Edgar Filing: FORTINET INC

Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



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

For the quarterly period ended March 31, 2018



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

For the transition period from to

Commission file number: 001-34511

______________________________________

FORTINET, INC.

(Exact name of registrant as specified in its charter)

______________________________________



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



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

(408) 235-7700

(Registrant’s telephone number, including area code)

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

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

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



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

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

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

As of April 30, 2018, there were 168,097,115 shares of the registrant’s common stock outstanding.

FORTINET, INC.

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended March 31, 2018

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		Page

	Part I

Item 1.	Financial Statements	1
	Condensed Consolidated Balance Sheets as of March 31, 2018 and December 31, 2017	1
	Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2018 and 2017	2
	Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2018 and 2017	3
	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2018 and 2017	4
	Notes to Condensed Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	37
Item 4.	Controls and Procedures	38

	Part II

Item 1.	Legal Proceedings	39
Item 1A.	Risk Factors	39
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	67
Item 6.	Exhibits	67
	Exhibit Index	68
	Signatures	69

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Part I


ITEM 1.	Financial Statements

FORTINET, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited, in millions, except per share amounts)



	March 31, 2018			December 31, 2017
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	835.6		$	811.0
Short-term investments	468.3			440.3
Accounts receivable—Net	313.1			348.2
Inventory	80.0			77.3
Prepaid expenses and other current assets	38.8			40.0
Total current assets	1,735.8			1,716.8
LONG-TERM INVESTMENTS	82.5			98.0
PROPERTY AND EQUIPMENT—NET	245.1			245.4
DEFERRED CONTRACT COSTS	148.7			—
DEFERRED TAX ASSETS	138.7			146.9
OTHER INTANGIBLE ASSETS—NET	14.5			16.3
GOODWILL	14.6			14.6
OTHER ASSETS	20.8			19.9
TOTAL ASSETS	$	2,400.7		$	2,257.9

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	55.7		$	70.0
Accrued liabilities	55.6			50.0
Accrued payroll and compensation	82.3			92.0
Income taxes payable	19.0			21.4
Deferred revenue	817.1			793.8
Total current liabilities	1,029.7			1,027.2
DEFERRED REVENUE	579.3			542.5
INCOME TAX LIABILITIES	84.8			90.2
OTHER LIABILITIES	13.4			8.6
Total liabilities	1,707.2			1,668.5
COMMITMENTS AND CONTINGENCIES (Note 9)
STOCKHOLDERS’ EQUITY:
Common stock, $0.001 par value—300 shares authorized; 168.0 and 167.9 shares issued and outstanding at March 31, 2018 and December 31, 2017, respectively	0.2			0.2
Additional paid-in capital	957.9			909.6
Accumulated other comprehensive loss	(2.0		)	(0.8		)
Accumulated deficit	(262.6		)	(319.6		)
Total stockholders’ equity	693.5			589.4
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	2,400.7		$	2,257.9

See notes to condensed consolidated financial statements.

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FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited, in millions, except per share amounts)



	Three Months Ended
	March 31, 2018			March 31, 2017
REVENUE:
Product	$	142.8		$	135.3
Service	256.2			205.3
Total revenue	399.0			340.6
COST OF REVENUE:
Product	58.2			55.3
Service	39.0			35.3
Total cost of revenue	97.2			90.6
GROSS PROFIT:
Product	84.6			80.0
Service	217.2			170.0
Total gross profit	301.8			250.0
OPERATING EXPENSES:
Research and development	59.1			51.2
Sales and marketing	185.3			170.4
General and administrative	25.0			22.6
Restructuring charges	—			0.4
Total operating expenses	269.4			244.6
OPERATING INCOME	32.4			5.4
INTEREST INCOME	4.5			2.4
OTHER INCOME (EXPENSE)—NET	(0.2		)	0.3
INCOME BEFORE INCOME TAXES	36.7			8.1
BENEFIT FROM INCOME TAXES	(4.9		)	(2.6		)
NET INCOME	$	41.6		$	10.7
Net income per share (Note 8):
Basic	$	0.25		$	0.06
Diluted	$	0.24		$	0.06
Weighted-average shares outstanding:
Basic	167.7			174.5
Diluted	171.8			178.3

See notes to condensed consolidated financial statements.

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FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited, in millions)



	Three Months Ended
	March 31, 2018			March 31, 2017
Net income	$	41.6		$	10.7
Other comprehensive income (loss):
Change in unrealized losses on investments	(1.2		)	0.4
Tax provision related to change in unrealized losses on investments	—			0.1
Other comprehensive income (loss)	(1.2		)	0.3
Comprehensive income	$	40.4		$	11.0

See notes to condensed consolidated financial statements.

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FORTINET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in millions)



	Three Months Ended
	March 31, 2018			March 31, 2017
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	41.6		$	10.7
Adjustments to reconcile net income to net cash provided by operating activities:
Stock-based compensation	36.5			33.3
Amortization of deferred contract costs	20.8			—
Depreciation and amortization	13.2			13.5
Other non-cash items—net	0.3			1.5
Amortization of investment premiums	0.1			1.0
Changes in operating assets and liabilities:
Accounts receivable—net	48.9			42.4
Inventory	(7.3		)	(3.5		)
Prepaid expenses and other current assets	1.2			(8.3		)
Deferred contract costs	(32.5		)	—
Deferred tax assets	(9.6		)	(16.6		)
Other assets	(0.9		)	0.7
Accounts payable	(13.6		)	(8.3		)
Accrued liabilities	(4.7		)	2.9
Accrued payroll and compensation	(10.0		)	(5.3		)
Other liabilities	(0.6		)	(1.1		)
Deferred revenue	64.1			61.8
Income taxes payable	(7.8		)	5.0
Net cash provided by operating activities	139.7			129.7
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of investments	(134.9		)	(133.0		)
Sales of investments	16.3			6.0
Maturities of investments	104.7			109.2
Purchases of property and equipment	(11.6		)	(13.5		)
Net cash used in investing activities	(25.5		)	(31.3		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repurchase and retirement of common stock	(115.5		)	—
Proceeds from issuance of common stock	45.1			29.5
Taxes paid related to net share settlement of equity awards	(19.2		)	(13.7		)
Net cash provided by (used in) financing activities	(89.6		)	15.8
NET INCREASE IN CASH AND CASH EQUIVALENTS	24.6			114.2
CASH AND CASH EQUIVALENTS—Beginning of period	811.0			709.0
CASH AND CASH EQUIVALENTS—End of period	$	835.6		$	823.2
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Transfers of evaluation units from inventory to property and equipment	$	4.9		$	5.7
Liability for purchase of property and equipment and asset retirement obligations	$	3.6		$	18.7

See notes to condensed consolidated financial statements.

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FORTINET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Preparation—The unaudited condensed consolidated financial statements of Fortinet, Inc. and its wholly owned subsidiaries (collectively, “we,” “us” or “our”) have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) for interim financial information, as well as the instructions to Form 10-Q pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2017, contained in our Annual Report on Form 10-K filed with the SEC on February 26, 2018. In the opinion of management, all adjustments, which includes normal recurring adjustments, considered necessary for a fair presentation have been included. All intercompany balances, transactions and cash flows have been eliminated. The results of operations for the three months ended March 31, 2018 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, 2017 is derived from the audited consolidated financial statements for the year ended December 31, 2017.

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

There have been no material changes to our significant accounting policies as of and for the three months ended March 31, 2018, except for the accounting policies for revenue recognition, trade receivables and deferred contract costs that were updated as a result of adopting Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). For more information, refer to the “Recently Adopted Accounting Standards” and Note 2.

Recently Adopted Accounting Standards

Financial Instruments – Recognition and Measurement

In January 2016, the FASB issued ASU 2016-01—Financial Instruments—Overall: Recognition and Measurement of Financial Assets and Financial Liabilities, which requires most equity investments to be measured at fair value, with subsequent changes in fair value recognized in net income. A practicality exception applies to those equity investments that do not have a readily determinable fair value. These investments may be measured at cost, adjusted for changes in observable prices minus impairment. ASU 2016-01 was effective prospectively for us beginning on January 1, 2018 for our equity investments, which were previously accounted for under the cost-method. We adopted ASU 2016-01 on January 1, 2018. There was no material impact on our condensed consolidated financial statements as of the adoption date.

Revenue Recognition

In May 2014, the FASB issued ASU 2014-09—Revenue from Contracts with Customers (Topic 606), which supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and requires entities to recognize revenue when control of the promised goods or services is transferred to customers at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. We adopted ASU 2014-09 and its related amendments (collectively known as Topic 606) as of January 1, 2018 using the modified retrospective transition method. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods.

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

We recorded a net reduction to our accumulated deficit as of January 1, 2018 of $117.3 million due to the cumulative impact of adopting Topic 606. The primary impact of adopting Topic 606 relates to the deferral of our incremental contract costs, which are comprised of sales commissions. Prior to January 1, 2018, we expensed all sales commissions upfront. Beginning on January 1, 2018, we continue to expense sales commissions related to product sales upfront, but will capitalize and then amortize certain sales commissions on service contracts over the applicable amortization period. The capitalized sales commissions for initial service contracts are deferred and then amortized as expense on a straight-line basis over the period of benefit which we have determined to be five years. Sales commissions for renewal contracts are deferred and then amortized on a straight line basis over the contractual period of the underlying contracts. The deferral of sales commissions generated deferred tax liability of $23.8 million, of which $18.0 million was recorded against deferred tax assets and the remaining $5.8 million was recorded in other long-term liabilities on our consolidated balance sheet. The impact on deferred revenue as of January 1, 2018 was $4.1 million, which primarily relates to certain changes in revenue recognition on software license sales and the acceleration of revenue from U.S.-based channel partners which were previously deferred until the product was sold through. Beginning on January 1, 2018, our sales returns reserve is now included on the balance sheet in accrued liabilities and no longer as a reduction to our accounts receivable. See Note 2 for further details.

The cumulative effects of the changes made to our January 1, 2018 consolidated balance sheet for the adoption of Topic 606 were as follows (in millions):



	Balance at December 31, 2017			Adjustments due to Topic 606			Balance at January 1, 2018
Assets:
Accounts receivable, net	$	348.2		$	13.6		$	361.8
Inventory	$	77.3		$	(0.1	)	$	77.2
Deferred tax assets	$	146.9		$	(18.0	)	$	128.9
Deferred contract costs	$	—		$	137.1		$	137.1

Liabilities:
Accrued liabilities	$	50.0		$	13.6		$	63.6
Deferred revenue, current	$	793.8		$	0.3		$	794.1
Deferred revenue, non-current	$	542.5		$	(4.4	)	$	538.1
Other liabilities, non-current	$	8.6		$	5.8		$	14.4

Stockholders’ equity:
Accumulated deficit	$	(319.6	)	$	117.3		$	(202.3	)

Recent Accounting Standards Not Yet Effective

Leases

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. ASU 2016-02 includes a number of optional practical expedients that entities may elect to apply. ASU 2016-02 will also require significant additional disclosures about the amount, timing and uncertainty of cash flows from leases. ASU 2016-02 will be effective for us beginning on January 1, 2019, using a modified retrospective approach. Based on our current lease portfolio, we currently estimate the value of leased assets and liabilities that may be recognized on the consolidated balance sheet to be at least $45.0 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 and cash flows. We expect to expand our disclosures in the notes to consolidated financial statements to include more details on our leases, significant judgments and lease-related amounts recognized in the consolidated financial statements.

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

2. REVENUE RECOGNITION

Revenue recognition

On January 1, 2018 we adopted Topic 606 using the modified retrospective method applied to those contracts which were not completed as of January 1, 2018. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported under Topic 605. The details of significant changes and quantitative impact of the changes are discussed below.

We derive the majority of our revenue from sales of our products, FortiGuard security subscription and FortiCare technical support services, and other services. Beginning in 2018, revenues are recognized when control of these goods or services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. Prior to 2018, revenue was recognized under Topic 605 when all of the following criteria were met: (i) persuasive evidence of an arrangement existed, (ii) delivery has occurred or services have been rendered, (iii) sales price was fixed or determinable and (iv) collectability was reasonably assured.

Under Topic 606, we determine revenue recognition through the following steps:

•identification of the contract, or contracts, with the customer,

•identification of the performance obligations in the contract,

•determination of the transaction price,

•allocation of the transaction price to the performance obligations in the contract, and

•recognition of revenue when, or as, we satisfy a performance obligation.

Product revenue primarily consists of sales of hardware and software licenses of our FortiGate, FortiSandbox, FortiManager, FortiAnalyzer and other complimentary products. We derive a substantial majority of product sales from our FortiGate products. We previously recognized product revenue for sales to distributors that had no general right of return and direct sales to end-customers upon shipment, based on general revenue recognition accounting guidance once all other revenue recognition criteria were met. Certain distributors are granted stock rotation rights, limited rights of return or rebates for sales of our products. The arrangement fee for this group of distributors was not fixed or determinable when products were shipped and revenue was therefore deferred and recognized upon sell-through. For sales that included end-customer acceptance criteria, revenue was recognized upon acceptance. Under Topic 606, we recognize product revenue upon shipment when control of the promised goods is transferred to the customer. We recognize revenue from time-based software licenses upon electronic transfer of the license key to the customer. Previously time-based software licenses were recognized over the license term.

We generally provide a 1-year warranty on hardware products and a 90-day warranty on software that provides assurance that our hardware or software products conform to published specifications. Such assurance-type warranties are not deemed to be separate performance obligations from the hardware or software product and costs associated with providing the warranties are accrued in accordance with ASC 460-10.

Service revenue relates to sales of our FortiGuard security subscription, FortiCare technical support services, and other services. Our FortiGuard security subscription services provide access to our antivirus, intrusion prevention, web filtering and anti-spam functionality. Our FortiCare support services include rights to unspecified software upgrades, maintenance releases and patches, telephone and internet access to technical support personnel. Our typical subscription and contractual support term is one to three years, and to a lesser extent, five years. Our revenue recognition for service arrangements did not change under Topic 606. We continue to recognize revenue from these arrangements ratably over the contractual service period because of continuous transfer of control to the customer. Revenue related to subsequent renewals of these services are recognized over the term of the renewal agreement. We also generate a small portion of our revenue from other services consisting of professional services, training and software-as-a-service (“SaaS”) which is either hosted or cloud-based services. We recognize revenue from professional and training services as the services are provided. We recognize revenue from SaaS as the subscription service is delivered over the term, which is typically one year, or on a monthly usage basis. Our revenue recognition for other services did not change under Topic 606. To date, SaaS revenue has not represented a significant percentage of our total revenue.

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Our sales arrangements typically contain multiple performance obligations, such as hardware, software license, security subscription, technical support services and other services, which are generally capable of being distinct and accounted for as separate performance obligations. We allocate the transaction price to each performance obligation based on relative standalone selling price. We determine standalone selling price based on the historical pricing and discounting practices for those services when sold separately. We determine standalone selling price for a product or service by considering multiple historical factors including, but not limited to, cost of products, gross margin objectives, pricing practices, geographies and the term of the service contract that fall within a reasonably range as a percentage of list price. Revenue is reported net of sales taxes.

Under Topic 605, our products and services in a multiple-element arrangement generally qualified as separate units of accounting. We allocated revenue to each unit of accounting based on an estimated selling price using vendor-specific objective evidence (“VSOE”) of selling price, if it existed, or third-party evidence (“TPE”) of selling price. If neither VSOE nor TPE of selling price existed for a deliverable, we used our best estimate of selling price for that deliverable. For multiple-element arrangements where software deliverables were included, revenue was allocated to the non-software deliverables and to the software deliverables as a group using the relative estimated selling prices of each of the deliverables in the arrangement based on the estimated selling price hierarchy. The amount allocated to the software deliverables was then allocated to each software deliverable using the residual method when VSOE of fair value existed. If evidence of VSOE of fair value of one or more undelivered elements did not exist, all software allocated revenue was deferred and recognized when delivery of those elements occurred or when fair value was established. When the undelivered element for which we did not have VSOE of fair value was support, revenue for the entire arrangement was recognized ratably over the support period. The same residual method and VSOE of fair value principles applied for our multiple element arrangements that contained only software elements.

In certain circumstances, our contracts include provisions for sales rebates and other customer incentive programs. Additionally, in limited circumstances, we may permit end-customers, distributors and resellers to return our products, subject to varying limitations, for a refund within a reasonably short period from the date of purchase. These amounts are accounted for as variable consideration that can decrease the transaction price. We estimate variable consideration at the most likely amounts to which we expect our customers to be entitled. We include estimated amounts in the transaction price to the extent that it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. Our estimate for sales return reserve was $12.9 million as of March 31, 2018 and is included in current liabilities in our condensed consolidated balance sheet. Under Topic 605, a sales return reserve of $13.6 million was presented as a reduction to accounts receivable as of December 31, 2017.

We generally invoice at the time of our sale for the total price of the products and security and technical support and other services, and the invoice is payable within 30 to 90 days. We also invoice certain software licenses and services on a monthly basis. Amounts billed and due from our customers are classified as receivables on the balance sheet and do not bear interest. We record deferred revenue when cash payments are received or due in advance of our performance.

During the three months ended March 31, 2018, we recognized $239.1 million in revenue that was included in the deferred revenue balance as of December 31, 2017.

Shipping and handling fees charged to our customers are recognized as product revenue in the period shipped and the related costs for providing these services are recorded as a cost of sale. Shipping and handling fees recognized as product revenue were not significant during the three months ended March 31, 2018 and 2017.

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Disaggregation of Revenue

The following table presents our revenue disaggregated by major product and service lines (in millions):



	Three Months Ended
	March 31, 2018		March 31, 2017 ⁽¹⁾
Product	$	142.8	$	135.3
Service:
Security subscription	136.6		113.5
Technical support	109.6		81.1
Professional services and training	10.0		10.7
Total service revenue	256.2		205.3
Total revenue	$	399.0	$	340.6
⁽¹⁾ As noted above, prior period amounts have not been adjusted under the modified retrospective method.

Transaction Price Allocated to the Remaining Performance Obligations

As of March 31, 2018, we had $1.40 billion in remaining performance obligations, which is substantially comprised of deferred security subscription and technical support services not yet delivered. We expect to recognize revenue on approximately 75% of these remaining performance obligations over the next one to two years, with the remaining balance to be recognized in three to five years.

Accounts Receivable

Trade accounts receivable are recorded at the invoiced amount. Trade accounts receivable is reduced by allowance for doubtful accounts which is determined based on our assessment of the collectability of customer accounts. The allowance for doubtful accounts was $0.7 million and $0.9 million as of March 31, 2018 and December 31, 2017, respectively. As of December 31, 2017, accounts receivable was also reduced by sales return reserve of $13.6 million which we reclassified to accrued liabilities account as of January 1, 2018 in accordance with the adoption of Topic 606.

Contract Assets

Contract assets represent amounts that have been recognized as revenue but for which we did not have the unconditional right to invoice the customer. We did not have contract assets as of March 31, 2018 and January 1, 2018.

Deferred Contract Costs

Sales commissions earned by our sales force are considered incremental and recoverable costs of obtaining a contract with a customer. Sales commissions for the sale of products are recognized at the time of sale. Sales commissions for initial service contracts are deferred and then amortized as an expense on a straight-line basis over the period of benefit which we have determined to be five years. We determined the period of benefit taking into consideration our customer contracts, our technology and other factors. Sales commissions for renewal contracts are deferred and then amortized on a straight line basis over the contractual period of the underlying contracts which ranges from one to three years and, to a lesser extent, five years. The amortization of deferred commissions is included in sales and marketing expense in our condensed consolidated statement of operations. Amortization of deferred contract costs during the three months ended March 31, 2018 was $20.8 million. No impairment loss was recognized during the three months ended March 31, 2018.

Practical Expedient

We elected to use the contract modification practical expedient. This practical expedient allows for all contract modifications before January 1, 2018 to be aggregated and evaluated at adoption date.

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Impact on Condensed Consolidated Financial Statements

The following tables summarize the impact of adopting Topic 606 on our condensed consolidated financial statements as of and for the three months ended March 31, 2018 (in millions). These tables do not represent the full condensed consolidated financial statements as they only reflect the accounts impacted by the adoption of Topic 606.

Condensed Consolidated Balance Sheet



	As of March 31, 2018
	As Reported			Balances Without Adoption of Topic 606			Effect of Change Increase (Decrease)
Assets:
Accounts receivable	$	313.1		$	300.2		$	12.9
Inventory	$	80.0		$	81.5		$	(1.5	)
Deferred contract costs	$	148.7		$	—		$	148.7
Deferred tax assets	$	138.7		$	160.6		$	(21.9	)

Liabilities:
Accrued liabilities	$	55.6		$	40.6		$	15.0
Deferred revenue, current	$	817.1		$	828.8		$	(11.7	)
Deferred revenue, non-current	$	579.3		$	580.2		$	(0.9	)
Other liabilities, non-current	$	13.4		$	7.6		$	5.8

Stockholders’ Equity
Accumulated deficit	$	(262.6	)	$	(392.6	)	$	130.0

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Condensed Consolidated Statement of Operations



	Three Months Ended March 31, 2018
	As Reported			Balances Without Adoption of Topic 606			Effect of Change Increase (Decrease)
REVENUE:
Product	$	142.8		$	137.1		$	5.7
Service	256.2			255.5			0.7
Total revenue	399.0			392.6			6.4
COSTS OF REVENUE:
Product	58.2			56.7			1.5
GROSS PROFIT:
Product	84.6			80.4			4.2
Service	217.2			216.5			0.7
Total gross profit	301.8			296.9			4.9
OPERATING EXPENSES:
Sales and marketing expenses	185.3			197.0			(11.7		)

OPERATING INCOME	32.4			15.8			16.6

INCOME BEFORE INCOME TAXES	36.7			20.1			16.6
BENEFIT FROM INCOME TAXES	(4.9		)	(8.7		)	3.8
NET INCOME	$	41.6		$	28.8		$	12.8
Net income per share:
Basic	$	0.25		$	0.17		$	0.08
Diluted	$	0.24		$	0.17		$	0.07

Condensed Consolidated Statement of Cash Flows



	Three Months Ended March 31, 2018
	As Reported			Balances Without Adoption of Topic 606			Effect of Change Increase (Decrease)
Cash flows from operating activities:
Net income	$	41.6		$	28.8		$	12.8
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of deferred contract costs	20.8			—			20.8
Other non-cash	0.3			0.9			(0.6		)
Changes in operating assets and liabilities:
Inventory	(7.3		)	(8.7		)	1.4
Deferred contract costs	(32.5		)	—			(32.5		)
Deferred tax assets	(9.6		)	(13.6		)	4.0
Accrued liabilities	(4.7		)	(6.1		)	1.4
Deferred revenue	64.1			71.4			(7.3		)
Net cash provided by operating activities	$	139.7		$	139.7		$	—

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)


3.	FINANCIAL INSTRUMENTS AND FAIR VALUE

The following tables summarize our investments (in millions):



	March 31, 2018
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Corporate debt securities	$	372.6	$	—	$	(2.3	)	$	370.3
Certificates of deposit and term deposits ⁽¹⁾	86.2		—		(0.1		)	86.1
Commercial paper	71.0		—		—			71.0
U.S. government and agency securities	23.5		—		(0.1		)	23.4
Total available-for-sale securities	$	553.3	$	—	$	(2.5	)	$	550.8

	December 31, 2017
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Corporate debt securities	$	391.0	$	—	$	(1.2	)	$	389.8
Commercial paper	74.2		—		—			74.2
Certificates of deposit and term deposits ⁽¹⁾	45.9		—		—			45.9
U.S. government and agency securities	28.5		—		(0.1		)	28.4
Total available-for-sale securities	$	539.6	$	—	$	(1.3	)	$	538.3
(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 millions):



	March 31, 2018
	Less Than 12 Months					12 Months or Greater					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
Corporate debt securities	$	317.7	$	(1.8	)	$	51.9	$	(0.5	)	$	369.6	$	(2.3	)
Certificates of deposit and term deposits	56.3		(0.1		)	—		—			56.3		(0.1		)
U.S. government and agency securities	15.0		—			8.4		(0.1		)	23.4		(0.1		)
Total available-for-sale securities	$	389.0	$	(1.9	)	$	60.3	$	(0.6	)	$	449.3	$	(2.5	)



	December 31, 2017
	Less Than 12 Months					12 Months or Greater					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
Corporate debt securities	$	317.4	$	(0.9	)	$	58.2	$	(0.3	)	$	375.6	$	(1.2	)
Certificates of deposit and term deposits	37.2		—			—		—			37.2		—
Commercial paper	29.0		—			—		—			29.0		—
U.S. government and agency securities	17.0		—			11.4		(0.1		)	28.4		(0.1		)
Total available-for-sale securities	$	400.7	$	(0.9	)	$	69.6	$	(0.4	)	$	470.3	$	(1.3	)

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



	March 31, 2018		December 31, 2017
Due within one year	$	468.3	$	440.3
Due within one to three years	82.5		98.0
Total	$	550.8	$	538.3

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. Realized losses on available-for-sale securities were insignificant in the periods presented and are included in other income (expense)—net in our condensed consolidated statements of operations. We use the specific identification method to determine the cost basis of investments sold.

The unrealized losses on our available-for-sale securities were caused by fluctuations in market value and interest rates as a result of the economic environment. As the decline in market value are attributable to changes in market conditions and not credit quality, and because we have concluded currently that we neither intend to sell nor is it more likely than not that we will be required to sell these investments prior to a recovery of par value, we do not consider these investments to be other-than temporarily impaired as of March 31, 2018.

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

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

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

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

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

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

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

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Fair Value of Financial Instruments

Assets Measured at Fair Value on a Recurring Basis

The following tables present the fair value of our financial assets measured at fair value on a recurring basis as of March 31, 2018 and December 31, 2017 (in millions):



	March 31, 2018								December 31, 2017
	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	$	371.5	$	—	$	371.5	$	—	$	411.1	$	—	$	411.1	$	—
Money market funds	108.0		108.0		—		—		195.6		195.6		—		—
Certificates of deposit and term deposits	143.8		—		143.8		—		132.1		—		132.1		—
Commercial paper	93.0		—		93.0		—		128.9		—		128.9		—
U.S. government and agency securities	23.4		20.0		3.4		—		28.4		24.9		3.5		—
Total	$	739.7	$	128.0	$	611.7	$	—	$	896.1	$	220.5	$	675.6	$	—

Reported as:
Cash equivalents	$	188.9							$	357.8
Short-term investments	468.3								440.3
Long-term investments	82.5								98.0
Total	$	739.7							$	896.1

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the three months ended March 31, 2018 and year ended December 31, 2017.

4. INVENTORY

Inventory consisted of the following (in millions):



	March 31, 2018		December 31, 2017
Raw materials	$	12.0	$	13.0
Finished goods	68.0		64.3
Inventory	$	80.0	$	77.3

Inventory includes materials at contract manufacturers of $2.0 million and $2.6 million as of March 31, 2018 and December 31, 2017, respectively. Inventory also includes finished goods held by distributors where revenue is recognized on a sell-through basis of $0.1 million as of December 31, 2017.

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

5. PROPERTY AND EQUIPMENT—Net

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



	March 31, 2018			December 31, 2017
Building and building improvements	$	135.2		$	133.2
Computer equipment and software	86.9			79.9
Land	65.6			65.6
Leasehold improvements	21.5			20.8
Evaluation units	19.2			20.1
Furniture and fixtures	15.4			14.7
Construction-in-progress	2.9			6.3
Total property and equipment	346.7			340.6
Less: accumulated depreciation	(101.6		)	(95.2		)
Property and equipment—net	$	245.1		$	245.4

Depreciation expense was $11.4 million and $11.2 million during the three months ended March 31, 2018 and March 31, 2017, respectively.

6. INVESTMENTS IN PRIVATELY HELD COMPANIES

Our investments in the equity securities of privately held companies totaled $12.1 million as of March 31, 2018 and December 31, 2017. These investments, which were previously accounted for at cost, are now accounted for at cost, adjusted for changes in observable prices minus impairment. 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 March 31, 2018, no events have occurred that would adversely affect the carrying value of these investments.

As of March 31, 2018, 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 VIEs are not required to be consolidated in our condensed consolidated financial statements.

7. GOODWILL AND OTHER INTANGIBLE ASSETS—Net

Goodwill

As of March 31, 2018, we had goodwill of $14.6 million. There were no impairments to goodwill during the three months ended March 31, 2018 or during prior periods.

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Other Intangible Assets—net

The following tables present other intangible assets—net as of March 31, 2018 and December 31, 2017 (in millions, except years):



	March 31, 2018
	Weighted-Average Useful Life (in Years)	Gross		Accumulated Amortization		Net
Other intangible assets—net:
Finite-lived intangible assets:
Developed technologies and other	3.8	$	25.6	$	15.0	$	10.6
Customer relationships	4.7	14.5		10.6		3.9
		$	40.1	$	25.6	$	14.5



	December 31, 2017
	Weighted-Average Useful Life (in Years)	Gross		Accumulated Amortization		Net
Other intangible assets—net:
Finite-lived intangible assets:
Developed technologies and other	3.8	$	24.0	$	13.7	$	10.3
Customer relationships	4.7	14.5		10.1		4.4
		38.5		23.8		14.7

Indefinite-lived intangible assets:
In-process research and development		1.6		—		1.6
Total other intangible assets—net		$	40.1	$	23.8	$	16.3

The in-process research and development intangible asset of $1.6 million was completed in the first quarter of 2018. Upon completion, the cost was transferred to developed technology and is amortized over the estimated useful life of four years.

Amortization expense was $1.8 million and $2.3 million, during the three months ended March 31, 2018 and March 31, 2017, respectively. The following table summarizes estimated future amortization expense of finite-lived intangible assets—net (in millions):



	Amount
Years:
2018	$	5.4
2019	5.8
2020	2.8
2021 and thereafter	0.5
Total	$	14.5

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 during the period, plus the dilutive effects of RSUs, stock options and the ESPP. Dilutive shares of common stock are determined by applying the treasury stock method.

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



	Three Months Ended
	March 31, 2018		March 31, 2017
Numerator:
Net income	$	41.6	$	10.7

Denominator:
Basic shares:
Weighted-average common stock outstanding-basic	167.7		174.5
Diluted shares:
Weighted-average common stock outstanding-basic	167.7		174.5
Effect of potentially dilutive securities:
RSUs	2.7		2.2
Stock options	1.3		1.5
ESPP	0.1		0.1
Weighted-average shares used to compute diluted net income per share	171.8		178.3
Net income per share:
Basic	$	0.25	$	0.06
Diluted	$	0.24	$	0.06

The following weighted-average shares of common stock were excluded from the computation of diluted net income per share for the periods presented, as their effect would have been antidilutive (in millions):



	Three Months Ended
	March 31, 2018	March 31, 2017
RSUs	1.1	2.5
Stock options	0.5	1.1
ESPP	0.2	0.3
	1.8	3.9

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

9. COMMITMENTS AND CONTINGENCIES

The following table summarizes our future principal contractual obligations as of March 31, 2018 (in millions):



	Total		2018 (remainder)		2019		2020		2021		2022		Thereafter
Operating lease commitments	$	55.4	$	12.6	$	13.9	$	10.7	$	6.8	$	4.2	$	7.2
Inventory purchase commitments	106.1		101.9		—		4.2		—		—		—
Total	$	161.5	$	114.5	$	13.9	$	14.9	$	6.8	$	4.2	$	7.2

Operating Leases—We lease certain facilities under various non-cancelable operating leases, which expire through 2026. Certain leases require us to pay variable costs such as taxes, maintenance, and insurance. The terms of certain operating leases also provide for renewal options and escalation clauses. Rent expense was $4.1 million and $4.5 million during the three months ended March 31, 2018 and March 31, 2017, respectively. Rent expense is recognized using the straight-line method over the term of the lease.

Inventory Purchase Commitments—Our independent contract manufacturers procure components and build our products based on our forecasts. These forecasts are based on estimates of future demand for our products, which are in turn based on historical trends and an analysis from our sales and marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate component supply, we may issue purchase orders to some of our independent contract manufacturers which may not be cancelable. As of March 31, 2018, we had $106.1 million of open purchase orders with our independent contract manufacturers that may not be cancelable.

Other Contractual Commitments and Open Purchase Orders—In addition to commitments with contract manufacturers, we have open purchase orders and contractual obligations in the ordinary course of business for which we have not received goods or services. As of March 31, 2018, we had $10.0 million in other contractual commitments having a remaining term in excess of one year that may not be cancelable.

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. We have been fully cooperating with this ongoing inquiry and have periodically met and spoken with the United States Attorney’s Office in connection with this matter.

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

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

10. STOCKHOLDERS’ EQUITY

Stock-Based Compensation Plans

We have stock-based compensation plans pursuant to which we have granted RSUs and stock options. We also have an ESPP for eligible employees. As of March 31, 2018, there were a total of 55.2 million 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 millions, except per share amounts):



	Restricted Stock Units Outstanding
	Number of Shares		Weighted-Average Grant Date Fair Value per Share
Balance—December 31, 2017	8.5		$	34.79
Granted	2.5		49.05
Forfeited	(0.3	)	35.63
Vested	(1.4	)	34.15
Balance—March 31, 2018	9.3		$	38.86

As of March 31, 2018, total compensation expense related to unvested RSUs granted to employees and non-employees under the 2009 Plan, but not yet recognized, was $333.3 million. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 2.91 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 millions):



	Three Months Ended
	March 31, 2018		March 31, 2017
Shares withheld for taxes	0.4		0.4
Amount withheld for taxes	$	19.2	$	13.7

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Employee Stock Options

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



	Three Months Ended
	March 31, 2018		March 31, 2017
Expected term in years	4.4		4.4
Volatility	32	%	36	%
Risk-free interest rate	2.6	%	1.9	%
Dividend rate	—	%	—	%

The following table summarizes the stock option activity and related information for the periods presented below (in millions, 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, 2017	4.3		$	27.50
Granted	0.7		49.06
Forfeited	(0.1	)	30.02
Exercised	(1.0	)	23.94
Balance—March 31, 2018	3.9		$	32.16
Options vested and expected to vest—March 31, 2018	3.9		$	32.16	4.03	$	83.4
Options exercisable—March 31, 2018	2.1		$	27.12	2.52	$	56.3

The aggregate intrinsic value represents the difference between the exercise price of stock options and the quoted market price of our common stock on March 31, 2018, for all in-the-money stock options. As of March 31, 2018, total compensation expense related to unvested stock options granted to employees but not yet recognized was $20.8 million. This expense is expected to be amortized on a straight-line basis over a weighted-average period of 3.0 years.

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



	Three Months Ended
	March 31, 2018		March 31, 2017
Weighted-average fair value per share granted	$	15.02	$	12.22
Intrinsic value of options exercised	23.7		17.9
Fair value of options vested	2.8		3.4

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Employee Stock Purchase Plan

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



	Three Months Ended
	March 31, 2018		March 31, 2017
Expected term in years	0.5		0.5
Volatility	27	%	33	%
Risk-free interest rate	1.8	%	0.7	%
Dividend rate	—	%	—	%

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



	Three Months Ended
	March 31, 2018		March 31, 2017
Weighted-average fair value per share granted	$	11.27	$	9.28
Shares issued under the ESPP	0.7		0.6
Weighted-average price per share issued	$	31.29	$	27.97

Stock-based Compensation Expense

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



	Three Months Ended
	March 31, 2018		March 31, 2017
Cost of product revenue	$	0.4	$	0.3
Cost of service revenue	2.5		2.3
Research and development	8.4		7.9
Sales and marketing	20.9		19.0
General and administrative	4.3		3.8
Total stock-based compensation expense	$	36.5	$	33.3

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



	Three Months Ended
	March 31, 2018		March 31, 2017
RSUs	$	32.0	$	29.0
Stock options	2.0		1.8
ESPP	2.5		2.5
Total stock-based compensation expense	$	36.5	$	33.3

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



	Three Months Ended
	March 31, 2018		March 31, 2017
Income tax benefit associated with stock-based compensation	$	6.0	$	6.6

Share Repurchase Program

In January 2016, our board of directors approved the Share Repurchase Program (the “Repurchase Program”), which authorized the repurchase of up to $200.0 million of our outstanding common stock through December 31, 2017. In 2016 and 2017, our board of directors approved the increases in the aggregate authorized repurchase amount under the Repurchase Program by $100.0 million and $700.0 million, respectively, to a total of $1.0 billion. Under the Repurchase Program, share repurchases may be made by us from time to time in privately negotiated transactions or in open market transactions. The 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 March 31, 2018, we repurchased 2.5 million shares of common stock under the Repurchase Program in open market transactions at an average price of $45.96 per share, for an aggregate purchase price of $115.5 million. As of March 31, 2018, $327.3 million remained available for future share repurchases under the Repurchase Program.

11. INCOME TAXES

Our effective tax rate was a tax benefit of 13% for the three months ended March 31, 2018, compared to a tax benefit of 32% for the same period last year, with the primary difference being the change in the federal tax rate to 21% in 2018 from 35% in the prior year. The effective tax rates for the periods presented are comprised of U.S. federal and state taxes, withholding taxes and foreign taxes of $8.5 million, which are offset by a tax provision benefit of $5.6 million for stock-based compensation and release of reserve on uncertain tax position including interests of $7.8 million. The tax rate for the three months ended March 31, 2017 was comprised of the U.S. federal and state taxes, withholding taxes and foreign taxes of $2.9 million, which were offset by a tax provision benefit of $5.5 million for stock compensation.

As of March 31, 2018 and December 31, 2017, unrecognized tax benefits were $77.6 million and $72.5 million, respectively. The amount of $76.2 million in unrecognized tax benefits, if recognized, would favorably affect our effective tax rate. It is our policy is to include accrued interest and penalties related to uncertain tax benefits in income tax expense. As of March 31, 2018 and December 31, 2017, accrued interest and penalties were $13.4 million and $13.5 million, respectively. It is reasonably possible that our gross unrecognized tax benefits will decrease by up to $7.0 million in the next 12 months, primarily due to the lapse of the statute of limitations and an audit settlement. 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 2008. We are no longer subject to examination by U.S federal income tax authorities for tax years prior to 2015. We have closed the Internal Revenue Service audit for tax years 2012, 2013 and 2014. In March 2018, we received a refund of $6.8 million for a carry-back claim approved in this audit. The tax authorities in France are examining the intercompany 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. The tax authorities in Israel have notified us that we will be audited for tax years from 2008 to 2014.

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FORTINET, INC.

NOTES TO 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 March 31, 2018 and March 31, 2017 were $1.5 million and $1.3 million, respectively.

13. SEGMENT 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 millions):



	Three Months Ended
Revenue	March 31, 2018		March 31, 2017
Americas:
United States	$	133.9	$	116.0
Latin America (“LATAM”)	26.5		18.2
Canada	15.4		12.2
Total Americas	175.8		146.4
Europe, Middle East and Africa (“EMEA”)	144.5		126.1
Asia Pacific (“APAC”)	78.7		68.1
Total revenue	$	399.0	$	340.6



Property and Equipment—net	March 31, 2018		December 31, 2017
Americas:
United States	$	115.3	$	115.6
Canada	103.2		103.8
LATAM	0.4		0.3
Total Americas	218.9		219.7
EMEA:
France	13.1		11.9
Other EMEA	3.9		5.8
Total EMEA	17.0		17.7
APAC	9.2		8.0
Total property and equipment—net	$	245.1	$	245.4

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FORTINET, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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



	Three Months Ended
	March 31, 2018 ⁽¹⁾		March 31, 2017
Exclusive Networks Group	29	%	20	%
Fine Tec Computers	*		12	%
* Represents less than 10%
⁽¹⁾ Due to the acquisition by Exclusive Networks Group of the U.S. division of Fine Tec Computers (“Fine Tec U.S.”) in July 2017, Fine Tec U.S.’s revenue and accounts receivable have been combined with Exclusive Networks Group.

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



	March 31, 2018		December 31, 2017
Exclusive Networks Group	34	%	35	%

14. ACCUMULATED OTHER COMPREHENSIVE LOSS

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



	March 31, 2018
	Unrealized Losses on Investments			Tax provision related to unrealized gains or losses on investments		Total
Beginning balance	$	(1.3	)	$	0.5	$	(0.8	)

Other comprehensive loss before reclassifications	(1.2		)	—		(1.2		)
Amounts reclassified from accumulated other comprehensive loss	—			—		—
Net current-period other comprehensive loss	(1.2		)	—		(1.2		)
Ending balance	$	(2.5	)	$	0.5	$	(2.0	)

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 benefit from income taxes, respectively.

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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, functionality and value in our standalone and bundled subscription service offerings;


•	growing our sales to businesses, service providers 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, cost 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;


•	the impact of the Tax Cuts and Jobs Act of 2017 (the “2017 Tax Act”);


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


•	competition in our markets;


•	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

Fortinet is a global leader in broad, integrated and automated cybersecurity solutions to a wide variety of businesses, such as enterprises, data centers and distributed offices, including a majority of the Fortune 100 companies. Our cybersecurity solutions are designed to provide broad, automated and integrated protection against dynamic and sophisticated security threats, while simplifying the information technology and security infrastructure of our end-customers.

We have four current focus areas for our business. First, we derive a majority of product sales from our FortiGate network security appliances. We continue to develop and improve our offerings, which provide opportunities for market share gains. Second, the Fortinet Security Fabric has been developed to provide unified security across the entire digital attack surface, 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. The Fortinet Security Fabric benefits from customers’ recognition of its value, performance and security coverage and is growing faster than network security. Third, cloud security provides opportunity for growth. We help customers secure their cloud implementations by offering integration, visibility and automation across multi-cloud and hybrid deployments. Our FortiCASB extends the core capabilities of our security fabric architecture to provide businesses the same level of cybersecurity and threat intelligence in cloud environments as they do on their physical networks. While cloud billings are still not significant as compared to the rest of our business, we experienced significant growth in both on-demand cloud consumption and bring-your-own-license (“BYOL”). The Fortinet cloud security is available across all major cloud providers, including Microsoft Azure, Amazon Web Services, Google Cloud, Oracle Cloud and IBM Cloud. Fourth, the emergence of the internet of things (“IoT”) is a new opportunity for us to grow our business and has created an environment where data move freely between devices across locations, network environments, remote offices, mobile workers and public cloud environments, making it difficult to consistently track and secure.

Financial Highlights

•

We recorded total revenue of $399.0 million in the three months ended March 31, 2018, an increase of 17% compared to $340.6 million in the same period last year. Product revenue was $142.8 million in the three months ended March 31, 2018, an increase of 6% compared to $135.3 million in the same period last year. Service revenue was $256.2 million in the three months ended March 31, 2018, an increase of 25% compared to $205.3 million in the same period last year.


•	We generated operating income of $32.4 million in the three months ended March 31, 2018, an increase of 500% compared to $5.4 million in the same period last year.


•	Cash, cash equivalents and investments were $1.39 billion as of March 31, 2018, an increase of $37.1 million, or 3%, from December 31, 2017.


•	Deferred revenue was $1.40 billion as of March 31, 2018, an increase of $60.1 million, or 4%, from December 31, 2017.


•	We generated cash flows from operating activities of $139.7 million in the three months ended March 31, 2018, an increase of $10.0 million, or 8%, compared to the same period last year.


•	During the three months ended March 31, 2018, we repurchased 2.5 million shares of common stock under our Share Repurchase Program (“Repurchase Program”) for an aggregate purchase price of $115.5 million.

During the three months ended March 31, 2018, our revenue growth was primarily driven by growth in service revenue due to the strength of our FortiCare technical support and FortiGuard security subscription revenue growing 35% and 20%, respectively, year-over-year.

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The percentage of our FortiGate-related billings from entry-level products increased from 33% in the three months ended March 31, 2017 to 36% in the three months ended March 31, 2018. The percentage of our FortiGate-related billings from mid-range products was 31% during the three months ended March 31, 2018 and March 31, 2017. The percentage of our FortiGate-related billings from high-end products decreased to 33% in the three months ended March 31, 2018 from 36% in the same period last year. Billings related to non-FortiGate products also grew during the three months ended March 31, 2018, with higher than average growth in the Cloud and Fabric. On a geographic basis, revenue continues to be diversified globally, which remains a key strength of our business.

During the three months ended March 31, 2018, operating expenses as a percentage of revenue decreased by 4 percentage points compared to the same period last year. The decrease was primarily driven by a reduction in sales and marketing expenses as a percentage of revenue, as a result of the adoption of Topic 606 for deferred contract costs, which reduced our commissions expense in absolute dollars and as a percentage of total revenue. Our sales and marketing expenses included a benefit of $11.7 million from the adoption of Topic 606 related to deferred contract costs. Under Topic 606, we capitalized certain commissions on service contracts and amortize the amount over a certain period. Prior to the adoption of Topic 606, we expensed the commission related to these service contracts upfront. Excluding this benefit, sales and marketing expense as a percentage of revenue would have been comparable to the same period last year. Refer to Note 1 and Note 2 in our notes to the condensed consolidated financial statement for more information. Headcount increased by 4% to 5,275 employees and contractors as of March 31, 2018, up from 5,066 as of December 31, 2017.

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 across all major cloud providers, and have recognized on demand revenue and BYOL revenue from Amazon Web Services, Microsoft Azure, Google Cloud, Oracle Cloud and IBM Cloud. In a BYOL arrangement, a customer purchases a perpetual license from us and deploys the software in a cloud provider’s hardware. 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 and FortiCare technical support services are purchased along with our hardware 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. The invoice is payable within 30 to 90 days. We also invoice certain licenses and services on a monthly basis.

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

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Key Metrics

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



	Three Months Ended Or As Of
	March 31, 2018		March 31, 2017
Revenue	$	399.0	$	340.6
Deferred revenue	$	1,396.4	$	1,098.1
Billings (non-GAAP)	$	463.2	$	403.3
Cash, cash equivalents and investments	$	1,386.4	$	1,441.0
Net cash provided by operating activities	$	139.7	$	129.7
Free cash flow (non-GAAP)	$	128.1	$	116.2

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 and free cash flow to be recognized in future periods. Deferred revenue was $1.40 billion as of March 31, 2018, an increase of $60.1 million, or 4%, from December 31, 2017. The adoption of Topic 606 did not have a material impact on the deferred revenue balance.

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 and adjustments to the deferred revenue balance due to adoption of the new revenue recognition standard 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. Total billings were $463.2 million for March 31, 2018, an increase of 15% compared to $403.3 million in the same period last year.

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



	Three Months Ended
	March 31, 2018		March 31, 2017
Billings:
Revenue	$	399.0	$	340.6
Add: Change in deferred revenue	60.1		62.7
Deferred revenue adjustment due to adoption of the new revenue recognition standard	4.1		—
Total billings (non-GAAP)	$	463.2	$	403.3

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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 repurchasing outstanding common stock, investing in our business, making strategic acquisitions and strengthening the balance sheet. 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 (in millions):



	Three Months Ended
	March 31, 2018			March 31, 2017
Free Cash Flow:
Net cash provided by operating activities	$	139.7		$	129.7
Less purchases of property and equipment	(11.6		)	(13.5		)
Free cash flow (non-GAAP)	$	128.1		$	116.2
Net cash used in investing activities	$	(25.5	)	$	(31.3	)
Net cash provided by (used in) financing activities	$	(89.6	)	$	15.8

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, cost of revenue and expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

We adopted Topic 606 on January 1, 2018 using the modified retrospective method. Refer to Note 2 in the notes to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for a discussion of the impact. Other than the adoption of Topic 606, there were no material changes to our critical accounting policies and estimates as of and for the three months ended March 31, 2018, as compared to the critical accounting policies and estimates described in our Annual Report on Form 10-K filed with the SEC on February 26, 2018 (the “Form 10-K”).

Recent Accounting Pronouncements

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

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Results of Operations

Three Months Ended March 31, 2018 and March 31, 2017

Revenue



	Three Months Ended
	March 31, 2018⁽¹⁾				March 31, 2017
	Amount		% of Revenue		Amount		% of Revenue		Change		% Change
	(in millions, except percentages)
Revenue:
Product	$	142.8	36	%	$	135.3	40	%	$	7.5	6	%
Service	256.2		64		205.3		60		50.9		25
Total revenue	$	399.0	100	%	$	340.6	100	%	$	58.4	17	%
Revenue by geography:
Americas	$	175.8	44	%	$	146.4	43	%	$	29.4	20	%
Europe, Middle East and Africa (“EMEA”)	144.5		36		126.1		37		18.4		15
Asia Pacific (“APAC”)