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FORTINET INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. These statements include, among other things, statements concerning our expectations regarding: • variability in sales in certain product categories from year to year and between quarters; • expected impact of certain acquisitions and investments in strategic relationships; • expected impact of sales of certain products; • the proportion of our revenue that consists of our product and service revenues, and the mix of billings between products and services; • the impact of our product innovation strategy; • expanding our reach into new high growth verticals and emerging markets and continuing to sell to large enterprises and service providers; • our ability to meet increasing customer expectations about the quality and functionality of our products; • trends in revenue, costs of revenue, and gross margin; • trends in our operating expenses, including personnel costs, research and development expense, sales and marketing expense and general and administrative expense, and expectations regarding these expenses as a percentage of total revenue; • continued investments in research and development tostrengthen our technology leadership position and in sales and marketing and the impact of those investments; • expectations regarding uncertain tax benefits and our effective tax rate; • expectations regarding spending related to capital expenditures; • competition in our markets; • the sufficiency of our existing cash, cash equivalents and investments to meet our cash needs for at least the next 12 months; • as well as other statements regarding our future operations, financial condition and prospects and business strategies. These forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q and, in particular, the risks discussed under the heading "Risk Factors" in Part II, Item 1A of this Quarterly Report on Form 10-Q and in our other SEC filings, including the Form 10-K. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Business Overview We provide high performance network security solutions, which enable broad, integrated and high performance protection against advanced security threats while simplifying the IT security infrastructure for enterprises, service providers and governmental entities worldwide, including the majority of the Fortune Global 100. Our core product platform is the FortiGate physical and virtual appliance, which ships with a set of broad security services, including firewall, virtual private network (VPN), application control, intrusion prevention, Web filtering and advanced threat protection (ATP). These security services are enabled by FortiGuard which provides extensive threat research and a global cloud network to deliver protection services to each FortiGate. FortiGate also has extensive networking capability 24-------------------------------------------------------------------------------- Table of Contents such as switching, routing, native internet protocol version 6 (IPv6) and different modes of deployment. FortiManager provides central management and the FortiAnalyzer provides reporting and analytics. The FortiGate platform can be extended to provide enhanced capabilities. For example, it can be used as a Wireless Controller for Access Points. An external sandbox can also be attached for local ATP analysis. Customers select the functions or combination of functions that best meet their specific security requirements such as a high-speed data center firewall (DCFW) at the network core, a next-generation firewall (NGFW) at the edge, or a broad unified threat management (UTM) solution at branch sites. We derive a substantial majority of product sales from our FortiGate appliances, which range from the FortiGate-20 to -100 series, designed for small businesses, FortiGate-200 to -800 series for mid-sized enterprises, to the FortiGate-1000 to -5000 series for large enterprises, telecommunications carriers, and service providers. Our network security platform also includes our FortiGuard security subscription services, which end-customers can subscribe to in order to obtain access to dynamic updates to intrusion prevention, application control, anti-malware, Web filtering, and anti-spam functionality. End-customers can also choose to purchase FortiCare technical support services for our products. End-customers also often use FortiManager and FortiAnalyzer products in conjunction with a FortiGate deployment to provide centralized management, analysis and reporting capabilities. We complement our core FortiGate product line with other appliances and software that offer additional protection from security threats to other critical areas of the enterprise, such as our FortiSandbox ATP messaging security product, Web application firewalls, databases security product, distributed denial of service attack (DDoS) security product, and endpoint security product for employee computers and mobile devices. Sales of these complementary products and related services represent less than 10% of our total revenue. Financial Highlights • We recorded total revenue of $193.3 million and $546.4 million during the three and nine months ended September 30, 2014, respectively, an increase of 25% during each of these periods compared to the same periods last year. Product revenue was $87.7 million and $249.9 million during the three and nine months ended September 30, 2014, respectively, an increase of 26% and 29%, respectively, compared to the same periods last year. Services and other revenue was $105.6 million and $296.5 million during the three and nine months ended September 30, 2014, respectively, an increase of 24% and 22%, respectively, compared to the same periods last year. • Cash, cash equivalents and investments were $963.8 million as of September 30, 2014, an increase of $120.7 million from December 31, 2013. • Deferred revenue was $500.0 million as of September 30, 2014, an increase of $67.4 million from December 31, 2013. • We generated cash flows from operating activities of $161.2 million during the nine months ended September 30, 2014, an increase of 60% compared to the same period last year. • We received $20.0 million pursuant to a six year mutual covenant-not-to-sue and release agreement with Palo Alto Networks, Inc. in January 2014. • We repurchased 1.4 million shares of common stock under our previously-announced Share Repurchase Program for an aggregate purchase price of $33.2 million during the nine months ended September 30, 2014. Revenue grew as a result of our focus on growth and our strategy to invest in our marketing and increase sales capacity during the three and nine months ended September 30, 2014. We also continued to gain traction with several recently introduced FortiGate products, including demand for certain of our high speed, low latency next-generation enterprise data center security products. We continue to invest in sales and marketing to expand brand awareness and our global sales team and distribution channels to expand our global reach and sales capacity. We continue to focus on selling to large customers, such as enterprise and service providers. As a result, we experienced increased deal volumes driven by traction in enterprise data center deployments and large enterprise deals. During the three months ended September 30, 2014, our revenue growth was primarily driven by greater sales volume in our FortiGate product family due to increased demand across all product categories, particularly from our entry-level and mid-range products, including our recently introduced FortiGate 300D and 500D enterprise security appliances. Sales of entry-level products (FortiGate-20 to -100 series) and mid-range products (FortiGate-200 to -800 series) increased compared to the 25-------------------------------------------------------------------------------- Table of Contents same period last year. During the nine months ended September 30, 2014, our revenue growth was primarily driven by an increase in the sale of our high-end products, including our recently introduced FortiGate 1500D and 3700D enterprise security appliances. During the three and nine months ended September 30, 2014, operating expenses increased by 31% and 30%, respectively, compared to the same periods last year. The increase was primarily driven by our accelerated pace of hiring and marketing investments to support our growth as we continued to invest in expanding our sales coverage, marketing capabilities, developing new products and scaling our customer support organization to meet the needs of our growing customer base. Headcount increased to 2,721 as of September 30, 2014 from 2,238 as of September 30, 2013. 26-------------------------------------------------------------------------------- Table of Contents Key Financial Metrics We monitor the key financial metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts, and assess operational efficiencies. The following table summarizes revenue, deferred revenue, billings (non-GAAP), cash, cash equivalents and investments, net cash provided by operating activities, and free cash flow (non-GAAP). We discuss revenue below under "-Results of Operations," and we discuss our cash, cash equivalents, and investments, and net cash provided by operating activities below under "-Liquidity and Capital Resources." Deferred revenue, billings (non-GAAP), and free cash flow (non-GAAP) are discussed immediately below the following table. Three Months Ended Or As Of September 30, September 30, 2014 2013 (in thousands) Revenue $ 193,348 $ 154,699 Deferred revenue $ 500,012 $ 400,173 Increase in deferred revenue $ 19,810 $ 10,491 Billings (non-GAAP) $ 213,158 $ 165,190 Cash, cash equivalents and investments $ 963,759 $ 841,005 Net cash provided by operating activities $ 56,518 $ 25,384 Free cash flow (non-GAAP) $ 50,738 $ 22,224 Deferred revenue. Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue. The majority of our deferred revenue balance consists of the unamortized portion of services revenue from FortiGuard subscription and FortiCare support service contracts. We monitor our deferred revenue balance because it represents a significant portion of revenue to be recognized in future periods. Billings (Non-GAAP). We define billings as revenue recognized plus the change in deferred revenue from the beginning to the end of the period less any deferred revenue balances acquired from business combination(s) during the period. We consider billings to be a useful metric for management and investors because billings drive deferred revenue, which is an important indicator of the health and visibility of our business, and has historically, represented a majority of the quarterly revenue that we recognize. There are a number of limitations related to the use of billings versus revenue calculated in accordance with GAAP. First, billings include amounts that have not yet been recognized as revenue. Second, we may calculate billings in a manner that is different from peer companies that report similar financial measures. Management compensates for these limitations by providing specific information regarding GAAP revenue and evaluating billings together with revenue calculated in accordance with GAAP. A reconciliation of billings to revenue, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below: Three Months Ended September 30, September 30, 2014 2013 (in thousands) Billings: Revenue $ 193,348 $ 154,699 Add increase in deferred revenue 19,810 10,491 Total billings (Non-GAAP) $ 213,158 $ 165,190 Free cash flow (Non-GAAP). We define free cash flow as net cash provided by operating activities less capital expenditures. We consider 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 the acquisition of property and equipment, can be used for strategic opportunities, including investing in our business, making strategic acquisitions, repurchasing outstanding common stock, and strengthening the balance sheet. Analysis of free cash flow facilitates comparisons of our operating results to competitors' operating results. A limitation of using free cash flow versus the GAAP measure of net cash provided by operating activities as a means for evaluating liquidity is that free cash flow does not represent the total increase or decrease in the cash, cash equivalents and investments balances for the period because it excludes cash used for capital expenditures and cash provided by or used for other investing and financing activities. We compensate for this limitation by providing 27-------------------------------------------------------------------------------- Table of Contents information about our capital expenditures and other investing and financing activities on the face of the cash flow statement and under "-Liquidity and Capital Resources." A reconciliation of free cash flow to net cash provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below: Three Months Ended September 30, September 30, 2014 2013 (in thousands)Free Cash Flow: Net cash provided by operating activities $ 56,518 $ 25,384 Less purchases of property and equipment (5,780 ) (3,160 ) Free cash flow (Non-GAAP) $ 50,738 $ 22,224 Critical Accounting Policies and Estimates-Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, cash flow and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, stock-based compensation expense, valuation of inventory, warranty liabilities, and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected. There have been no material changes to our critical accounting policies and estimates as of and for the three and nine months ended September 30, 2014, as compared to the critical accounting policies and estimates described in the Form 10-K. Reclassification-Beginning in the first quarter of 2014, the amounts previously reported as Ratable and other revenue have been combined with the amounts previously reported as Services revenue in the condensed consolidated statements of operations. The combined amounts are now being presented as Services and other revenue in the condensed consolidated statements of operations. The related Cost of revenue and Gross profit, including prior period amounts, have also been combined to conform to the current period presentation. The Ratable and other revenue amounts, including the related Cost of revenue and Gross profit amounts, are not material, and the reclassification did not have any impact on our gross margin or net income. Recent Accounting Pronouncement-In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09 (Topic 606) - Revenue from Contracts with Customers ("ASU 2014-09") to create a single, joint revenue standard that is consistent across all industries and markets for companies that prepare their financial statements in accordance with U.S. 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 in exchange for those goods or services. ASU 2014-09 is effective for us beginning on January 1, 2017. We are currently evaluating the impact of ASU 2014-09 on our consolidated financial statements. 28-------------------------------------------------------------------------------- Table of Contents Results of Operations Three Months Ended September 30, 2014 and September 30, 2013 Revenue Three Months Ended September 30, September 30, 2014 2013 % of % of Amount Revenue Amount Revenue Change % Change (in thousands except percentages) Revenue: Product $ 87,731 45 % $ 69,687 45 % $ 18,044 26 % Services and other 105,617 55 85,012 55 20,605 24 Total revenue $ 193,348 100 % $ 154,699 100 % $ 38,649 25 % Revenue by geography: Americas $ 82,218 43 % $ 65,448 42 % $ 16,770 26 % Europe, Middle East and Africa ("EMEA") 66,157 34 51,373 33 14,784 29 Asia Pacific and Japan ("APAC") 44,973 23 37,878 25 7,095 19 Total revenue $ 193,348 100 % $ 154,699 100 % $ 38,649 25 % Total revenue increased by $38.6 million, or 25%, in the three months ended September 30, 2014 compared to the same period last year. The Americas region contributed the largest portion of our revenue growth on an absolute dollar basis and all three regions experienced revenue growth compared to the same period last year. Product revenue increased by $18.0 million, or 26%, in the three months ended September 30, 2014, compared to the same period last year. The increase in product revenue was primarily driven by greater sales volume in our FortiGate product family due to increased demand across all product categories, particularly from our entry-level and mid-range products including our recently introduced FortiGate 300D and 500D enterprise security appliances. Services and other revenue increased by $20.6 million, or 24%, in the three months ended September 30, 2014 compared to the same period last year due to the recognition of revenue from our growing deferred revenue balance consisting of FortiGuard subscription and FortiCare support contracts sold to a larger customer base. Cost of revenue and Gross margin Three Months Ended September 30, September 30, 2014 2013 Change % Change (in thousands except percentages) Cost of revenue: Product $ 35,636 $ 27,126 $ 8,510 31 % Services and other 21,249 16,804 4,445 26 Total cost of revenue $ 56,885 $ 43,930 $ 12,955 29 % Gross margin: Product 59.4 % 61.1 % (1.7 )% Services and other 79.9 80.2 (0.3 ) Total gross margin 70.6 % 71.6 % (1.0 )% Total gross margin decreased by 1.0 percentage point in the three months ended September 30, 2014 compared to the same period last year, as product gross margin declined. Product gross margin decreased by 1.7 percentage points in the three months ended September 30, 2014 compared to the same period last year primarily as a result of the sale of a higher mix of 29-------------------------------------------------------------------------------- Table of Contents entry-level and mid-range products and higher overhead costs. In addition, warranty-related costs increased by $1.4 million. Services and other gross margin decreased by 0.3 percentage points during the three months ended September 30, 2014 as our continued investments in our technical support and global threat research organizations were relatively in line with our rate of growth of services and other revenue. Cost of services and other revenue increased by $4.4 million in the three months ended September 30, 2014 compared to the same period last year, primarily due to a $2.6 million increase in personnel costs related to headcount increases, a $0.8 million increase in professional services and a $0.8 million increase in depreciation and occupancy-related costs. Operating expenses Three Months Ended September 30, September 30, 2014 2013 % of % of Amount Revenue Amount Revenue Change % Change (in thousands except percentages) Operating expenses: Research and development $ 30,790 16 % $ 26,421 17 % $ 4,369 17 % Sales and marketing 80,433 42 56,687 37 23,746 42 General and administrative 9,789 5 9,382 6 407 4 Total operating expenses $ 121,012 63 % $ 92,490 60 % $ 28,522 31 % Research and development Research and development expense increased by $4.4 million, or 17%, in the three months ended September 30, 2014 compared to the same period last year, primarily due to an increase of $3.4 million in personnel costs as a result of increased headcount to support the development of new products and continued enhancements of our existing products. In addition, we incurred higher stock-based compensation expense of $1.0 million, higher occupancy-related costs of $0.6 million, and higher consulting service costs of $0.3 million. This increase was partially offset by lower product development expenses, such as third-party testing and prototypes costs of $0.5 million and depreciation and other costs of $0.3 million. We intend to continue to invest in our research and development organization but expect research and development expense as a percentage of total revenue to remain at similar levels during the remainder of fiscal 2014. Sales and marketing Sales and marketing expense increased by $23.7 million, or 42%, in the three months ended September 30, 2014 compared to the same period last year, primarily due to an increase of $15.3 million in personnel costs as we continued to increase our headcount in order to drive continued market share gains globally. In addition, we increased our investments in marketing, including increasing expenditure on tradeshows, lead generation campaigns and other marketing-related expenses of $3.6 million. Our stock-based compensation expense increased by $2.2 million, depreciation expense, occupancy-related and other costs increased by $1.3 million and travel expense increased by $0.7 million. As a percentage of total revenue, sales and marketing expenses increased as we accelerated the investment in our sales force and marketing campaigns to drive future growth. We intend to continue to make investments in sales and marketing and expect sales and marketing expense as a percentage of total revenue to remain at similar levels or increase during the remainder of fiscal 2014. General and administrative General and administrative expense increased by $0.4 million, or 4%, in the three months ended September 30, 2014 compared to the same period last year. Personnel costs increased by $1.2 million as we continued to increase our headcount in order to support our expanding business. The increase was partially offset by lower stock-based compensation expense of $0.4 million and other costs of $0.4 million. We expect general and administrative expense as a percentage of total revenue to remain at similar levels during the remainder of fiscal 2014. 30-------------------------------------------------------------------------------- Table of Contents Interest income and Other expense-net Three Months Ended September 30, September 30, 2014 2013 Change % Change (in thousands except percentages) Interest income $ 1,339 $ 1,282 $ 57 4 % Other expense-net (1,005 ) (1,151 ) 146 (13 ) Interest income increased in the three months ended September 30, 2014 compared to the same period last year due to interest earned on higher invested balances of cash, cash equivalents and investments. The change in other expense-net, for the three months ended September 30, 2014 when compared to the same period last year, was the result of lower foreign exchange losses. Provision for income taxes Three Months Ended September 30, September 30, 2014 2013 Change % Change (in thousands except percentages) Provision for income taxes $ 11,729 $ 7,381 $ 4,348 59 % Effective tax rate 74 % 40 % 34 % - Our effective tax rate was 74% for the three months ended September 30, 2014, compared to 40% for the same period last year. The provision for income taxes for the three months ended September 30, 2014 was comprised primarily of U.S. federal and state taxes, Singapore and other foreign income taxes, withholding tax, discrete taxes resulting from an increase in tax reserves, as well as the inclusion of stock compensation benefits and transfer pricing allocations which impact jurisdictional income taxed at various tax rates. The increase in the effective tax rate for the three months ended September 30, 2014 as compared to the same period last year was primarily due to a change in the mix of profitability between jurisdictions, an increase in estimated tax liability related to foreign operations, an increase in tax reserves, an increase in non-tax deductible stock-based compensation expense, limitations on utilizing foreign tax credits, and expiration of the U.S. federal research and development credit effective December 31, 2013. The U.S. Congress has not extended the research and development tax credit as of September 30, 2014. 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, 2014, we had accrued approximately $1.6 million for estimated interest related to uncertain tax positions. Within the next twelve months, we do not believe there will be a decrease in uncertain tax benefits that could impact our future effective tax rate. 31-------------------------------------------------------------------------------- Table of Contents Nine Months Ended September 30, 2014 and September 30, 2013 Revenue Nine Months Ended September 30, September 30, 2014 2013 % of % of Amount Revenue Amount Revenue Change % Change (in thousands except percentages) Revenue: Product $ 249,880 46 % $ 194,162 44 % $ 55,718 29 % Services and other 296,515 54 243,785 56 52,730 22 Total revenue $ 546,395 100 % $ 437,947 100 % $ 108,448 25 % Revenue by geography: Americas $ 233,035 43 % $ 178,101 41 % $ 54,934 31 % EMEA 185,354 34 149,500 34 35,854 24 APAC 128,006 23 110,346 25 17,660 16 Total revenue $ 546,395 100 $ 437,947 100 % $ 108,448 25 % Total revenue increased by $108.4 million, or 25%, in the nine months ended September 30, 2014 compared to the same period last year. The Americas region contributed the largest portion of our revenue growth on both an absolute dollar basis and percentage basis. Product revenue increased by $55.7 million, or 29%, in the nine months ended September 30, 2014, compared to the same period last year. The increase in product revenue was primarily driven by greater sales volume in our FortiGate product family due to increased demand across all product categories, particularly in our high-end products including our recently introduced FortiGate 1500D and 3700D enterprise security appliances. Services and other revenue increased by $52.7 million, or 22%, in the nine months ended September 30, 2014 compared to the same period last year due to the recognition of revenue from our increased deferred revenue balance consisting of FortiGuard subscription and FortiCare support contracts sold to a larger customer base. Cost of revenue and Gross margin Nine Months Ended September 30, September 30, 2014 2013 Change % Change (in thousands except percentages) Cost of revenue: Product $ 105,230 $ 77,032 $ 28,198 37 % Services and other 60,155 49,734 10,421 21 Total cost of revenue $ 165,385 $ 126,766 $ 38,619 30 % Gross margin: Product 57.9 % 60.3 % (2.4 )% Services and other 79.7 79.6 0.1 Total gross margin 69.7 % 71.1 % (1.4 )% Total gross margin decreased by 1.4 percentage points in the nine months ended September 30, 2014 compared to the same period last year, as product gross margin declined. Product gross margin decreased by 2.4 percentage points in the nine months ended September 30, 2014 compared to the same period last year, primarily due to a $2.4 million impairment charge related to certain intangible assets. In addition, warranty-related costs increased by $2.7 million, excess inventory write-offs increased by $1.1 million, and personnel costs increased by $0.6 million. Services and other gross margin increased by 0.1 percentage points during the nine months ended September 30, 2014 as our continued investments in our technical support and global threat research organizations were relatively in line with our rate of growth of services and other revenue. Cost of services and other revenue increased by $10.4 million primarily due to a $6.1 million increase in personnel costs related to 32-------------------------------------------------------------------------------- Table of Contents headcount increases, a $1.3 million increase in depreciation, a $1.0 million increase in occupancy-related costs, and a $0.7 million increase in stock-based compensation expense. Operating expenses Nine Months Ended September 30, September 30, 2014 2013 % of % of Amount Revenue Amount Revenue Change % Change (in thousands except percentages) Operating expenses: Research and development $ 89,783 16 % $ 74,913 17 % $ 14,870 20 % Sales and marketing 222,576 41 162,660 37 59,916 37 General and administrative 29,243 5 26,161 6 3,082 12 Total operating expenses $ 341,602 63 % $ 263,734 60 % $ 77,868 30 % Research and development Research and development expense increased by $14.9 million, or 20%, in the nine months ended September 30, 2014 compared to the same period last year, primarily due to an increase of $8.7 million in personnel costs as a result of increased headcount to support the development of new products and continued enhancements of our existing products. In addition, we incurred higher product development expenses, such as third-party testing, prototypes and supplies, of $3.7 million, higher stock-based compensation expense of $3.0 million, and higher depreciation and occupancy-related costs of $2.2 million. These increases were partially offset by a $3.0 million reversal of estimated contingent consideration. Sales and marketing Sales and marketing expense increased by $59.9 million, or 37%, in the nine months ended September 30, 2014 compared to the same period last year, primarily due to an increase of $39.3 million in personnel costs as we continued to increase our headcount in order to drive continued market share gains globally. We also significantly increased marketing-related expenses by $9.2 million as we invested in tradeshows and lead generation campaigns. In addition, we incurred increases in stock-based compensation of $5.0 million, depreciation expense of $2.1 million, travel expense of $1.8 million and other costs of $2.6 million. As a percentage of total revenue, sales and marketing expenses increased as we are accelerating the investment in our sales force and marketing campaigns to drive future growth. General and administrative General and administrative expense increased by $3.1 million, or 12%, in the nine months ended September 30, 2014 compared to the same period last year. Personnel costs increased by $2.9 million and stock-based compensation expense increased by $1.9 million as we continued to increase our headcount in order to support our expanding business. The increase in expense was partially offset by a decrease of $0.8 million in professional services fees and $0.9 million in occupancy-related costs including depreciation and supplies. Interest income and Other expense-net Nine Months Ended September 30, September 30, 2014 2013 Change % Change (in thousands except percentages) Interest income $ 3,991 $ 3,988 $ 3 - Other expense-net (1,968 ) (1,036 ) (932 ) 90 The change in other expense-net, for the nine months ended September 30, 2014 when compared to the same period last year, was the result of higher foreign exchange losses and the impact of a reevaluation of the functional currency selection of certain of our international subsidiaries. 33-------------------------------------------------------------------------------- Table of Contents . Provision for income taxes Nine Months Ended September 30, September 30, 2014 2013 Change % Change (in thousands except percentages) Provision for income taxes $ 22,901 $ 18,142 $ 4,759 26 % Effective tax rate 55 % 36 % 19 % - Our effective tax rate was 55% for the nine months ended September 30, 2014, compared to 36% for the same period last year. The provision for income taxes for the nine months ended September 30, 2014 was comprised primarily of U.S. federal and state taxes, Singapore and other foreign income taxes, withholding tax, as well as the inclusion of stock compensation benefits and transfer pricing allocations which impact jurisdictional income taxed at various tax rates. The increase in the effective tax rate for the nine months ended September 30, 2014 as compared to the same period last year was primarily due to a change in the mix of profitability between jurisdictions, an increase in estimated tax liability related to foreign operations, an increase in tax reserves, an increase in non-tax deductible stock-based compensation expense, limitations on utilizing foreign tax credits, and expiration of the U.S. federal research and development credit effective December 31, 2013. The U.S. Congress has not extended the research and development tax credit as of September 30, 2014. Liquidity and Capital Resources September 30, December 31, 2014 2013 (in thousands) Cash and cash equivalents $ 258,096 $ 115,873 Investments 705,663 727,172 Total cash, cash equivalents and investments $ 963,759 $ 843,045 Working capital $ 461,944 $ 322,485 Nine Months Ended September 30, September 30, 2014 2013 (in thousands) Net cash provided by operating activities $ 161,218 $ 100,716 Net cash used in investing activities (16,508 ) (104,148 ) Net cash (used in) provided by financing activities (1,887 ) 26,008 Effect of exchange rates on cash and cash equivalents (600 ) (1,005 ) Net increase in cash and cash equivalents $ 142,223 $ 21,571 Liquidity and capital resources may be impacted by our operating activities, as well as acquisitions, capital expenditures, stock repurchases, and investments in strategic relationships that we have made or may make in the future. In January 2014, we received a cash payment of $20.0 million pursuant to a six year mutual covenant-not-to-sue and release agreement with Palo Alto Networks, Inc. We expect to spend up to $7.0 million related to our capital expenditures, primarily related to purchase of computer equipment, expansion of our offices, as well as the implementation of our enterprise resource planning system during the remainder of fiscal 2014. As of September 30, 2014, $127.9 million remained available for future share repurchases under our Share Repurchase Program ("Program"), which will be financed through our available working capital. On October 17, 2014, our board of directors extended the share repurchase authorization under the Program through December 31, 2015. As of October 17, 2014, $124.9 million remained authorized for future share repurchases under the Program. 34-------------------------------------------------------------------------------- Table of Contents As of September 30, 2014, our cash, cash equivalents and investments of $963.8 million were held for working-capital purposes and were invested primarily in corporate debt securities, commercial paper, municipal bonds, certificates of deposit and term deposits, money market funds, and U.S. government and agency securities. It is our investment policy to invest excess cash in a manner that preserves capital, provides liquidity and maximizes return. As of September 30, 2014, $233.4 million of our cash and investments was held by our international subsidiaries and is therefore not immediately available to fund domestic operations unless the cash is repatriated. While we do not intend to do so, should this amount be repatriated, it would be subject to U.S. federal income tax which would be partially offset by foreign tax credits. We do not enter into investments for trading or speculative purposes. 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 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 costs to ensure access to adequate manufacturing capacity, the continuing market acceptance of our products, share repurchases, and future capital expenditures related to real estate and infrastructure. Historically, we have required capital principally to fund our working capital needs, capital expenditures, share repurchases, and acquisition activities. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition would be adversely affected. Operating Activities Cash generated by operating activities is our primary source of liquidity. It is primarily comprised of net income, adjusted for non-cash items, and changes in operating assets and liabilities. Non-cash adjustments consist primarily of stock-based compensation, depreciation of property and equipment, amortization of intangible assets, excess tax benefit from stock-based compensation, and amortization of investment premiums. Our operating activities during the nine months ended September 30, 2014 provided $161.2 million in cash as a result of profitability, timing of billings and collections, and the ability to successfully manage our working capital. The primary sources of cash from operating activities during the nine months ended September 30, 2014 consisted of net income of $18.5 million increased by non-cash adjustments of $65.0 million and changes in operating assets and liabilities of $77.7 million. In January 2014, we received $20.0 million pursuant to a six year mutual covenant-not-to-sue and release agreement with Palo Alto Networks, Inc. Changes in operating assets and liabilities primarily included an increase in payments received from customers and a receipt of cash related to the mutual covenant-not-to-sue and release agreement, partially offset by payments for inventory purchases and payment of income taxes during the period. Our operating activities during the nine months ended September 30, 2013 provided $100.7 million in cash. The primary sources of cash from operating activities during the nine months ended September 30, 2013 consisted of net income of $32.3 million increased by non-cash adjustments of $50.2 million and changes in operating assets and liabilities of $18.2 million. Changes in operating assets and liabilities primarily included an increase in payments received from customers, partially offset by payment for inventory purchases. Investing Activities The changes in cash flows from investing activities primarily relate to timing of purchases, maturities, and sales of investments, purchases of property and equipment, and payments made in connection with acquisitions. During the nine months ended September 30, 2014, cash used was primarily due to $26.8 million for our capital expenditures, partially offset by positive cash flow due to maturities, net of purchases, from our investments of $10.3 million. During the nine months ended September 30, 2013, cash used was primarily due to $89.8 million net purchases of investments, $7.6 million for acquisitions, and $6.7 million for the purchases of property and equipment. Financing Activities The changes in cash flows from financing activities primarily relate to proceeds from the issuance of common stock, taxes paid related to net share settlement of equity awards, excess tax benefit from stock-based compensation, and repurchase and retirement of common stock. 35-------------------------------------------------------------------------------- Table of Contents During the nine months ended September 30, 2014, we used $38.2 million and $8.5 million of our cash to repurchase and retire our common stock and pay taxes related to withholding upon the issuance of restricted stock units, respectively. This cash outflow was partially offset by proceeds of $40.5 million from the issuance of common stock under our stock plans, as well as excess tax benefit from employee stock-based compensation of $4.3 million. During the nine months ended September 30, 2013, we had positive cash flow of $26.0 million from financing activities as a result of proceeds of $24.5 million from the issuance of common stock under our stock plans and an excess tax benefit from employee stock option exercises of $2.5 million. Contractual Obligations and Commitments There have been no material changes outside the ordinary course of business during the nine months ended September 30, 2014, 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 9 to the notes to the condensed consolidated financial statements included in Part I, Item 1 of this Form 10-Q for additional information regarding contractual obligations and commitments. Off-Balance Sheet Arrangements As of September 30, 2014, 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. |