What changed in this filing

/stocks — the workspaceLOADING

Item 2. Management’s Discussion and Analysis

2020-08-06 compared with 2020-05-07 · 241 added, 109 removed, 198 unchanged (64% of the section changed)

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• the effects of government regulation, tariffs and other related policies;

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

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

• growing our sales to businesses, service providers and government organizations, our ability to execute these sales and of the complexity of selling to all segments (including the increased competition and unpredictability of timing associated with sales to larger enterprises), the impact of sales to these organizations on our long-term growth, expansion and operating results, and the effectiveness of our internal sales organization;

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• estimates of a range of 2020 spending on our headquarters expansion project;

expectations regarding uncertain tax benefits and our effective domestic and global tax rates, and the impact of the Tax Cuts and Jobs Act (the “ 2017 Tax Act ”) and the Ninth Circuit’s Altera decision regarding stock-based compensation in cost sharing arrangements;

• expectations regarding uncertain tax benefits and our effective domestic and global tax rates, and the impact of the Tax Cuts and Jobs Act (the “2017 Tax Act”) and the U.S.

Court of Appeals for the Ninth Circuit’s (the “Ninth Circuit”) decision in Altera Corporation and Subsidiaries vs.

Commissioner of Internal Revenue (“Altera”) regarding stock-based compensation in cost sharing arrangements;

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

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• Dynamic Cloud Security —We help customers connect securely to and across their hybrid, public and private cloud environments by offering security through our virtual firewall and other software products.

Our public and private cloud security solutions, including virtual appliances and hosted solutions, extend the core capabilities of the Fortinet Security Fabric platform to provide businesses with the same level of cybersecurity and threat intelligence in and across cloud environments that they receive on their physical networks, delivering security that follows their applications and data.

Fortinet cloud security offerings are available across all major cloud providers, including

Amazon Web Services, Microsoft Azure, Google Cloud, Oracle Cloud, Alibaba Cloud and IBM Cloud.

applications and data.

Fortinet cloud security offerings are available across all major cloud providers, including Amazon Web Services, Microsoft Azure, Google Cloud, Oracle Cloud, Alibaba Cloud and IBM Cloud.

Our Cloud Security portfolio also includes securing applications, including email and web.

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We offer network access control solutions that provide visibility, control and automated event responses in order to secure IoT devices.

AI-Driven Security Operations —We develop and provide AI-driven security operations solutions, including FortiGuard security services, that can be applied across the entire Fortinet Security Fabric platform.

• AI-Driven Security Operations —We develop and provide AI-driven security operations solutions, including FortiGuard and other security subscription services and our security operations, analytics, and reporting (“SOAR”) capabilities and solutions, that can be applied across the entire Fortinet Security Fabric platform.

These solutions help customers better secure their environments by delivering deeper intelligence and insights and by narrowing the gaps in security skills and resources that are present in many organizations.

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Financial Highlights

Total revenue was $576.9 million during the three months ended March 31, 2020 , an increase of 22% compared to $472.6 million in the same period last year.

Product revenue was $192.3 million during the three months ended March 31, 2020 , an increase of 18% compared to $162.7 million in the same period last year.

Service revenue was $384.6 million during the three months ended March 31, 2020 , an increase of 24% compared to $309.9 million in the same period last year.

We generated operating income of $115.9 million , which included a gain on an intellectual property (“ IP ”) matter of $36.8 million , during the three months ended March 31, 2020 , an increase of 129% compared to $50.6 million in the same period last year.

Cash, cash equivalents and investments were $1.57 billion as of March 31, 2020 , a decrease of $636.6 million , or 29% , from December 31, 2019 .

During the three months ended March 31, 2020 , we repurchased 10.0 million shares of common stock under our Share Repurchase Program (the “ Repurchase Program ”), for a total purchase price of $899.9 million .

Deferred revenue was $2.23 billion as of March 31, 2020 , an increase of $90.9 million , or 4% , from December 31, 2019 .

We generated cash flows from operating activities of $319.4 million , which includes $50 million proceeds from an IP matter , during the three months ended March 31, 2020 , an increase of $118.1 million , or 59% , compared to the same period last year.

• Total revenue was $615.5 million and $1.19 billion during the three and six months ended June 30, 2020, respectively, an increase of 18% and 20%, respectively, compared to $521.7 million and $994.3 million in the same periods last year, respectively.

Product revenue was $211.9 million and $404.2 million during the three and six months ended June 30, 2020, respectively, an increase of 12% and 15%, respectively, compared to $189.9 million and $352.6 million in the same periods last year, respectively.

Service revenue was $403.6 million and $788.2 million during the three and six months ended June 30, 2020, respectively, an increase of 22% and 23%, respectively, compared to $331.8 million and $641.7 million in the same periods last year, respectively.

• Total gross profit was $480.4 million and $928.6 million during the three and six months ended June 30, 2020, respectively, an increase of 22% and 23%, respectively, compared to $393.4 million and $753.0 million in the same periods last year.

• We generated operating income of $116.7 million and $232.6 million during the three and six months ended June 30, 2020, respectively, an increase of 55% and 85%, respectively, compared to $75.2 million and $125.8 million in the same periods last year, respectively.

Operating income during the three and six months ended June 30, 2020 included gains on an intellectual property (“IP”) matter of $1.1 million and $37.9 million, respectively.

• Cash, cash equivalents and investments were $1.63 billion as of June 30, 2020, a decrease of $582.6 million, or 26%, from December 31, 2019.

• During the six months ended June 30, 2020, we repurchased 11.4 million shares of common stock under our Share Repurchase Program (the “Repurchase Program”), for a total purchase price of $1.05 billion.

• Deferred revenue was $2.32 billion as of June 30, 2020, an increase of $186.9 million, or 9%, from December 31, 2019.

• We generated cash flows from operating activities of $566.4 million, which includes $50.0 million proceeds from an IP matter, during the six months ended June 30, 2020, an increase of $170.0 million, or 43%, compared to the same period last year.

Our revenue growth was driven by both product and service revenue.

On a geographic basis, revenue continues to be diversified globally, which remains a key strength of our business.

Americas, Europe, Middle East and Africa (“EMEA”) and Asia Pacific (“APAC”) comprised 42%, 38% and 20% of the total revenue, respectively, in the three months ended March 31, 2020 and 2019.

Product revenue grew 18% during the three months ended March 31, 2020 compared to the same period last year.

Product revenue grew 12% and 15% during the three and six months ended June 30, 2020, respectively, compared to the same periods last year.

We experienced revenue growth across several of our hardware and software products, including SD-WAN and teleworker and remote security solutions.

Service revenue growth of 24% during the three months ended March 31, 2020 compared to the same period last year was driven by the strength of our FortiGuard and other security subscription revenue, which grew 25% compared to the same period last year.

During the three months ended March 31, 2020 , FortiCare technical support and other service revenue grew 23% compared to the same period last year.

During the three months ended March 31, 2020 , we recognized a $36.8 million gain on an IP matter in connection with a mutual covenant-not-to-sue and release agreement with a competitor in the network security industry.

Excluding the gain on the IP matter , operating expenses as a percentage of revenue decreased by one percentage point compared to the same period last year.

Headcount increased to 7,448 employees and contractors as of March 31, 2020 , a 5% growth compared to 7,082 as of December 31, 2019 and a 24% growth compared to 6,015 as of March 31, 2019.

Service revenue growth of 22% and 23% during the three and six months ended June 30, 2020, respectively, compared to the same periods last year was driven by the strength of our FortiGuard and other security subscription revenue, which grew 22% and

23%, respectively, and of our FortiCare technical support and other service revenue, which grew 22% and 23%, respectively, compared to the same periods last year.

During the three and six months ended June 30, 2020, we recognized gains of $1.1 million and $37.9 million, respectively, on an IP matter in connection with a mutual covenant-not-to-sue and release agreement with a competitor in the network security industry.

Excluding the gains on the IP matter, operating expenses as a percentage of revenue decreased by 1.9% and 1.6%, respectively, during the three and six months ended June 30, 2020 compared to the same periods last year.

Headcount increased to 7,756 employees and contractors as of June 30, 2020, a 4% growth compared to 7,448 as of March 31, 2020 and a 10% growth compared to 7,082 as of December 31, 2019.

COVID-19 Update

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In response to the pandemic, we have taken a number of actions to protect our employees, including restricting travel and directing most of our employees to work from home.

Where onsite work is permitted, we have implemented measures such as staggered work shifts, social distancing, health safety awareness training and frequent disinfection of shared spaces.

We have implemented our readiness plans, which include steps to maintain critical internet infrastructure with most employees working remotely.

We have not conducted any employee layoffs related to the COVID-19 pandemic, and we do not anticipate any related layoffs for the foreseeable future.

We have also increased our employee charitable contributions matching program for COVID-19 related donations and will match up to $2.0 million of employee charitable contributions.

In order to help address the needs of organizations securing highly distributed and remote workforces, we have opened our online, self-paced catalogue of advanced Network Security Expert training courses for free to the public.

Costs incurred to date relating to COVID-19 impact mitigation efforts have not been material.

While we believe the pandemic has had certain impacts on our business, we do not believe there has been a material impact from the effects of the pandemic on our business and operations, results of operations, financial condition, cash flows, liquidity and capital and financial resources as of and during the three months ended March 31, 2020.

While our linearity during the first quarter of 2020 was consistent with prior quarters, we saw an elevated level of buying during the middle two weeks of March.

Our average service contract term remained consistent with the same period of 2019.

Average customer payment terms increased by less than 15%.

We have also increased our employee charitable contribution matching program to match employees’ contributions up to $2,000 per employee.

We are also providing free online information technology security training for the public, aimed at helping high school and college students and professionals augment their security skill sets to open career opportunities and to help narrow the security skills gap.

As of August 6, 2020, there have been over 500,000 registrations for our free online trainings since we launched the program.

Costs incurred to date relating to COVID-19 pandemic impact mitigation efforts have not been material.

While the broader implications of the COVID-19 pandemic on our employees and overall financial performance remain uncertain, we have seen certain impacts on our business and operations, results of operations, financial condition, cash flows, liquidity and capital and financial resources as of and during the three and six months ended June 30, 2020.

Conversely, some aspects of our business do not appear to have been significantly affected.

During the three and six months ended June 30, 2020, we have observed the following:

• The practice of social distancing in most countries has reduced the ability for travel by our employees.

In-person sales and marketing events or meetings that would normally have been held during the three and six months ended June 30, 2020 were canceled, postponed or converted into virtual events.

As a result, expenses related to travel and marketing events decreased significantly.

To the extent that it becomes safe for our employees to travel and for us to hold or attend marketing events, we expect these expenses to increase in the future.

• We have offered payment terms in excess of our contractual agreements to some of our distributor customers, which we believe will result in an increase to the average collection period of our trade receivables.

• The countries and geographic regions in which we experienced the fastest billings growth in the second quarter of 2020, as compared to the second quarter of 2019, were countries and geographic regions in which the COVID-19 pandemic is generally considered to have had a comparatively less severe impact on the population and economy during the quarter.

• We have noted that, for some of our customers, sales cycles appear to have lengthened, though it is unclear by how long or whether this trend will persist.

• Our average service contract duration remained consistent with the same period of 2019.

• With respect to our supply chain, our product backlog was in line with historical averages and our suppliers delivered over 90% of their commitments to us.

Our channel inventory levels were consistent with prior quarters.

In order to mitigate supply chain risk, we have increased, and we plan to further increase, our on-hand stock of certain products.

• The yield on investment-grade debt has decreased, contributing to the decrease in our interest income.

• In accordance with the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), we have deferred the deposit and payment of our employer’s share of Social Security taxes.

This did not materially affect net cash provided by operating activities during the period.

T hrough the filing of this Quarterly Report on Form 10-Q, t here have been no material changes to the trends described above.

Going forward, however, the situation is uncertain, rapidly changing and hard to predict, and the COVID-19 pandemic may have a material negative impact on our future periods, including our results for the three months ending June 30, 2020, our annual results for 2020, and beyond.

To highlight the uncertainty remaining for the three months ending June 30, 2020, it should be noted that, due to customer buying patterns and the efforts of our sales force and channel partners to meet or exceed quarterly quotas, we have historically received a substantial portion of each quarter’s sales orders and generated a substantial portion of each quarter’s billings and revenue during the last two weeks of the quarter.

If we experience significant changes in our billings growth rates, it will impact current quarter product revenue and future quarters of our FortiGuard and FortiCare service revenues, as we sell annual and multi-year service contracts that are recognized ratably over the service term.

Going forward, however, the situation is uncertain, rapidly changing and hard to predict, and the COVID-19 pandemic may have a material negative impact on our future periods, including our results for the three months ending September 30, 2020, our annual results for 2020, and beyond.

To highlight the uncertainty remaining for the three months ending September 30, 2020, it should be noted that, due to customer buying patterns and the efforts of our sales force and channel partners to meet or exceed quarterly quotas, we have historically received a substantial portion of each quarter’s sales orders and generated a substantial portion of each quarter’s billings and revenue during the last two weeks of the quarter.

If we experience significant changes in our billings growth rates, it will impact product revenue in the current quarter and FortiGuard and FortiCare service revenues in subsequent quarters, as we sell annual and multi-year service contracts that are recognized ratably over the contractual service term.

In addition, the broader implications of the pandemic on our business and operations and our financial results, including the extent to which the effects of the pandemic will impact future results and growth in the cybersecurity industry, remain uncertain.

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In certain cases, we sell directly to large service providers and major systems integrators.

We also offer our products through major cloud providers, and have recognized on-demand revenue from Amazon Web Services, Microsoft Azure, IBM Cloud, Google Cloud and Oracle Cloud.

We have also recognized revenue from customers who deploy our products in a bring-your-own-license (“BYOL”) arrangement in private clouds or at cloud providers such as Amazon Web Services, Microsoft Azure, Google Cloud, Oracle Cloud and Alibaba Cloud.

We also offer our products through major cloud providers, and have recognized revenue on a usage basis from Amazon Web Services, Microsoft Azure, IBM Cloud, Google Cloud, Oracle Cloud and Alibaba Cloud.

We have also recognized revenue from customers who deploy our products in a bring-your-own-license (“BYOL”) arrangement in private clouds or at cloud providers.

In a BYOL arrangement, a customer purchases a software license from us through our channel partners and deploys the software in a cloud provider’s environment.

Similarly, customers may purchase such a license from us and deploy in their private cloud.

Our customers purchase our hardware products and software licenses, as well as our FortiGuard security subscription and FortiCare technical support services.

Our customers purchase our hardware products and software licenses, as well as our FortiGuard and other security subscription and FortiCare technical support services.

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 typically payable within 30 to 60 days.

We also invoice certain services on a monthly basis.

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 invoice is typically payable within 30 to 60 days, though we have recently offered extended payment terms to certain customers.

The following table summarizes revenue, deferred revenue, billings (non-GAAP), net cash provided by operating activities, and free cash flow (non-GAAP).

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Three Months Ended Or As Of

March 31, 2020

March 31, 2019

June 30, 2020 June 30, 2019

(in millions)

Revenue $ 615.5 $ 521.7

Deferred revenue $ 2,322.8 $ 1,866.5

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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.

The majority of our deferred revenue balance consists of the unrecognized portion of service revenue

from FortiGuard and other 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, deferred revenue growth and the mix of short-term and long-term deferred revenue because deferred revenue represents a significant portion of free cash flow and of revenue to be recognized in future periods.

Deferred revenue was $2.23 billion as of March 31, 2020 , an increase of $90.9 million , or 4% , from December 31, 2019 .

Deferred revenue was $2.32 billion as of June 30, 2020, an increase of $186.9 million, or 9%, from December 31, 2019.

Billings (non-GAAP).

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Management accounts for these limitations by providing specific information regarding GAAP revenue and evaluating billings together with GAAP revenue.

Total billings were $667.8 million for the three months ended March 31, 2020 , an increase of 21% compared to $551.6 million in the same period last year.

Total billings were $711.5 million for the three months ended June 30, 2020, an increase of 14% compared to $622.4 million in the same period last year.

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

Three Months Ended

March 31, 2020

March 31, 2019

June 30, 2020 June 30, 2019

(in millions)

Revenue $ 615.5 $ 521.7

Change in deferred revenue 96.0 100.7

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Free cash flow (non-GAAP).

We define free cash flow as net cash provided by operating activities minus purchases of property and equipment and excluding any significant non-recurring items, such as proceeds from IP matter .

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 and net of proceeds from IP matter , 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 measures of cash provided by or used in operating activities, investing activities, and financing activities is that free cash flow does not represent the total increase or decrease in the cash and cash equivalents balance for the period because it excludes proceeds from IP matter , cash flows from investing activities other than capital expenditures and cash flows from financing activities.

Management accounts

for this limitation by providing information about our proceeds from IP matter , our capital expenditures and other investing and financing activities on the face of the consolidated statements of cash flows and under “—Liquidity and Capital Resources” and by presenting cash flows from investing and financing activities in our reconciliation of free cash flow.

We define free cash flow as net cash provided by operating activities minus purchases of property and equipment and excluding any significant non-recurring items.

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 measures of cash provided by or used in operating activities, investing activities, and financing activities is that free cash flow does not represent the total increase or decrease in the cash and cash equivalents balance for the period because it excludes cash flows from investing activities other than capital expenditures and cash flows from 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 consolidated statements of cash flows and under “—Liquidity and Capital Resources” and by presenting cash flows from investing and financing activities in our reconciliation of free cash flow.

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 flow as a comparative measure.

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Three Months Ended

March 31, 2020

March 31, 2019

June 30, 2020 June 30, 2019

(in millions)

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Purchases of property and equipment (30.9) (17.3)

Proceeds from IP matter

Free cash flow (non-GAAP) $ 216.1 $ 177.8

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To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

There were no material changes to our critical accounting policies and estimates as of and for the three months ended March 31, 2020 , 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, 2020 (the “ Form 10-K ”).

There were no material changes to our critical accounting policies and estimates as of and for the three and six months ended June 30, 2020, 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, 2020 (the “Form 10-K”).

Recent Accounting Pronouncements

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Results of Operations

Three Months Ended March 31, 2020 and March 31, 2019

Three Months Ended June 30, 2020 and June 30, 2019

Three Months Ended

2020 June 30,

Revenue Amount % of

Revenue Change % Change

(in millions, except percentages)

Product $ 211.9 34 % $ 189.9 36 % $ 22.0 12 %

Service 403.6 66 331.8 64 71.8 22

Total revenue $ 615.5 100 % $ 521.7 100 % $ 93.8 18 %

Revenue by geography:

Americas $ 260.2 42 % $ 225.5 43 % $ 34.7 15 %

Europe, Middle East and Africa (“EMEA”) 228.4 37 192.0 37 36.4 19

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Total revenue $ 615.5 100 % $ 521.7 100 % $ 93.8 18 %

Total revenue increased by $104.3 million , or 22% , during the three months ended March 31, 2020 compared to the same period last year.

Total revenue increased by $93.8 million, or 18%, during the three months ended June 30, 2020 compared to the same period last year.

We continued to experience diversification of revenue globally and across both customer and industry segments.

Revenue from all regions grew, with EMEA contributing the largest portion of our revenue growth on a percentage basis and on an absolute dollar basis.

Product revenue increased by $29.6 million , or 18% , during the three months ended March 31, 2020 compared to the same period last year.

We experienced revenue growth across many of our hardware and software products due to an increase in product revenue from our FortiGate solutions, including SD-WAN , growth in sales of our Infrastructure Security solutions and teleworker and remote security solutions .

Service revenue increased by $74.7 million , or 24% , during the three months ended March 31, 2020 compared to the same period last year.

FortiGuard security subscription and FortiCare technical support and other revenues increased by $41.8 million , or 25% , and by $32.9 million , or 23% , respectively, during the three months ended March 31, 2020 compared to the same period last year.

Revenue from all regions grew, with EMEA contributing the largest portion of our revenue growth on an absolute dollar basis.

Product revenue increased by $22.0 million, or 12%, during the three months ended June 30, 2020 compared to the same period last year.

We experienced revenue growth across many of our hardware and software products due to an increase in product revenue from our FortiGate solutions, including SD-WAN, as well as growth in sales of our Infrastructure Security, Cloud Security and Endpoint Protection solutions, including virtual firewall, teleworker and remote security solutions.

Service revenue increased by $71.8 million, or 22%, during the three months ended June 30, 2020 compared to the same period last year.

FortiGuard and other security subscription and FortiCare technical support and other revenues increased by $39.5 million, or 22%, and by $32.3 million, or 22%, respectively, during the three months ended June 30, 2020 compared to the same period last year.

The increases were primarily due to the recognition of revenue from our growing deferred revenue balance related to FortiGuard and other security subscriptions and FortiCare technical support, including our customers moving to higher-tier support offerings.

Of the service revenue recognized during the three months ended March 31, 2020 , 91% was included in the deferred revenue balance as of December 31, 2019.

Of the service revenue recognized during the three months ended June 30, 2020, 91% was included in the deferred revenue balance as of March 31, 2020.

Cost of revenue and gross margin

Three Months Ended

2020 June 30,

2019 Change % Change

(in millions, except percentages)

Cost of revenue:

Product $ 84.4 $ 82.7 $ 1.7 2 %

Service 50.7 45.6 5.1 11

Total cost of revenue $ 135.1 $ 128.3 $ 6.8 5 %

Gross margin (%):

Product 60.2 % 56.5 %

Service 87.4 86.3

Total gross margin 78.1 % 75.4 %

Total gross margin increased by 1.6 percentage points during the three months ended March 31, 2020 compared to the same period last year, driven by improvements to both product and service gross margins.

Product gross margin increased by 3.4 percentage points during the three months ended March 31, 2020 compared to the same period last year.

Product gross margin benefited from increased software sales and lower indirect costs of hardware as a percentage of product revenue.

Total gross margin increased by 2.7 percentage points during the three months ended June 30, 2020 compared to the same period last year, driven by improvements to both product and service gross margins.

Product gross margin increased by 3.7 percentage points during the three months ended June 30, 2020 compared to the same period last year.

Product gross margin benefited from increased software sales and lower direct costs of h ardware as a percentage of product revenue.

Cost of product revenue was comprised primarily of third party contract manufacturers’ costs and the costs of materials used in production.

Service gross margin increased by 0.2 percentage points during the three months ended March 31, 2020 compared to the same period last year, as our service revenue growth outpaced our growth in related personnel costs.

Service gross margin increased by 1.1 percentage points during the three months ended June 30, 2020 compared to the same period last year, as we experienced lower costs to replace and repair our products and our personnel costs grew more slowly than our service revenue.

Cost of service revenue was comprised primarily of personnel costs.

Operating expenses

Three Months Ended

Three Months Ended Change % Change

2020 June 30,

Revenue Amount % of

(in millions, except percentages)

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Research and development

Research and development expense increased by $11.7 million , or 17% , during the three months ended March 31, 2020 compared to the same period last year, primarily due to an increase of $11.6 million in personnel-related costs as a result of increased headcount to support the development of new products, continued enhancements to our existing products and patent creation.

Research and development expense increased by $14.7 million, or 22%, during the three months ended June 30, 2020 compared to the same period last year, primarily due to an increase of $12.0 million in personnel-related costs as a result of increased headcount to support the development of new products, continued enhancements to our existing products and patent creation.

We currently intend to continue to invest in our research and development organization, and expect research and development expense to remain at or increase in absolute dollars during the remainder of 2020.

Sales and marketing

Sales and marketing expense increased by $44.1 million , or 20% , during the three months ended March 31, 2020 compared to the same period last year, primarily due to an increase of $37.9 million in personnel-related costs as a result of increases to sales and marketing headcount in order to drive global market share gains.

This increase was offset by savings related to decreased travel in the first quarter of 2020 as a response to the COVID-19 pandemic.

Sales and marketing expense increased by $27.3 million, or 12%, during the three months ended June 30, 2020 compared to the same period last year, primarily due to an increase of $40.4 million in personnel-related costs as a result of increases to sales and marketing headcount in order to drive global market share gains.

This increase was offset by savings related to decreased travel and fewer in-person marketing events as a result of the COVID-19 pandemic.

We currently intend to continue to make investments in our sales resources and infrastructure and marketing strategy, which are critical to support our future growth, and expect sales and marketing expense to remain at or increase in absolute dollars during the remainder of 2020.

General and administrative

General and administrative expense increased by $4.3 million , or 18% , during the three months ended March 31, 2020 compared to the same period last year, primarily due to an increase in personnel-related costs of $2.4 million and an increase in professional services costs of $1.2 million.

General and administrative expense increased by $4.6 million, or 19%, during the three months ended June 30, 2020 compared to the same period last year, primarily due to an increase in personnel-related costs of $3.2 million and an increase in the provision for expected credit losses of $1.1 million.

We currently expect general and administrative expense to remain at or increase in absolute dollars during the remainder of 2020.

Gain on IP matter

In January 2020, we entered into an agreement with a competitor in the network security industry, whereby, in February 2020, the competitor party paid us a lump sum of $50.0 million for a seven-year mutual covenant-not-to-sue for patent claims.

Pursuant to this agreement, at the end of this first seven-year period, either party may extend the agreement for an additional seven-year mutual covenant-not-to-sue in return for this competitor paying us an additional $50.0 million .

We determined the agreement to be a 14-year contract with a total transaction price of $100.0 million .

During the three months ended March 31, 2020 , we recorded $36.0 million upfront and an additional $0.8 million in amortization of the deferred component as a gain on IP matter in our condensed consolidated statements of income.

During the three months ended June 30, 2020, we recorded $1.1 in amortization of the deferred component as a gain on IP matter in our condensed consolidated statements of income.

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

Operating income and margin

We generated operating income of $115.9 million during the three months ended March 31, 2020 , an increase of $65.3 million , or 129% , compared to $50.6 million in the same period last year.

Operating income as a percentage of revenue increased to 20% during the three months ended March 31, 2020 compared to 11% in the same period last year.

The increase in operating margin is primarily due to the $36.8 million gain on IP matter , combined with the improvement in gross margin of 1.6 percentage points.

Interest income — net and other expense — net

We generated operating income of $116.7 million during the three months ended June 30, 2020, an increase of $41.5 million, or 55%, compared to $75.2 million in the same period last year.

Operating income as a percentage of revenue increased to 19% during the three months ended June 30, 2020 compared to 14% in the same period last year.

The increase in operating margin is primarily due to the 2.7 percentage point improvement in gross margin and the 2.2 percentage point decrease in sales and marketing expense as a percentage of revenue.

Interest income — net and other income (expense) — net

Three Months Ended

2020 June 30,

2019 Change % Change

(in millions, except percentages)

Interest income—net $ 4.0 $ 11.0 $ (7.0) (64) %

Other expense—net

Interest income—net decreased during the three months ended March 31, 2020 compared to the same period last year, primarily due to lower interest rates and, to a lesser extent, lower invested balances of cash, cash equivalents and investments.

The lower cash, cash equivalents and investments were mainly due to our $889.9 million payment for repurchase and retirement of common stock under the Repurchase Program in the three months ended March 31, 2020.

Other income (expense)—net $ 0.9 $ (0.4) $ 1.3 (325) %

Interest income—net decreased during the three months ended June 30, 2020 compared to the same period last year, primarily due to lower interest rates and lower invested balances of cash, cash equivalents and investments.

The lower cash, cash equivalents and investments were mainly due to our repurchases of common stock under the Repurchase Program during the past twelve months.

Interest income—net varies depending on our average investment balances during the period, types and mix of investments, and market interest rates.

The change in other expense—net during the three months ended March 31, 2020 compared to the same period last year was the result of a $4.3 million impairment charge on an investment in a privately held company during the first quarter of 2020.

The change in other income (expense)—net during the three months ended

June 30, 2020 compared to the same period last year was primarily due to net gains from foreign currency exchange compared to net losses in the same period last year.

Provision for income taxes

Three Months Ended Change % Change

2020 June 30,

(in millions, except percentages)

Provision for income taxes $ 9.5 $ 13.1 $ (3.6) (27) %

Effective tax rate (%) 8 % 15 %

Our effective tax rate was 8% for the three months ended June 30, 2020 compared to an effective tax rate of 15% for the same period last year.

The provision for income taxes for the three months ended June 30, 2020 was primarily comprised of U.S.

federal and state taxes, withholding taxes and foreign taxes that were $28.2 million, which included a tax benefit of $5.0 million from the foreign-derived intangible income deduction.

This tax provision for income taxes was favorably affected by excess tax benefits from stock-based compensation expense of $10.0 million and release of reserves of $8.7 million on uncertain tax positions and the interest due to the expiration of the statute of limitations.

The provision for income taxes for the three months ended June 30, 2019 was comprised of U.S.

federal and state taxes, withholding taxes, and foreign taxes that were $24.5 million, which were offset by excess tax benefits from stock-based compensation expense of $11.7 million and release of reserves of $10.0 million on uncertain tax positions and the interest due to the expiration of the statute of limitations.

This tax provision for income taxes was further impacted by an increase in tax expense of $10.3 million for an unrecognized tax benefit related to the Ninth Circuit’s Altera decision, regarding stock-based compensation expense in cost sharing arrangements.

Results of Operations

Six Months Ended June 30, 2020 and June 30, 2019

Six Months Ended

2020 June 30,

Revenue Amount % of

Revenue Change % Change

(in millions, except percentages)

Product $ 404.2 34 % $ 352.6 35 % $ 51.6 15 %

Service 788.2 66 641.7 65 146.5 23

Total revenue $ 1,192.4 100 % $ 994.3 100 % $ 198.1 20 %

Revenue by geography:

Americas $ 502.4 42 % $ 426.0 43 % $ 76.4 18 %

EMEA 449.1 38 369.2 37 79.9 22

APAC 240.9 20 199.1 20 41.8 21

Total revenue $ 1,192.4 100 % $ 994.3 100 % $ 198.1 20 %

Total revenue increased by $198.1 million, or 20%, during the six months ended June 30, 2020 compared to the same period last year.

We continued to experience diversification of revenue globally and across both customer and industry segments.

Revenue from all regions grew, with EMEA contributing the largest portion of our revenue growth on a percentage basis and on an absolute dollar basis.

Product revenue increased by $51.6 million, or 15%, during the six months ended June 30, 2020 compared to the same period last year.

Service revenue increased by $146.5 million, or 23%, during the six months ended June 30, 2020 compared to the same period last year.

FortiGuard and other security subscription and FortiCare technical support and other revenues increased by $81.3 million, or 23%, and by $65.2 million, or 23%, respectively, during the six months ended June 30, 2020 compared to the same period last year.

Of the service revenue recognized during the six months ended June 30, 2020, 83% was included in the deferred revenue balance as of December 31, 2019.

Cost of revenue and gross margin

Six Months Ended

2020 June 30,

2019 Change % Change

(in millions, except percentages)

Cost of revenue:

Product $ 160.7 $ 152.9 $ 7.8 5 %

Service 103.1 88.4 14.7 17

Total cost of revenue $ 263.8 $ 241.3 $ 22.5 9 %

Gross margin (%):

Product 60.2 % 56.6 %

Service 86.9 86.2

Total gross margin 77.9 % 75.7 %

Total gross margin increased by 2.2 percentage points during the six months ended June 30, 2020 compared to the same period last year, driven by improvements to both product and service gross margins.

Product gross margin increased by 3.6 percentage points during the six months ended June 30, 2020 compared to the same period last year.

Product gross margin benefited from increased software sales and lower direct costs of hardware as a percentage of product revenue.

Cost of product revenue was comprised primarily of third-party contract manufacturers’ costs and the costs of materials used in production.

Service gross margin increased by 0.7 percentage points during the six months ended June 30, 2020 compared to the same period last year, as our personnel costs grew more slowly than our service revenue and we experienced lower costs to replace and repair our products.

Cost of service revenue was comprised primarily of personnel costs.

Operating expenses

Six Months Ended Change % Change

2020 June 30,

Revenue Amount % of

(in millions, except percentages)

Operating expenses:

Research and development $ 162.4 14% $ 136.0 14 % $ 26.4 19 %

Sales and marketing 513.8 43 442.4 44 71.4 16

General and administrative 57.7 5 48.8 5 8.9 18

Gain on IP matter (37.9) (3) — — (37.9) *

Total operating expenses $ 696.0 58% $ 627.2 63 % $ 68.8 11 %

Percentages have been rounded for presentation purposes and may differ from unrounded results.

* Not meaningful

Research and development

Research and development expense increased by $26.4 million, or 19%, during the six months ended June 30, 2020 compared to the same period last year, primarily due to an increase of $23.6 million in personnel-related costs as a result of increased headcount to support the development of new products, continued enhancements to our existing products and patent creation.

Sales and marketing

Sales and marketing expense increased by $71.4 million, or 16%, during the six months ended June 30, 2020 compared to the same period last year, primarily due to an increase of $78.3 million in personnel-related costs as a result of increases to sales and marketing headcount in order to drive global market share gains.

This increase was offset by savings related to decreased travel and fewer in-person marketing events as a result of the COVID-19 pandemic.

General and administrative

General and administrative expense increased by $8.9 million, or 18%, during the six months ended June 30, 2020 compared to the same period last year, primarily due to an increase in personnel-related costs of $5.6 million and an increase in the provision for expected credit losses of $1.1 million.

We currently expect general and administrative expense to remain at or increase in absolute dollars during the remainder of 2020.

Gain on IP matter

During the six months ended June 30, 2020, we recorded $36.0 million upfront and an additional $1.9 million in amortization of the deferred component as a gain on IP matter in our condensed consolidated statements of income.

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

Operating income and margin

We generated operating income of $232.6 million during the six months ended June 30, 2020, an increase of $106.8 million, or 85%, compared to $125.8 million in the same period last year.

Operating income as a percentage of revenue increased to 20% during the six months ended June 30, 2020 compared to 13% in the same period last year.

The increase in

operating margin is primarily due to the $37.9 million gain on IP matter, the 2.2 percentage point improvement in gross margin and the 1.4 percentage point decrease in sales and marketing expense as a percentage of revenue.

Interest income — net and other income (expense) — net

Six Months Ended

2020 June 30,

2019 Change % Change

(in millions, except percentages)

Interest income—net $ 13.2 $ 21.2 $ (8.0) (38) %

Other income (expense)—net $ (7.1) $ (0.9) $ (6.2) 689 %

Interest income—net decreased during the six months ended June 30, 2020 compared to the same period last year, primarily due to lower interest rates and lower invested balances of cash, cash equivalents and investments.

The lower cash, cash equivalents and investments were mainly due to our repurchases of common stock under the Repurchase Program during the past twelve months.

Interest income—net varies depending on our average investment balances during the period, types and mix of investments, and market interest rates.

The change in other income (expense)—net during the six months ended June 30, 2020 compared to the same period last year was the result of a $4.3 million impairment charge on an investment in a privately held company during the first quarter of 2020.

In addition, foreign currency exchange losses increased by $2.4 million compared to the same period last year.

Provision for income taxes

Three Months Ended

Six Months Ended Change % Change

2020 June 30,

(in millions, except percentages)

1 unchanged sentence

Effective tax rate (%) 9 % 10 %

Our effective tax rate was 11% for the three months ended March 31, 2020 compared to an effective tax rate of 2% for the same period last year.

The provision for income taxes for the three months ended March 31, 2020 was primarily comprised of U.S.

Our effective tax rate was 9% for the six months ended June 30, 2020 compared to an effective tax rate of 10% for the same period last year.

The provision for income taxes for the six months ended June 30, 2020 was primarily comprised of U.S.

federal and state taxes, withholding taxes and foreign taxes that were $56.5 million, which included a tax benefit of $9.6 million from the foreign-derived intangible income deduction.

This tax provision for income taxes was further offset by excess tax benefits from stock-based compensation expense of $15.2 million.

The provision for income taxes for the three months ended March 31, 2019 was comprised of U.S.

federal and state taxes, withholding taxes, and foreign taxes that were $17.5 million, which were offset by excess tax benefits from stock-based compensation expense of $16.0 million.

This tax provision for income taxes was favorably affected by excess tax benefits from stock-based compensation expense of $25.2 million and release of reserves of $8.7 million on uncertain tax positions and the interest due to the expiration of the statute of limitations.

The provision for income taxes for the six months ended June 30, 2019 was comprised of U.S.

federal and state taxes, withholding taxes, and foreign taxes that were $42.0 million, which were offset by excess tax benefits from stock-based compensation expense of $27.7 million and release of reserves of $10.0 million on uncertain tax positions and the interest due to the expiration of the statute of limitations.

Liquidity and Capital Resources

2020 December 31,

(in millions)

Cash and cash equivalents $ 916.4 $ 1,222.5

Investments 710.9 987.4

Total cash, cash equivalents and investments $ 1,627.3 $ 2,209.9

Working capital $ 596.8 $ 1,295.4

Three Months Ended

Six Months Ended

2020 June 30,

(in millions)

2 unchanged sentences

Net cash used in financing activities (1,089.3) (111.1)

Net increase in cash and cash equivalents

Net decrease in cash and cash equivalents $ (306.1) $ (90.3)

Liquidity and capital resources may be impacted by our operating activities, as well as by our stock repurchases, proceeds associated with stock option exercises, issuances of common stock under our the Amended and Restated Fortinet, Inc.

2009 Equity Incentive Plan (the “Amended Plan”) and payment of taxes in connection with the net settlement of equity awards, real estate and other capital expenditures and business acquisitions.

During the three months ended March 31, 2020 , we repurchased $899.9 million in shares of our common stock under the Repurchase Program.

In February 2020, we received a cash payment of $50.0 million pursuant to a mutual covenant-not-to-sue and release agreement with a competitor in the network security industry.

In recent years, we have received significant capital resources from our billings to customers and, to some extent, from exercise of stock options.

In recent years, we have received significant capital resources from our billings to customers and, to some extent, from the exercise of stock options by our employees.

Additional increases in billings may depend on a number of factors, including demand for our products and services, competition, market or industry changes, macroeconomic events such as the COVID-19 pandemic and our ability to execute.

We expect proceeds from the exercise of stock options in future years to be impacted by the increased mix of restricted stock units versus stock options granted and also to vary based on our share price.

As of March 31, 2020 , $692.9 million remained available for future share repurchases under the Repurchase Program .

We expect proceeds from the exercise of stock options in future years to be impacted by the increased mix of restricted stock units versus stock options granted to our employees and to vary based on our share price.

In February 2020, we received a cash payment of $50.0 million pursuant to a mutual covenant-not-to-sue and release agreement with a competitor in the network security industry.

In July 2020, our board of directors approved a $500.0 million increase in the authorized stock repurchase amount under the Repurchase Program and extended the term of the Repurchase Program to February 28, 2022, bringing the aggregate amount authorized to be repurchased to $3.0 billion.

During the six months ended June 30, 2020, we repurchased $1.05 billion in shares of our common stock under the Repurchase Program.

As of August 6, 2020, $1.05 billion remained available for future share repurchases under the Repurchase Program.

Construction of a second building at our headquarters campus started in the fourth quarter of 2018 and related spending will continue in 2020 and until project completion.

We estimate 2020 spending on the headquarters campus project to

be between $110.0 million and $120.0 million dollars.

We estimate 2020 spending on the headquarters campus project to be between $100.0 million and $110.0 million dollars.

The COVID-19 pandemic has resulted in a delay to the project schedule.

We now estimate construction to be completed in early 2021.

As of March 31, 2020 , our cash, cash equivalents and investments of $1.57 billion were invested primarily in deposit accounts, money market funds, corporate debt securities, commercial paper, certificates of deposit and term deposits and U.S.

As of June 30, 2020, our cash, cash equivalents and investments of $1.63 billion were invested primarily in deposit accounts, money market funds, corporate debt securities, commercial paper, certificates of deposit and term deposits and U.S.

government securities.

1 unchanged sentence

We do not enter into investments for trading or speculative purposes.

The amount of cash, cash equivalents and investments held by our international subsidiaries was $116.8 million as of March 31, 2020 and $109.3 million as of December 31, 2019.

The amount of cash, cash equivalents and investments held by our international subsidiaries was $113.6 million as of June 30, 2020 and $109.3 million as of December 31, 2019.

We believe that our existing cash and cash equivalents will be sufficient to meet our anticipated cash needs for at least the next 12 months.

Our future capital requirements will depend on many factors, including our growth rate, the timing and amount of our share repurchases, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced products and services offerings, the continuing market acceptance of our products, our investments in purchasing or leasing real estate and macroeconomic impacts such as the COVID-19 pandemic.

marketing activities, the introduction of new and enhanced products and services offerings, the continuing market acceptance of our products, our investments in purchasing or leasing real estate and macroeconomic impacts such as the COVID-19 pandemic.

Historically, we have required capital principally to fund our working capital needs, share repurchases, capital expenditures and acquisition activities.

5 unchanged sentences

Changes in operating assets and liabilities consist primarily of changes in deferred revenue, deferred contract costs, accounts receivable, inventory and prepaid expenses and other current assets.

Our operating activities during the three months ended March 31, 2020 provided $319.4 million in cash as a result of the continued growth of our business and our ability to successfully manage our working capital.

Changes in operating assets and liabilities primarily resulted from an increase in sales of our FortiGuard security subscription and FortiCare technical support services to new and existing customers, as reflected by an increase in our deferred revenue, and proceeds from the mutual covenant-not-to-sue and release agreement.

Our total deferred revenue balance grew $90.9 million , or 4% , during the three months ended March 31, 2020 .

Our operating activities during the six months ended June 30, 2020 provided $566.4 million in cash as a result of the continued growth of our business and our ability to successfully manage our working capital.

Changes in operating assets and liabilities primarily resulted from an increase in sales of our FortiGuard and other security subscription and FortiCare technical support services to new and existing customers, as reflected by an increase in our deferred revenue, and proceeds from the mutual covenant-not-to-sue and release agreement.

Our total deferred revenue balance grew $186.9 million, or 9%, during the six months ended June 30, 2020.

Investing Activities

4 unchanged sentences

We may also make cash payments in connection with future business combinations.

During the three months ended March 31, 2020 , cash provided by investing activities was $4.6 million , primarily driven by $35.7 million in cash proceeds from maturities and sales of investments, net of purchases of investments, and partially offset by $27.6 million of purchases of property and equipment, a large portion of which relates to our headquarters building construction.

During the six months ended June 30, 2020, cash provided by investing activities was $216.8 million, primarily driven by $278.8 million in cash proceeds from maturities and sales of investments, net of purchases of investments, and partially offset by $58.5 million of purchases of property and equipment, a large portion of which relates to our headquarters building construction.

Financing Activities

The changes in cash flows from financing activities primarily relate to repurchase and retirement of common stock and taxes paid related to net share settlement of equity awards, net of proceeds from the issuance of common stock under the Amended Plan.

During the three months ended March 31, 2020 , cash used in financing activities was $920.4 million , primarily driven by $889.9 million used to repurchase shares of our common stock and $30.4 million used to pay tax withholding, net of proceeds from the issuance of common stock.

During the six months ended June 30, 2020, cash used in financing activities was $1.09 billion, primarily driven by $1.05 billion used to repurchase shares of our common stock and $43.2 million used to pay tax withholding, net of proceeds from the issuance of common stock.

Contractual Obligations and Commitments

There were no material changes outside the ordinary course of business during the three months ended March 31, 2020 to the contractual obligations and commitments disclosed in Management’s Discussion and Analysis of Financial Condition and Results of Operations, set forth in Part II, Item 7, of the Form 10-K .

There were no material changes outside the ordinary course of business during the six months ended June 30, 2020 to the contractual obligations and commitments disclosed in Management’s Discussion and Analysis of Financial Condition and Results of Operations, set forth in Part II, Item 7, of the Form 10-K.

See Note 11 of the notes to condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information regarding contractual obligations and commitments.

Off-Balance Sheet Arrangements

As of March 31, 2020 , we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

As of June 30, 2020, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Quantitative and Qualitative Disclosures about Market Risk

There were no material changes in our market risk during the three months ended March 31, 2020 compared to the disclosures in Part II, Item 7A of the Form 10-K .

There were no material changes in our market risk during the six months ended June 30, 2020 compared to the disclosures in Part II, Item 7A of the Form 10-K.

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 2. Management’s Discussion and Analysis