Program, share repurchases may be made by us from time to time in privately negotiated transactions or in open market transactions. The 2016 Repurchase Program does not require us to purchase a minimum number of shares, and may be suspended, modified or discontinued at any time without prior notice.

During the three months ended June 30, 2017, we repurchased 0.8 million shares of common stock under the 2016 Repurchase Program in open market transactions at an average price of $39.07 per share, for an aggregate purchase price of $33.2 million. As of June 30, 2017, $156.0 million remained available for future share repurchases under the 2016 Repurchase Program.
 
11. INCOME TAXES

Our effective tax rate was 30% for the three months ended June 30, 2017, compared to an effective tax rate of 62% for the same period last year. Our effective tax rate was 18% for the six months ended June 30, 2017, compared to an effective tax rate of 111% for the same period last year. The effective tax rates for the periods presented are comprised of U.S. federal and state taxes, excess tax benefits from stock-based compensation, withholding taxes and foreign income taxes. The tax rates for the three months ended June 30, 2017 and June 30, 2016 were impacted by excess tax benefits of $4.1 million and $2.6 million, respectively, from stock-based compensation. The tax rates for the six months ended June 30, 2017 and June 30, 2016 were impacted by excess tax benefits of $9.6 million and $6.2 million, respectively, from stock-based compensation. Our effective tax rates fluctuate based on the amount of pre-tax income or loss. The impact of discrete items, such as excess tax benefits from stock-based compensation, on our effective tax rate is greater when our pre-tax income is lower.

As of June 30, 2017 and December 31, 2016, unrecognized tax benefits were $76.9 million and $65.5 million, respectively. The total amount of $75.2 million in unrecognized tax benefits, if recognized, would favorably affect our effective tax rate.

It is our policy to classify accrued interest and penalties related to uncertain tax benefits in the provision for income taxes. As of June 30, 2017 and December 31, 2016, accrued interest and penalties were $11.5 million and $9.5 million, respectively.
 
It is reasonably possible that our gross unrecognized tax benefits will decrease by up to $7.0 million in the next twelve months, primarily due to the lapse of the statute of limitations. These adjustments, if recognized, would positively impact our effective tax rate, and would be recognized as additional tax benefits.

We file income tax returns in the U.S. federal jurisdiction and in various U.S. state and foreign jurisdictions. Generally, we are no longer subject to U.S. state and non-U.S. income tax examinations by tax authorities for tax years prior to 2009. We are no longer subject to examination by U.S federal income tax authorities for tax years prior to 2012. We are currently under examination by U.S federal income tax authorities for tax years 2012, 2013 and 2014. We have filed a waiver extending the statute of limitations to September 15, 2018 for U.S. federal income tax returns for tax years 2012 and 2013. In addition, the tax authorities in France are examining the inter-company relationship between Fortinet, Inc., Fortinet France and Fortinet Singapore. In May 2017, we received a notice from the French tax authorities that an audit was officially opened for tax years from 2007 to 2015. Our Japan tax audit for tax years 2013, 2014 and 2015 was closed with no material adjustment.


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



12. DEFINED CONTRIBUTION PLANS

Our tax-deferred savings plan under our 401(k) Plan, permits participating employees to defer a portion of their pre-tax earnings. In Canada, we have a Group Registered Retirement Savings Plan Program (the “RRSP”), which permits participants to make tax deductible contributions. Our board of directors approved 50% matching contributions on employee contributions up to 4% of each employee’s eligible earnings. Our matching contributions to our 401(k) Plan and the RRSP for the three months ended June 30, 2017 and June 30, 2016 were $1.3 million and $1.2 million, respectively. Our matching contributions to our 401(k) Plan and the RRSP for the six months ended June 30, 2017 and June 30, 2016 were $2.6 million and $2.2 million, respectively.

13. SEGMENT AND SIGNIFICANT CUSTOMER INFORMATION

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our chief executive officer. Our chief executive officer reviews financial information presented on a consolidated basis, accompanied by information about revenue by geographic region for purposes of allocating resources and evaluating financial performance. We have one business activity, and there are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Accordingly, we have determined that we have one operating segment, and therefore, one reportable segment.
Revenue by geographic region is based on the billing address of the customer. The following tables set forth revenue and property and equipment—net by geographic region (in thousands):
 
 
Three Months Ended
 
Six Months Ended
Revenue
June 30, 2017
 
June 30, 2016
 
June 30, 2017
 
June 30, 2016
Americas:
 
 
 
 
 
 
 
U.S.
$
97,905

 
$
80,811

 
$
188,677

 
$
156,369

Canada
40,859

 
33,782

 
78,204

 
65,087

Latin America (“LATAM”)
21,949

 
18,053

 
40,195

 
31,236

Total Americas
160,713

 
132,646

 
307,076

 
252,692

Europe, Middle East and Africa (“EMEA”)
129,730

 
114,453

 
255,879

 
219,944

Asia Pacific (“APAC”)
73,026

 
64,292

 
141,090

 
123,331

Total revenue
$
363,469

 
$
311,391

 
$
704,045

 
$
595,967


Property and Equipment—net
June 30,
2017
 
December 31,
2016
Americas:
 
 
 
U.S.
$
110,044

 
$
96,414

Canada
101,302

 
12,881

LATAM
406

 
607

Total Americas
211,752

 
109,902

EMEA:
 
 
 
France
12,656

 
13,241

Other EMEA
6,255

 
6,391

Total EMEA
18,911

 
19,632

APAC
7,850

 
7,715

Total property and equipment—net
$
238,513

 
$
137,249


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

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




 
Three Months Ended
 
Six Months Ended
 
June 30,
2017
 
June 30,
2016
 
June 30,
2017
 
June 30,
2016
Exclusive Networks Group
20
%
 
20
%
 
20
%
 
20
%
Fine Tec Computers
12
%
 
*

 
12
%
 
*

Ingram Micro
10
%
 
10
%
 
*

 
*


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

 
June 30,
2017
 
December 31,
2016
Exclusive Networks Group
25
%
 
26
%
Fine Tec Computers
11
%
 
10
%
Arrow Electronics
11
%
 
*


* Represents less than 10%

14. ACCUMULATED OTHER COMPREHENSIVE LOSS

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

 
June 30, 2017
 
Unrealized losses on investments
 
Tax provision related to unrealized gains or losses on investments
 
Total
Beginning balance
$
(1,179
)
 
$
414

 
$
(765
)
Other comprehensive income before reclassifications
332

 
(91
)
 
241

Amounts reclassified from accumulated other comprehensive loss
2

 
(1
)
 
1

Net current-period other comprehensive income
334

 
(92
)
 
242

Ending balance
$
(845
)
 
$
322

 
$
(523
)

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


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



15. FOREIGN CURRENCY DERIVATIVES

Our sales contracts are primarily denominated in U.S. dollars and therefore substantially all of our revenue is not subject to foreign currency translation risk. However, a substantial portion of our operating expenses incurred outside the United States 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 the value and the volatility of future cash flows caused by changes in currency exchange rates, we engage in foreign currency risk management activities to minimize the impact of 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 a maturity of one month. Changes in the fair value of forward exchange contracts related to balance sheet accounts are insignificant and are included in Other income (expense)—net in the consolidated statement of operations. As of June 30, 2017, the fair value of the forward exchange contracts was not material.

Additionally, independent of our use of foreign currency risk management activities, fluctuations in foreign currency exchange rates may cause us to recognize transaction gains and losses in our 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 forward exchange contracts to hedge balance sheet accounts as of June 30, 2017 and December 31, 2016 were (in thousands):

 
Buy/Sell
 
Notional
Balance Sheet Contracts:
 
 
 
Currency—As of June 30, 2017
 
 
 
CAD
Buy
 
$
12,866

 
 
 
 
Currency—As of December 31, 2016
 
 
 
CAD
Sell
 
$
2,615



16. RELATED PARTY TRANSACTIONS

The son of one member of our board of directors is a partner of an outside law firm that we utilize for certain complex litigation matters. Expenses for legal services provided by the law firm were $0.4 million and $0.1 million during the three months ended June 30, 2017 and June 30, 2016, respectively. No contingent fees were incurred in the three months ended June 30, 2017 and 2016. Expenses for legal services provided by the law firm were $0.5 million and $0.4 million during the six months ended June 30, 2017 and June 30, 2016, respectively. No contingent fees were incurred in the six months ended June 30, 2017. Of the $0.4 million legal expenses incurred in the six months ended June 30, 2016, $0.2 million were incurred under contingent fee arrangements. Amounts due and payable to the law firm were $0.5 million and $0.1 million as of June 30, 2017 and December 31, 2016, respectively.

17. SUBSEQUENT EVENT

In July 2017, our Board of Directors authorized a $300.0 million increase to the 2016 Repurchase Program, bringing the amount authorized to be repurchased to $600.0 million, and extended the 2016 Repurchase Program until January 31, 2019.


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

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities and Exchange Act of 1934 (the “Exchange Act”). These statements include, among other things, statements concerning our expectations regarding:

•
continued growth and market share gains;

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

•
expected impact of sales of certain products and services;

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

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

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

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

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

•
continued investments in research and development;

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

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

•
expectations regarding spending related to real estate and other capital expenditures and the impact on free cash flows;

•
competition in our markets;

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

•
success and expansion of our enterprise resource planning system;

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

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

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


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

Business Overview

We provide high performance cybersecurity solutions to a wide variety of enterprises, service providers and government organizations of all sizes across the globe, including a majority of the 2016 Fortune 100. Our cybersecurity solutions are designed to provide broad, rapid protection against dynamic and sophisticated security threats, while simplifying the information technology (“IT”) and security infrastructure of our end-customers.

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

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

Enterprise customers select the form and deployment method that best meet their specific security requirements, such as a high-speed data center firewall at the network core, a next generation firewall at the edge, an internal segmentation firewall between network zones, a distributed enterprise firewall at branch sites or software- and hardware-based solutions designed for virtualized and cloud environments. Many smaller businesses also tend to deploy unified threat management devices. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20 to -100 series, designed for small businesses, FortiGate-200 to -900 series for medium-sized businesses, to the FortiGate-1000 to -7000 series for large enterprises and service providers. Our network security platform also includes our FortiGuard security subscription services, which end-customers can subscribe to in order to obtain access to dynamic updates to application control, anti-virus, intrusion prevention, web filtering and anti-spam functionality. End-customers may also purchase FortiManager and FortiAnalyzer products in conjunction with a FortiGate deployment to provide enterprise-class centralized management, analysis and reporting capabilities. FortiSIEM provides organizations with a solution for analyzing and managing network security, performance and compliance standards across our and other vendors’ products. Finally, end-customers may purchase FortiCare technical support services for our products and FortiCare professional services to assist in the design, implementation and maintenance of their networks.

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

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across public, private and hybrid cloud environments continue to grow faster on a percentage basis than other parts of our business.

Financial Highlights

•
We recorded total revenue of $363.5 million and $704.0 million in the three and six months ended June 30, 2017, an increase of 17% and 18%, respectively, compared to the same periods last year. Product revenue was $142.7 million and $278.0 million in the three and six months ended June 30, 2017, an increase of 4% and 6%, respectively, compared to the same periods last year. Service revenue was $220.8 million and $426.1 million in the three and six months ended June 30, 2017, an increase of 26% and 27%, respectively, compared to the same period last year.

•
We generated operating income of $28.5 million and $33.9 million in the three and six months ended June 30, 2017, respectively, compared to operating loss of $4.0 million and $7.7 million in the three and six months ended June 30, 2016, respectively.

•
Cash, cash equivalents and investments were $1.46 billion as of June 30, 2017, an increase of $154.4 million, or 12%, from December 31, 2016.

•
Deferred revenue was $1.16 billion as of June 30, 2017, an increase of $126.1 million, or 12%, from December 31, 2016.

•
We generated cash flows from operating activities of $274.5 million in the six months ended June 30, 2017, an increase of $106.0 million, or 63%, compared to the same period last year.

•
We repurchased 0.8 million shares of common stock under our 2016 Share Repurchase Program (the “2016 Repurchase Program”) for an aggregate price of $33.2 million in the three months ended June 30, 2017. In July 2017, our Board of Directors authorized a $300.0 million increase to the 2016 Repurchase Program, bringing the total amount authorized to $600.0 million through January 31, 2019.

During the three and six months ended June 30, 2017, our revenue growth was driven by the strength in sales of our products, including FortiGate products, our renewals of service contracts and the sale of our enterprise bundles. During the three months ended June 30, 2017, our high-end products accounted for 39% of billings, which reflected strong sales to large enterprises and an increase in large deals. Our mid-range products accounted for 29% of billings, and our entry-level products accounted for 32% of billings. In addition, we continue to see a shift to higher services growth, which reflected our success in driving higher-priced subscription bundles and metered model business. On a geographic basis, revenue continues to be diversified globally, which remains a key strength of our business.
 
During the three and six months ended June 30, 2017, operating expenses increased by 4% and 10%, respectively, as compared to the same periods last year. The increase was primarily driven by our investments made to develop new products and enhance our existing products, as we continued to invest in research and development to strengthen our technology. We believe that continued product innovation has strengthened our technology and resulted in market share gains. As a percentage of revenue, operating expenses decreased as we continued to focus on productivity and efficiency. Headcount increased by 5% to 4,792 employees and contractors as of June 30, 2017, up from 4,562 as of June 30, 2016.

Business Model

Our sales strategy is based on a distribution model whereby we primarily sell our products, software licenses and services directly to distributors which sell to resellers and service providers, which, in turn, sell to our end-customers. In certain cases, we sell directly to large service providers and major systems integrators. We also offer our products through Amazon Web Services and Microsoft Azure. While the revenue from such sales are still relatively insignificant, they have increased significantly in recent periods on a percentage basis.

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


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

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

Key Metrics

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

 
Three Months Ended Or As Of
 
June 30, 2017
 
June 30, 2016
 
(in thousands)
Revenue
$
363,469

 
$
311,391

Deferred revenue
$
1,161,471

 
$
903,981

Billings (non-GAAP)
$
426,889

 
$
373,784

Cash, cash equivalents and investments
$
1,464,946

 
$
1,221,991

Net cash provided by operating activities
$
144,771

 
$
67,941

Free cash flow (non-GAAP)
$
58,409

 
$
53,498

    
Deferred revenue. Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue. The majority of our deferred revenue balance consists of the unrecognized portion of service revenue from FortiGuard security subscription and FortiCare technical support service contracts, which is recognized as revenue ratably over the contractual service period. We monitor our deferred revenue balance, growth and the mix of short-term and long-term deferred revenue because it represents a significant portion of revenue to be recognized in future periods. Deferred revenue was $1.16 billion as of June 30, 2017, an increase of $126.1 million, or 12%, from December 31, 2016.

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

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


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Table of Contents

 
Three Months Ended
June 30, 2017
 
June 30, 2016

(in thousands)
Billings:
 
 
 
Revenue
$
363,469

 
$
311,391

Add change in deferred revenue
63,420

 
66,793

Less deferred revenue balance acquired in business acquisition
—

 
(4,400
)
Total billings (non-GAAP)
$
426,889

 
$
373,784


Free cash flow (non-GAAP). We define free cash flow as net cash provided by operating activities minus capital expenditures such as purchases of real estate and other property and equipment. We believe free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after capital expenditures, can be used for strategic opportunities, including investing in our business, making strategic acquisitions, repurchasing outstanding common stock, and strengthening the balance sheet. However, free cash flow is not intended to represent our residual cash flow available for discretionary expenditures, since we may have other non-discretionary expenditures that are not deducted from the measure. A limitation of using free cash flow rather than the GAAP measure of net cash provided by operating activities is that free cash flow does not represent the total increase or decrease in the cash, cash equivalents and investments balance for the period because it excludes cash provided by or used for other investing and financing activities. Management accounts for this limitation by providing information about our capital expenditures and other investing and financing activities on the face of the cash flow statement and under “—Liquidity and Capital Resources” and by presenting cash flows from investing and financing activities in our reconciliation of free cash flows. In addition, it is important to note that other companies, including companies in our industry, may not use free cash flow, may calculate free cash flow in a different manner than we do or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of free cash flows as a comparative measure. A reconciliation of free cash flow to net cash provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

 
Three Months Ended