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 September 30, 2016
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, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. 
Large accelerated filer
x
 
 
Accelerated filer
o
Non-accelerated filer
o
(Do not check if smaller reporting company)
 
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  o     No  x
As of October 31, 2016, there were 173,039,498 shares of the registrant’s common stock outstanding.



FORTINET, INC.
QUARTERLY REPORT ON FORM 10-Q
For the Quarter Ended September 30, 2016
Table of Contents
 
 
 
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


 

Table of Contents

Part I

ITEM 1.
Financial Statements

FORTINET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except per share amounts)
 
 
September 30,
2016
 
December 31,
2015
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
647,513

 
$
543,277

Short-term investments
382,909

 
348,074

Accounts receivable—net of reserves for sales returns and doubtful accounts of $14,582 and $6,228 at September 30, 2016 and December 31, 2015, respectively
238,988

 
259,563

Inventory
93,731

 
83,868

Prepaid expenses and other current assets
31,732

 
35,761

Total current assets
1,394,873

 
1,270,543

LONG-TERM INVESTMENTS
240,228

 
272,959

DEFERRED TAX ASSETS
189,434

 
119,216

PROPERTY AND EQUIPMENT—net
126,109

 
91,067

OTHER INTANGIBLE ASSETS—net
27,849

 
17,640

GOODWILL
14,553

 
4,692

OTHER ASSETS
17,114

 
14,393

TOTAL ASSETS
$
2,010,160

 
$
1,790,510

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
57,530

 
$
61,500

Accrued liabilities
37,280

 
33,028

Accrued payroll and compensation
65,610

 
61,111

Income taxes payable
7,795

 
8,379

Deferred revenue
582,145

 
514,652

Total current liabilities
750,360

 
678,670

DEFERRED REVENUE
352,647

 
276,651

INCOME TAX LIABILITIES
67,996

 
60,624

OTHER LIABILITIES
16,069

 
19,188

Total liabilities
1,187,072

 
1,035,133

COMMITMENTS AND CONTINGENCIES (Note 10)


 


STOCKHOLDERS’ EQUITY:
 
 
 
Common stock, $0.001 par value—300,000 shares authorized; 173,513 and 171,399 shares issued and outstanding at September 30, 2016 and December 31, 2015, respectively
173

 
171

Additional paid-in capital
779,669

 
687,658

Accumulated other comprehensive income (loss)
153

 
(933
)
Retained earnings
43,093

 
68,481

Total stockholders’ equity
823,088

 
755,377

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
2,010,160

 
$
1,790,510

See notes to condensed consolidated financial statements.


3
Table of Contents

FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share amounts)
 
 
Three Months Ended
 
Nine Months Ended
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
REVENUE:
 
 
 
 
 
 
 
Product
$
127,972

 
$
119,737

 
$
389,185

 
$
332,023

Service
188,674

 
140,331

 
523,428

 
380,716

Total revenue
316,646

 
260,068

 
912,613

 
712,739

COST OF REVENUE:
 
 
 
 
 
 
 
Product
50,267

 
46,167

 
152,368

 
134,932

Service
34,532

 
25,534

 
94,578

 
69,869

Total cost of revenue
84,799

 
71,701

 
246,946

 
204,801

GROSS PROFIT:
 
 
 
 
 
 
 
Product
77,705

 
73,570

 
236,817

 
197,091

Service
154,142

 
114,797

 
428,850

 
310,847

Total gross profit
231,847

 
188,367

 
665,667

 
507,938

OPERATING EXPENSES:
 
 
 
 
 
 
 
Research and development
47,239

 
42,110

 
137,495

 
115,315

Sales and marketing
154,831

 
120,994

 
463,628

 
333,531

General and administrative
22,006

 
21,220

 
63,629

 
51,199

Restructuring charges
2,283

 
5,883

 
3,164

 
5,883

Total operating expenses
226,359

 
190,207

 
667,916

 
505,928

OPERATING INCOME (LOSS)
5,488

 
(1,840
)
 
(2,249
)
 
2,010

INTEREST INCOME
1,888

 
1,333

 
5,339

 
4,119

OTHER EXPENSE—net
(787
)
 
(653
)
 
(3,449
)
 
(2,160
)
INCOME (LOSS) BEFORE INCOME TAXES
6,589

 
(1,160
)
 
(359
)
 
3,969

PROVISION FOR (BENEFIT FROM) INCOME TAXES
298

 
(9,329
)
 
(7,380
)
 
(6,552
)
NET INCOME
$
6,291

 
$
8,169

 
$
7,021

 
$
10,521

Net income per share (Note 8):
 
 
 
 
 
 
 
Basic
$
0.04

 
$
0.05

 
$
0.04

 
$
0.06

Diluted
$
0.04

 
$
0.05

 
$
0.04

 
$
0.06

Weighted-average shares outstanding:
 
 
 
 
 
 
 
Basic
173,335

 
171,648

 
172,212

 
169,898

Diluted
177,938

 
177,897

 
176,046

 
175,963

See notes to condensed consolidated financial statements.


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Table of Contents

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Net income
$
6,291

 
$
8,169

 
$
7,021

 
$
10,521

Other comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized gains (losses) on investments
(879
)
 
337

 
1,670

 
400

Tax provision (benefit)
(308
)
 
118

 
584

 
141

Other comprehensive income (loss)—net of taxes
(571
)
 
219

 
1,086

 
259

Comprehensive income
$
5,720

 
$
8,388

 
$
8,107

 
$
10,780


See notes to condensed consolidated financial statements.




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Table of Contents

FORTINET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
7,021

 
$
10,521

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
34,896

 
22,206

Amortization of investment premiums
3,828

 
5,770

Stock-based compensation
90,342

 
67,001

Other non-cash items—net
4,846

 
2,681

Changes in operating assets and liabilities:
 
 
 
Accounts receivable—net
12,788

 
20,923

Inventory
(24,555
)
 
(12,427
)
Deferred tax assets
(35,005
)
 
(28,297
)
Prepaid expenses and other current assets
4,301

 
(7,806
)
Other assets
(2,595
)
 
(264
)
Accounts payable
(1,584
)
 
(9,842
)
Accrued liabilities
598

 
(3,296
)
Accrued payroll and compensation
3,253

 
(1,895
)
Other liabilities
(3,119
)
 
(1,232
)
Deferred revenue
142,867

 
136,193

Income taxes payable
6,789

 
13,753

Net cash provided by operating activities
244,671

 
213,989

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of investments
(370,573
)
 
(329,687
)
Sales of investments
21,805

 
35,384

Maturities of investments
344,959

 
364,256

Purchases of property and equipment
(50,319
)
 
(29,013
)
Payments made in connection with business acquisition, net of cash acquired
(22,087
)
 
(38,025
)
Net cash provided by (used in) investing activities
(76,215
)
 
2,915

CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock
42,292

 
63,543

Taxes paid related to net share settlement of equity awards
(29,886
)
 
(22,989
)
Repurchase and retirement of common stock
(75,000
)
 
—

Payments of debt assumed in connection with business acquisition
(1,626
)
 
—

Net cash provided by (used in) financing activities
(64,220
)
 
40,554

NET INCREASE IN CASH AND CASH EQUIVALENTS
104,236

 
257,458

CASH AND CASH EQUIVALENTS—Beginning of period
543,277

 
283,254

CASH AND CASH EQUIVALENTS—End of period
$
647,513

 
$
540,712

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid for income taxes—net of refunds
$
20,534

 
$
15,272

NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Transfers of evaluation units from inventory to property and equipment
$
15,627

 
$
13,695

Liability for purchase of property and equipment and asset retirement obligations
$
8,325

 
$
2,243

Equity awards assumed in connection with business acquisition
$
—

 
$
471

See notes to condensed consolidated financial statements.

6
Table of Contents

FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Preparation—The unaudited condensed consolidated financial statements of Fortinet, Inc. and its wholly-owned subsidiaries (collectively, “we,” “us” or “our”) have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) for interim financial information, as well as the instructions to Form 10-Q pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2015, contained in our Annual Report on Form 10-K (the “Form 10-K”) filed with the SEC on February 26, 2016. In the opinion of management, all adjustments, which includes normal recurring adjustments, considered necessary for a fair presentation have been included. All intercompany balances, transactions and cash flows have been eliminated. The results of operations for the three and nine months ended September 30, 2016 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, 2015 is derived from the audited consolidated financial statements for the year ended December 31, 2015.

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

There have been no material changes to our significant accounting policies as of and for the three and nine months ended September 30, 2016, except for changes to our policy related to stock-based compensation expense. For more information, refer to the “Recently Adopted Accounting Standards.”

Recently Adopted Accounting Standards

In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-09—Compensation—Stock Compensation—Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). The new guidance changes the accounting for certain aspects of stock-based payments to employees and requires excess tax benefits and tax deficiencies to be recorded in the income statement when the awards vest or are settled. In addition, cash flows related to excess tax benefits will no longer be separately classified as a financing activity apart from other income tax cash flows. The standard also allows us to repurchase more of an employee’s shares for tax withholding purposes without triggering liability accounting, clarifies that all cash payments made on an employee’s behalf for withheld shares should be presented as a financing activity on our cash flows statement, and provides an accounting policy election to account for forfeitures as they occur.

We elected to early adopt the new guidance in the second quarter of 2016. The primary impact of the adoption was the recognition of excess tax benefits in our provision for income taxes rather than paid-in capital, as well as the adjustment in stock-based compensation expense as a result of our change in forfeiture policy. The new guidance eliminates the requirement to delay the recognition of excess tax benefits until it reduces current taxes payable. We adopted this change on a modified retrospective basis, and recorded unrecognized excess tax benefits of $32.4 million as a cumulative-effect adjustment, which increased retained earnings on January 1, 2016. The new guidance also requires us to record, subsequent to the adoption, excess tax benefits and tax deficiencies in the period these arise. As a result, our provision for income taxes decreased by $3.6 million during the first quarter of 2016.

Under the new guidance, we have elected to change our policy and have started to recognize forfeitures of awards as they occur. The change in forfeiture policy was adopted using a modified retrospective transition method. We recorded a cumulative-effect adjustment to decrease retained earnings by $0.8 million upon transition on January 1, 2016 and a retrospective decrease of stock-based compensation of $2.0 million during the first quarter of 2016.

The amendment to the minimum statutory withholding tax requirements was adopted on a modified retrospective basis. The adoption had no impact on the January 1, 2016 retained earnings. In addition, we adopted the presentation of taxes paid related to net share settlement of equity awards as a financing activity on the statement of cash flows on a retrospective basis. Our adoption had no impact to any of the periods presented in our consolidated cash flows statements since such cash flows have historically been presented as a financing activity.


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



The adoption of ASU 2016-09 impacted our previously reported quarterly results for the three months ended March 31, 2016, as well as our weighted average shares outstanding—diluted, as follows (in thousands, except for earnings per share):

 
Three Months Ended
 
March 31, 2016
 
As Reported
 
As Adjusted
Statements of Operations:
 
 
 
Stock-based compensation expense
$
30,881

 
$
28,901

Benefit from income taxes
$
(1,809
)
 
$
(5,376
)
Net income (loss)
$
(3,429
)
 
$
2,118

Net income (loss) per share—Basic
$
(0.02
)
 
$
0.01

Net income (loss) per share—Diluted
$
(0.02
)
 
$
0.01

Weighted-average shares outstanding—Diluted
171,745

 
174,421


 
March 31, 2016
 
As Reported
 
As Adjusted
Balance Sheets:
 
 
 
Deferred tax assets
$
131,696

 
$
167,625

Additional paid-in capital
$
718,849

 
$
717,671

Retained earnings
$
23,089

 
$
60,196


In September 2015, the FASB issued ASU 2015-16—Business Combinations—Simplifying the Accounting for Measurement-Period Adjustments, which eliminates the requirement for an acquirer in a business combination to account for measurement-period adjustments retrospectively. Instead, acquirers must recognize measurement-period adjustments during the period in which they determine the amounts, including the effect on earnings of any amounts they would have recorded in previous periods if the accounting had been completed at the acquisition date. We adopted ASU 2015-16 on January 1, 2016. The adoption of ASU 2015-16 has not had any impact on our consolidated financial statements.

Recent Accounting Standards Not Yet Effective

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

In August 2016, the FASB issued ASU 2016-15—Statement of Cash Flows—Classification of Certain Cash Receipts and Cash Payments, which clarifies how companies present and classify certain cash receipts and cash payments in the statement of cash flows. ASU 2016-15 is effective for us beginning on January 1, 2018. Early adoption is permitted, including adoption in an interim period. We are currently evaluating the impact of adopting ASU 2016-15 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 ASU 2016-13 will have on our consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02—Leases, which amends lease accounting requirements to begin recording assets and liabilities arising from leases on the balance sheet. 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. The modified retrospective approach includes a

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



number of optional practical expedients that entities may elect to apply. We expect our assets and liabilities to increase as a result of the adoption of this standard. We are currently evaluating the impact of adopting ASU 2016-02 on our consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09—Revenue from Contracts with Customers, which creates a single, joint revenue standard that is consistent across all industries and markets for companies that prepare their financial statements in accordance with GAAP. Under ASU 2014-09, an entity is required to recognize revenue upon the transfer of promised goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to receive in exchange for those goods or services. In July 2015, the FASB decided to delay the effective date of the new revenue standard by one year. In March 2016, the FASB issued ASU 2016-08, which clarifies the implementation guidance on principal versus agent considerations. In April 2016, the FASB issued ASU 2016-10, which clarifies the implementation guidance on identifying performance obligations and licensing. In May 2016, the FASB issued ASU 2016-12—Revenue from Contracts with Customers—Narrow-scope Improvements and Practical Expedients, which amends the guidance on collectability, noncash consideration, presentation of sales tax and transition. These standards will be effective for us beginning on January 1, 2018. We are currently evaluating the impact of these new standards on our consolidated financial statements.

2. FINANCIAL INSTRUMENTS AND FAIR VALUE

Our investments as of September 30, 2016 and December 31, 2015 were (in thousands):
 
 
September 30, 2016
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
385,016

 
$
425

 
$
(211
)
 
$
385,230

Commercial paper
127,059

 
18

 
(43
)
 
127,034

Municipal bonds
53,821

 
14

 
(36
)
 
53,799

Certificates of deposit and term deposits (1)
4,322

 
—

 
—

 
4,322

U.S. government and agency securities
52,686

 
72

 
(6
)
 
52,752

Total available-for-sale securities
$
622,904

 
$
529

 
$
(296
)
 
$
623,137


 
December 31, 2015
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
438,533

 
$
30

 
$
(1,369
)
 
$
437,194

Commercial paper
66,263

 
3

 
(34
)
 
66,232

Municipal bonds
61,050

 
12

 
(40
)
 
61,022

Certificates of deposit and term deposits (1)
14,897

 
—

 
—

 
14,897

U.S. government and agency securities
41,727

 
3

 
(42
)
 
41,688

Total available-for-sale securities
$
622,470

 
$
48

 
$
(1,485
)
 
$
621,033

 
 
 
 
 
 
 
 

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

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



The gross unrealized losses and the related fair values of our investments that have been in a continuous unrealized loss position as of September 30, 2016 and December 31, 2015 were (in thousands):

 
September 30, 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
$
157,390

 
$
(188
)
 
$
37,548

 
$
(22
)
 
$
194,938

 
$
(210
)
Commercial paper
19,320

 
(43
)
 
—

 
—

 
19,320

 
(43
)
Municipal bonds
36,163

 
(37
)
 
—

 
—

 
36,163

 
(37
)
U.S. government and agency securities
5,492

 
(6
)
 
—

 
—

 
5,492

 
(6
)
Total available-for-sale securities
$
218,365

 
$
(274
)
 
$
37,548

 
$
(22
)
 
$
255,913

 
$
(296
)

 
December 31, 2015
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
Corporate debt securities
$
348,534

 
$
(1,187
)
 
$
42,033

 
$
(182
)
 
$
390,567

 
$
(1,369
)
Commercial paper
31,977

 
(34
)
 
—

 
—

 
31,977

 
(34
)
Municipal bonds
41,677

 
(36
)
 
1,008

 
(4
)
 
42,685

 
(40
)
U.S. government and agency securities
34,703

 
(42
)
 
—

 
—

 
34,703

 
(42
)
Total available-for-sale securities
$
456,891

 
$
(1,299
)
 
$
43,041

 
$
(186
)
 
$
499,932

 
$
(1,485
)

The contractual maturities of our investments as of September 30, 2016 and December 31, 2015 were (in thousands):
 
 
September 30,
2016
 
December 31,
2015
Due within one year
$
382,909

 
$
348,074

Due within one to three years
240,228

 
272,959

Total
$
623,137

 
$
621,033


Available-for-sale securities are reported at fair value, with unrealized gains and losses, net of tax, included as a separate component of stockholders’ equity and in total comprehensive income. Realized gains and losses on available-for-sale securities are insignificant in the periods presented and are included in Other 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 September 30, 2016.

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.


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



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.

Fair Value of Financial Instruments

Assets Measured at Fair Value on a Recurring Basis

The fair values of our financial assets measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015 were (in thousands):
 
 
September 30, 2016
 
 
 
December 31, 2015
 
 
 
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
$
385,230

 
$
—

 
$
385,230

 
$
—

 
$
437,194

 
$
—

 
$
437,194

 
$
—

Commercial paper
132,033

 
—

 
132,033

 
—

 
69,231

 
—

 
69,231

 
—

Municipal bonds
53,799

 
—

 
53,799

 
—

 
61,022

 
—

 
61,022

 
—

Certificates of deposit and term deposits
4,322

 
—

 
4,322

 
—

 
14,897

 
—

 
14,897

 
—

Money market funds
21,886

 
21,886

 
—

 
—

 
50,030

 
50,030

 
—

 
—

U.S. government and agency securities
52,752

 
42,243

 
10,509

 
—

 
41,688

 
25,693

 
15,995

 
—

Total
$
650,022

 
$
64,129

 
$
585,893

 
$
—

 
$
674,062

 
$
75,723

 
$
598,339

 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reported as:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
$
26,885

 
 
 
 
 
 
 
$
53,029

 
 
 
 
 
 
Short-term investments
382,909

 
 
 
 
 
 
 
348,074

 
 
 
 
 
 
Long-term investments
240,228

 
 
 
 
 
 
 
272,959

 
 
 
 
 
 
Total
$
650,022

 
 
 
 
 
 
 
$
674,062

 
 
 
 
 
 

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the nine months ended September 30, 2016.


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




3. INVENTORY

Our inventory as of September 30, 2016 and December 31, 2015 consisted of (in thousands):
 
 
September 30,
2016
 
December 31,
2015
Raw materials
$
19,690

 
$
15,425

Finished goods
74,041

 
68,443

Inventory
$
93,731

 
$
83,868


Inventory includes finished goods held by distributors where revenue is recognized on a sell-through basis of $1.4 million and $1.1 million as of September 30, 2016 and December 31, 2015, respectively. Inventory also includes materials at contract manufacturers of $6.3 million and $4.9 million as of September 30, 2016 and December 31, 2015, respectively.
 
4. PROPERTY AND EQUIPMENT—net
Our property and equipment—net as of September 30, 2016 and December 31, 2015 consisted of (in thousands):
 
 
September 30,
2016
 
December 31,
2015
Land
$
31,251

 
$
21,683

Building and building improvements
44,513

 
28,841

Evaluation units
17,633

 
15,784

Computer equipment and software
62,585

 
45,632

Furniture and fixtures
13,127

 
8,901

Construction-in-progress
4,365

 
8,106

Leasehold improvements
16,501

 
11,179

Total property and equipment
189,975

 
140,126

Less: accumulated depreciation
(63,866
)
 
(49,059
)
Property and equipment—net
$
126,109

 
$
91,067


Depreciation expense was $10.2 million and $7.5 million during the three months ended September 30, 2016 and September 30, 2015, respectively. Depreciation expense was $28.6 million and $20.3 million during the nine months ended September 30, 2016 and September 30, 2015, respectively.

5. INVESTMENTS IN PRIVATELY-HELD COMPANIES

Our investments in the equity securities of three privately-held companies totaled $10.3 million as of September 30, 2016 and December 31, 2015. Each of these investments are accounted for as cost-basis investments, as we own less than 20% of the voting securities and do not have the ability to exercise significant influence over operating and financial policies of the respective entities. These investments are carried at historical cost and are recorded as Other assets on our condensed consolidated balance sheet and would be measured at fair value if indicators of impairment exist. As of September 30, 2016, no events have occurred that would adversely affect the carrying value of these investments.

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 were not required to be consolidated in our condensed consolidated financial statements.


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



6. BUSINESS COMBINATIONS

AccelOps, Inc.

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. We believe this acquisition will extend the Fortinet Security Fabric (as defined below) by enhancing our network security visibility, security data analytics, and threat intelligence across multi-vendor solutions.

The acquisition of AccelOps is accounted as a business combination in accordance with the Accounting Standards Codification Topic 805 “Business Combinations” (“ASC 805”) issued by the FASB. We use 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 for the three and six months period ended June 30, 2016 and December 31, 2016, respectively. The financial target for the three months period ended June 30, 2016 was not met.  As of September 30, 2016, no fair value was assigned to the contingent consideration based on the estimated probability of attainment of the remaining target. We will remeasure the contingent consideration during the contingency period for the remaining target, with changes in fair value to be recorded in our consolidated statements of operations.

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):

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



 
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 service 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.

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. The financial results of this acquisition are considered immaterial for purposes of pro forma financial disclosures.

Meru Networks, Inc.

On July 8, 2015, we completed our acquisition of Meru Networks, Inc. (“Meru”), a provider of Wi-Fi networking products and services.

In connection with the acquisition, we paid $41.8 million, comprised of cash consideration of $40.9 million, withholding tax liability of $0.4 million and $0.5 million in estimated fair value associated with restricted stock units (“RSUs”) of Meru that were converted for 53,401 shares of our common stock.

We accounted for this transaction as a business combination. During the three and nine months ended September 30, 2015, we included acquisition-related costs of $1.7 million in general and administrative expenses. The total purchase price was allocated to Meru’s identifiable tangible and intangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date.

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

Cash and cash equivalents
$
3,268

Accounts receivable
8,191

Inventory
11,610

Prepaid expenses and other assets
2,409

Property and equipment
920

Deferred tax assets
18,585

Finite-lived intangible assets
19,600

Goodwill
1,868

Total assets acquired
66,451

Deferred revenue
9,800

Accounts payable and accrued liabilities
14,887

Total liabilities assumed
24,687

Total purchase price allocation
$
41,764



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



The goodwill of $1.9 million represents the premium we paid over the fair value of the net tangible liabilities assumed and identified intangible assets acquired, due primarily to Meru’s assembled workforce. The goodwill recorded as part of the Meru acquisition is not deductible for U.S. federal income tax purposes.

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

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

Developed technologies
4
 
7,200

Trade name
0.5
 
200

Total
 
 
$
19,600


Customer relationships and trade name are amortized and the amortization expense is recorded in sales and marketing expenses in the condensed consolidated statement of operations. Developed technologies are amortized and the amortization expense is recorded in cost of product revenue in the condensed consolidated statement of operations.

7. GOODWILL AND OTHER INTANGIBLE ASSETS—net

Goodwill

Changes in the carrying amount of goodwill were (in thousands):

 
Amount
Balance—December 31, 2015
$
4,692

Addition due to business acquisition
9,861

Balance—September 30, 2016
$
14,553


There were no impairments to goodwill during the three and nine months ended September 30, 2016.

Other Intangible Assets—net

Other intangible assets—net as of September 30, 2016 and December 31, 2015 were (in thousands):


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



 
September 30, 2016
 
Weighted-Average Useful Life (in Years)
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
 
 
Finite-lived intangible assets:
 
 
 
 
 
 
 
Customer relationships
4.7
 
$
14,500

 
$
4,735

 
$
9,765

Developed technologies and other
3.8
 
23,984

 
7,500

 
16,484

 
 
 
38,484

 
12,235

 
26,249

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

 
—

 
1,600

Total other intangible assets—net
 
 
$
40,084

 
$
12,235

 
$
27,849


 
December 31, 2015
 
Weighted-Average Useful Life (in Years)
 
Gross
 
Accumulated Amortization
 
Net
Other intangible assets—net:
 
 
 
 
 
 
 
Customer relationships
5.0
 
$
12,200

 
$
1,220

 
$
10,980

Developed technologies and other
3.6
 
11,384

 
4,724

 
6,660

Total other intangible assets—net
 
 
$
23,584

 
$
5,944

 
$
17,640


Amortization expense was $2.8 million and $1.3 million during the three months ended September 30, 2016 and September 30, 2015, respectively. Amortization expense was $6.3 million and $1.9 million during the nine months ended September 30, 2016 and September 30, 2015, respectively. The following table summarizes estimated future amortization expense of Other intangible assets—net with finite lives (in thousands):

 
Amount
Years:
 
2016 (remainder)
$
2,798

2017
8,450

2018
7,098

2019
5,540

2020
2,363

Total
$
26,249


8. NET INCOME PER SHARE

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


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



A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per share is as follows (in thousands, except per share amounts):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Numerator:
 
 
 
 
 
 
 
Net income
$
6,291

 
$
8,169

 
$
7,021

 
$
10,521

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Basic shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding-basic
173,335

 
171,648

 
172,212

 
169,898

Diluted shares:
 
 
 
 
 
 
 
Weighted-average common stock outstanding-basic
173,335

 
171,648

 
172,212

 
169,898

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Stock options
2,009

 
3,451

 
1,867

 
3,669

RSUs (including PSUs)
2,513

 
2,742

 
1,891

 
2,335

ESPP
81

 
56

 
76

 
61

Weighted-average shares used to compute diluted net income per share
177,938

 
177,897

 
176,046

 
175,963

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.04

 
$
0.05

 
$
0.04

 
$
0.06

Diluted
$
0.04

 
$
0.05

 
$
0.04

 
$
0.06


The following potentially dilutive shares of common stock were excluded from the computation of diluted net income per share for the periods presented, as their effect would have been antidilutive (in thousands):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Stock options
836

 
265

 
1,067

 
271

RSUs (including PSUs)
2,409

 
1,331

 
3,946

 
1,026

ESPP
353

 
209

 
211

 
126

 
3,598

 
1,805

 
5,224

 
1,423



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



9. RESTRUCTURING CHARGES

The following table provides a summary of restructuring activity for the nine months ended September 30, 2016 (in thousands):

 
Employee Severance and Other Benefits
 
Contract Terminations and Other Charges
 
Total
Balance as of December 31, 2015
$
3,689

 
$
229

 
$
3,918

Costs incurred
3,120

 
44

 
3,164

Less cash payments
(5,060
)
 
(273
)
 
(5,333
)
Less non-cash charges
(89
)
 
—

 
(89
)
Balance as of September 30, 2016
$
1,660

 
$
—

 
$
1,660


2015 Meru Restructuring

In connection with the acquisition of Meru, we initiated planned cost reduction and restructuring activities to improve our cost structure and operational efficiencies starting in the third quarter of 2015. To date, we have incurred $7.9 million of charges related to this restructuring. These charges are primarily related to severance payments to be paid in cash and are included in operating expense in the condensed consolidated statements of operations of the period when incurred. We incurred $0.1 million and $0.3 million of charges related to this restructuring during the three and nine months ended September 30, 2016, respectively, and these charges are included in operating expense in the condensed consolidated statements of operations. We do not anticipate incurring additional charges related to this restructuring.

The remaining restructuring reserve of $1.1 million is included in accrued liabilities on the condensed consolidated balance sheet as of September 30, 2016 and is expected to be paid within one year.

2016 Restructuring

In the second and third quarter of 2016, we implemented a plan to restructure and further improve efficiencies in our operations due to the acquisition of AccelOps and certain other activities. We estimate that we will incur approximately $4.1 million of restructuring charges, primarily consisting of severance and other benefits, of which $2.2 million and $2.9 million were incurred during the three and nine months ended September 30, 2016, respectively, and are included in operating expense in the condensed consolidated statements of operations. We expect to incur the remaining charges in the fourth quarter of 2016. 

The remaining restructuring reserve of $0.6 million is included in accrued liabilities on the condensed consolidated balance sheet as of September 30, 2016 and is expected to be paid within one year.

10. COMMITMENTS AND CONTINGENCIES

Our future principal contractual obligations as of September 30, 2016 were (in thousands):

 
Total
 
2016 (remainder)
 
2017
 
2018
 
2019
 
2020
 
Thereafter
Operating lease commitments
$
74,107

 
$
5,756

 
$
17,678

 
$
14,653

 
$
12,359

 
$
10,497

 
$
13,164

Inventory purchase commitments
116,494

 
90,169

 
26,325

 
—

 
—

 
—

 
—

Other contractual commitments and open purchase orders
48,864

 
33,805

 
11,466

 
2,451

 
855

 
287

 
—

Total
$
239,465

 
$
129,730

 
$
55,469


$
17,104


$
13,214


$
10,784


$
13,164



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



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 $6.1 million and $3.7 million during the three months ended September 30, 2016 and September 30, 2015, respectively. Rent expense was $14.7 million and $9.7 million during the nine months ended September 30, 2016 and September 30, 2015, 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 September 30, 2016, we had $116.5 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 September 30, 2016, we had $48.9 million in other contractual commitments that may not be cancelable.

Warranties—Accrued warranty activities are summarized as follows (in thousands):
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
Accrued warranty balance—beginning of the period
$
3,144

 
$
4,269

Warranty costs incurred
(2,260
)
 
(3,413
)
Provision for warranty for the period
925

 
3,638

Adjustment related to pre-existing warranties
(279
)
 
(94
)
Accrued warranty balance—end of the period
$
1,530

 
$
4,400


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, 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. We have not recorded any significant accrual for loss contingencies associated with such legal proceedings; determined that a significant unfavorable outcome is probable or reasonably possible; or determined that the amount or range of any possible significant loss is reasonably estimable.

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


19
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FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



11. STOCKHOLDERS’ EQUITY

Stock-Based Compensation Plans

We have stock-based compensation plans pursuant to which we have granted stock options and RSUs and PSUs. We also have an ESPP for all eligible employees. As of September 30, 2016, there were a total of 44,406,659 shares of common stock available for grant under our stock-based compensation plans.

Restricted Stock Units

The activity and related information for RSUs, including PSUs, was (in thousands, except per share amounts):

 
Restricted Stock Units Outstanding
 
Number of Shares
 
Weighted-Average Grant Date Fair Value per Share
Balance—December 31, 2015
9,257

 
$
32.97

Granted
4,867

 
27.54

Forfeited
(1,270
)
 
32.12

Vested
(2,864
)
 
30.37

Balance—September 30, 2016
9,990

 
$
30.99


As of September 30, 2016, total compensation expense related to unvested RSUs, including PSUs, that were granted to employees and non-employees, but not yet recognized, was $273.0 million. This expense is expected to be amortized on a straight-line basis over a weighted-average vesting period of 2.85 years. We did not grant any PSUs during the three and nine months ended September 30, 2016. The stock-based compensation expense related to PSU awards is not material. 

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 number of shares and amount withheld for employee taxes were (in thousands):

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Shares withheld for taxes
347

 
245

 
937

 
590

Amount withheld for taxes
$
12,528

 
$
11,628

 
$
29,886

 
$
22,989




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



Employee Stock Options

The weighted-average assumptions relating to our employee stock options were:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Expected term in years
4.3

 
4.3

 
4.3

 
4.3

Volatility
38
%
 
37
%
 
42
%
 
38
%
Risk-free interest rate
1.1
%
 
1.6
%
 
1.1
%
 
1.5
%
Dividend rate
—
%
 
—
%
 
—
%
 
—
%

The stock option activity and related information was (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, 2015
6,968

 
$
20.03

 
 
 
 
Granted
1,405

 
$
25.39

 
 
 
 
Forfeited
(221
)
 
$
34.91

 
 
 
 
Exercised
(1,750
)
 
$
10.37

 
 
 
 
Balance—September 30, 2016
6,402

 
$
23.33

 
3.22
 
$
89,714

Options exercisable—September 30, 2016
4,469

 
$
21.26

 
1.99
 
$
70,864


The aggregate intrinsic value represents the pre-tax difference between the exercise price of stock options and the quoted market price of our common stock on September 30, 2016, for all in-the-money options. As of September 30, 2016, total compensation expense related to unvested stock options granted to employees but not yet recognized was $16.8 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 thousands, except per share amounts):

 
Three Months Ended
 
Nine Months Ended
 
September 30, 2016
 
September 30, 2015
 
September 30, 2016
 
September 30, 2015
Weighted-average fair value per share granted
$
10.62

 
$
15.89

 
$
9.08

 
$
13.60

Intrinsic value of options exercised
$
9,340

 
$
40,132

 
$
35,593

 
$
103,170

Fair value of options vested
$
1,706

 
$
2,491

 
$
4,583

 
$
9,001




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



Employee Stock Purchase Plan

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Expected term in years
0.5

 
0.5

 
0.5

 
0.5

Volatility
34
%
 
32
%
 
39
%
 
31
%
Risk-free interest rate
0.5
%
 
0.2
%
 
0.4
%
 
0.1
%
Dividend rate
—
%
 
—
%
 
—
%
 
—
%

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Weighted-average fair value per share granted
$
8.07

 
$
11.42

 
$
7.68

 
$
8.23

Shares issued under the ESPP
537

 
337

 
1,151

 
764

Weighted-average price per share issued
$
21.61

 
$
28.05

 
$
21.01

 
$
24.30




Stock-based Compensation Expense

Stock-based compensation expense is included in costs and expenses as follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Cost of product revenue
$
309

 
$
291

 
$
887

 
$
641

Cost of service revenue
2,238

 
1,849

 
6,495

 
5,141

Research and development
7,648

 
6,663

 
22,249

 
17,361

Sales and marketing
17,378

 
13,904

 
50,183

 
34,482

General and administrative
3,520

 
3,612

 
10,528

 
9,376

Total stock-based compensation expense
$
31,093

 
$
26,319

 
$
90,342

 
$
67,001


The stock-based compensation expense by award type was (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
RSUs
$
27,342

 
$
21,996

 
$
79,244

 
$
53,674

Stock options
1,516

 
2,669

 
5,062

 
9,141

ESPP
2,235

 
1,654

 
6,036

 
4,186

Total stock-based compensation expense
$
31,093

 
$
26,319

 
$
90,342

 
$
67,001



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FORTINET, INC.
NOTES TO CONDENSED 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 thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Income tax benefit associated with stock-based compensation
$
8,223

 
$
5,224

 
$
22,961

 
$
12,867


Share Repurchase Program

In January 2016, our board of directors approved a new Share Repurchase Program (the “Program”), which authorizes the repurchase of up to $200.0 million of our outstanding common stock through December 31, 2017. Under the Program, share repurchases may be made by us from time to time in privately negotiated transactions or in open market transactions. The Program does not require us to purchase a minimum number of shares, and may be suspended, modified or discontinued at any time without prior notice. During the three and nine months ended September 30, 2016, we repurchased 0.7 million and  2.7 million shares of common stock under the Program, respectively, in open market transactions at an average price of $36.04 and $27.82 per share, respectively, for an aggregate purchase price of $25.0 million and $75.0 million, respectively. As of September 30, 2016, $125.0 million remained available for future share repurchases under the Program.

12. INCOME TAXES

Our effective tax rate was 5% for the three months ended September 30, 2016, compared to an effective tax rate of 804% for the same period last year. The effective tax rate was 2,053% for the nine months ended September 30, 2016, compared to an effective tax rate of -165% for the same period last year. The effective tax rate for the periods presented was comprised of U.S. federal and state taxes, foreign withholding taxes and foreign income taxes. The changes in the tax provision for the periods presented were primarily due to the tax benefit from the adoption of the new accounting guidance relating to stock-based compensation. The effective tax rate for the three months ended September 30, 2016 was an expense as compared to a benefit for the same period last year. The increase in effective tax rate for the nine months ended September 30, 2016 was primarily due to additional tax benefits from the adoption of the new accounting guidance relating to stock-based compensation. As a result of the early adoption of the new guidance on stock-based compensation, we recorded income tax benefit of $2.5 million and $8.7 million during the three and nine months ended September 30, 2016, respectively.

As of September 30, 2016 and December 31, 2015, unrecognized tax benefits were $64.9 million and $59.7 million, respectively. The total amount of $63.5 million in unrecognized tax benefits, if recognized, would favorably impact the effective tax rate. It is our policy to classify accrued interest and penalties related to unrecognized tax benefits in the provision for income taxes. As of September 30, 2016, we had accrued $8.8 million for estimated interest related to uncertain tax positions.

We file income tax returns in the U.S. federal jurisdiction, and various U.S. state and foreign jurisdictions. The statute of limitations is open for years that generated state net operating loss carryforwards and after 2009 for state jurisdictions. Additionally, we have foreign net operating losses that have an indefinite life. Generally, we are no longer subject to non-U.S. income tax examinations by tax authorities for tax years prior to 2009. We are no longer subject to examination by U.S. federal tax authorities for tax years prior to 2012. We are currently under examination by U.S federal income tax authorities for the tax years 2012, 2013, and 2014. In addition, the tax authorities in France are examining the inter-company relationship between Fortinet, Inc., Fortinet France and Fortinet Singapore. We are in the early stages of this inquiry and as of yet no official audit has been opened. We are also under audit by the Japanese tax authorities for the years 2013, 2014 and 2015. We do not expect any material adjustments as a result of this audit.


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



13. 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 the 401(k) Plan and RRSP for the three months ended September 30, 2016 and September 30, 2015 were $1.2 million and $0.9 million, respectively. Our matching contributions to the 401(k) Plan and RRSP during the nine months ended September 30, 2016 and September 30, 2015 were $3.4 million and $2.7 million, respectively.

14. 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
 
Nine Months Ended
Revenue
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Americas:
 
 
 
 
 
 
 
United States
$
83,049

 
$
72,767

 
$
239,417

 
$
202,491

Canada
35,211

 
26,027

 
100,299

 
72,676

Other Americas
15,614

 
14,371

 
46,850

 
38,151

Total Americas
133,874

 
113,165

 
386,566

 
313,318

Europe, Middle East, and Africa (“EMEA”)
116,967

 
91,740

 
336,911

 
250,808

Asia Pacific (“APAC”)
65,805

 
55,163

 
189,136

 
148,613

Total revenue
$
316,646

 
$
260,068

 
$
912,613

 
$
712,739


Property and Equipment—net
September 30,
2016
 
December 31,
2015
Americas:
 
 
 
United States
$
92,096

 
$
61,064

Other Americas
9,872

 
8,972

Total Americas
101,968

 
70,036

EMEA:
 
 
 
France
13,649

 
13,201

Other EMEA
6,199

 
3,977

Total EMEA
19,848

 
17,178

APAC
4,293

 
3,853

Total property and equipment—net
$
126,109

 
$
91,067



24
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FORTINET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)



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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Exclusive Networks Group
19
%
 
17
%
 
19
%
 
17
%
Ingram Micro
10
%
 
*

 
*

 
*

* Represents less than 10%

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

 
September 30,
2016
 
December 31,
2015
Exclusive Networks Group
20
%
 
23
%
Fine Tec Computers
12
%
 
*

Ingram
10
%
 
*

* Represents less than 10%

15. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The changes in accumulated balances of other comprehensive income or loss were (in thousands):

 
September 30, 2016
 
Unrealized Gains/Losses on Investments
 
Tax benefit (provision) related to items of other comprehensive income or loss
 
Total
Beginning balance at December 31, 2015
$
(1,437
)
 
$
504

 
$
(933
)
Other comprehensive income (loss) before reclassifications
1,668

 
(583
)
 
1,085

Amounts reclassified from accumulated other comprehensive income (loss)
2

 
(1
)
 
1

Net current-period other comprehensive income (loss)
1,670

 
(584
)
 
1,086

Ending balance at September 30, 2016
$
233

 
$
(80
)
 
$
153


The details of reclassification out of accumulated other comprehensive income (loss) were (in thousands):

Nine Months Ended September 30, 2016
Details about Accumulated Other Comprehensive Income Components
Amount Reclassified from Accumulated Other Comprehensive Income (Loss)
 
Affected Line Item in the Statement Where Net Income is Presented
Unrealized losses on investments
$
2

 
Other expense—net
Tax benefit related to items of other comprehensive loss
(1
)
 
Provision for income taxes
Total reclassification for the period
$
1

 
 


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



16. 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 is denominated in foreign currencies and is subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Canadian dollar (“CAD”), Euro (“EUR”), Great British pound (“GBP”), and Chinese yen (“CNY”). To help protect against significant fluctuations in value and the volatility of future cash flows caused by changes in currency exchange rates, we engage in foreign currency risk management activities to hedge balance sheet items denominated in CAD. We do not use these contracts for speculative or trading purposes. All of the derivative instruments are with high quality financial institutions and we monitor the creditworthiness of these parties. These contracts typically have maturities between one and three months. Changes in the fair value of forward exchange contracts related to balance sheet accounts are insignificant and are included in Other expense—net in the condensed consolidated statement of operations. As of September 30, 2016, the fair value of the forward exchange contracts was not material.

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

The notional amount of forward exchange contracts to hedge balance sheet accounts as of September 30, 2016 and December 31, 2015 were (in thousands):

 
Buy/Sell
 
Notional
Balance Sheet Contracts:
 
 
 
Currency—As of September 30, 2016