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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

__________________

FORM 10-Q

__________________



x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2018



o	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to

Commission file number 001-35662

__________________

QUALYS, INC.

(Exact name of registrant as specified in its charter)

__________________



Delaware		77-0534145
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification Number)

919 E. Hillsdale Boulevard, 4th Floor, Foster City, California 94404

(Address of principal executive offices, including zip code)

(650) 801-6100

(Registrant’s telephone number, including area code)

__________________

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

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨

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



Large accelerated filer	x	Accelerated filer	o
Non-accelerated filer	o	Smaller reporting company	o
		Emerging growth company	o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

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

The number of shares of the Registrant's common stock outstanding as of October 30, 2018 was 39,379,168.

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Qualys, Inc.

TABLE OF CONTENTS



		Page
PART I – FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets as of September 30, 2018 and December 31, 2017	3
	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2018 and 2017	4
	Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2018 and 2017	5
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2018 and 2017	6
	Notes to Condensed Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	29
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	43
Item 4.	Controls and Procedures	44
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings	45
Item 1A.	Risk Factors	45
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	67
Item 3.	Defaults upon Senior Securities	67
Item 4.	Mine Safety Disclosures	67
Item 5.	Other Information	67
Item 6.	Exhibits	68
	Signatures	69

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PART I. FINANCIAL INFORMATION


Item 1.	Financial Statements

Qualys, Inc.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands, except share and per share data)



	September 30, 2018			December 31, 2017
Assets
Current assets:
Cash and cash equivalents	$	97,964		$	86,591
Short-term marketable securities	228,542			201,823
Accounts receivable, net of allowance of $764 and $816 as of September 30, 2018 and December 31, 2017, respectively	58,612			64,412
Prepaid expenses and other current assets	16,623			16,524
Total current assets	401,741			369,350
Long-term marketable securities	64,103			67,224
Property and equipment, net	64,503			58,557
Deferred tax assets, net	28,248			25,066
Intangible assets, net	13,741			12,401
Long-term investment	2,500			—
Goodwill	1,849			1,549
Restricted cash	1,200			1,200
Other noncurrent assets	8,115			2,178
Total assets	$	586,000		$	537,525
Liabilities and Stockholders’ Equity
Current liabilities :
Accounts payable	$	4,723		$	1,144
Accrued liabilities	23,208			21,444
Deferred revenues, current	155,115			143,186
Total current liabilities	183,046			165,774
Deferred revenues, noncurrent	17,558			17,136
Other noncurrent liabilities	11,256			11,071
Total liabilities	211,860			193,981
Commitments and contingencies (Note 7)
Stockholders’ equity:
Preferred stock, $0.001 par value; 20,000,000 shares authorized, no shares issued and outstanding at September 30, 2018 and December 31, 2017	—			—
Common stock, $0.001 par value; 1,000,000,000 shares authorized; 39,341,476 and 38,598,117 shares issued and outstanding at September 30, 2018 and December 31, 2017	39			39
Additional paid-in capital	329,045			304,155
Accumulated other comprehensive loss	(752		)	(574		)
Retained earnings	45,808			39,924
Total stockholders’ equity	374,140			343,544
Total liabilities and stockholders’ equity	$	586,000		$	537,525

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

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Qualys, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2018			2017			2018			2017
Revenues	$	71,658		$	59,490		$	204,689		$	167,913
Cost of revenues	16,511			12,728			48,660			37,175
Gross profit	55,147			46,762			156,029			130,738
Operating expenses:
Research and development	12,501			10,892			38,182			31,240
Sales and marketing	15,489			15,475			50,698			46,872
General and administrative	9,040			9,546			29,731			25,112
Total operating expenses	37,030			35,913			118,611			103,224
Income from operations	18,117			10,849			37,418			27,514
Other income (expense), net:
Interest expense	(35		)	—			(112		)	(3		)
Interest income	1,651			753			4,193			1,775
Other expense, net	(500		)	(82		)	(836		)	(288		)
Total other income, net	1,116			671			3,245			1,484
Income before income taxes	19,233			11,520			40,663			28,998
(Benefit from) provision for income taxes	(4,236		)	3,068			(2,241		)	(8,586)
Net income	$	23,469		$	8,452		$	42,904		$	37,584
Net income per share:
Basic	$	0.60		$	0.22		$	1.10		$	1.01
Diluted	$	0.56		$	0.21		$	1.02		$	0.95
Weighted average shares used in computing net income per share:
Basic	39,170			37,703			38,907			37,162
Diluted	42,197			40,299			42,113			39,601

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

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Qualys, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(In thousands)



	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2018			2017		2018			2017
Net income	$	23,469		$	8,452	$	42,904		$	37,584
Available-for-sale marketable securities:
Change in net unrealized (loss) gain, net of tax	(85		)	103		(427		)	32
Reclassification adjustment for net realized gain included in net income, net of tax	154			12		249			4
Other comprehensive income (loss), net of tax	69			115		(178		)	36
Comprehensive income	$	23,538		$	8,567	$	42,726		$	37,620

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

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Qualys, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)



	Nine Months Ended
	September 30,
	2018			2017
Cash flows from operating activities:
Net income	$	42,904		$	37,584
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization expense	21,224			15,054
Bad debt expense	—			353
Loss on disposal of property and equipment	31			3
Stock-based compensation	22,672			18,522
Amortization of premiums and accretion of discounts on marketable securities	(586		)	1,155
Deferred income taxes	(4,024		)	(17,631		)
Excess tax benefits included in deferred tax assets	—			7,880
Changes in operating assets and liabilities:
Accounts receivable	5,800			317
Prepaid expenses and other assets	(5,733		)	(405		)
Accounts payable	182			(706		)
Accrued liabilities	5,803			747
Deferred revenues	12,351			17,716
Other non-current liabilities	(1,804		)	1,190
Net cash provided by operating activities	98,820			81,779
Cash flows from investing activities:
Purchases of marketable securities	(242,056		)	(198,866		)
Sales and maturities of marketable securities	218,865			148,025
Purchases of property and equipment	(19,496		)	(26,612		)
Business acquisition	(3,359		)	(5,753		)
Purchase of privately-held investment	(2,500		)	—
Net cash used in investing activities	(48,546		)	(83,206		)
Cash flows from financing activities:
Proceeds from exercise of stock options	20,896			22,778
Payments for taxes related to net share settlement of equity awards	(12,010		)	(17,571		)
Principal payments under capital lease obligations	(1,203		)	—
Repurchase of common stock	(46,542		)	—
Net cash (used in) provided by financing activities	(38,859		)	5,207
Effect of exchange rate changes on cash and cash equivalents	(42		)	—
Net increase in cash, cash equivalents and restricted cash	11,373			3,780
Cash, cash equivalents and restricted cash at beginning of period	87,791			87,937
Cash, cash equivalents and restricted cash at end of period	$	99,164		$	91,717

Supplemental disclosures of cash flow information:
Cash paid for interest expense	$	115		$	—
Cash paid for income taxes, net of refunds	$	2,018		$	1,083
Non-cash investing and financing activities
Purchases of property and equipment recorded in accounts payable and accrued liabilities	$	6,008		$	1,371
Purchase of assets under capital lease	$	2,300		$	—
Not yet received tenant allowance recorded in other assets, accrued liabilities and other non-current liabilities	$	—		$	8,076

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


NOTE 1.	The Company and Summary of Significant Accounting Policies

Description of Business

Qualys, Inc. (the “Company”, "we", "us", "our") was incorporated in the state of Delaware on December 30, 1999. The Company is headquartered in Foster City, California and has wholly-owned subsidiaries throughout the world. The Company is a pioneer and leading provider of cloud-based security and compliance solutions that enable organizations to identify security risks to their IT infrastructures, help protect their IT systems and applications from ever-evolving cyber-attacks and achieve compliance with internal policies and external regulations. The Company’s cloud solutions address the growing security and compliance complexities and risks that are amplified by the dissolving boundaries between internal and external IT infrastructures and web environments, the rapid adoption of cloud computing and the proliferation of geographically dispersed IT assets. Organizations can use the Company’s integrated suite of solutions delivered on its Qualys cloud platform to cost-effectively obtain a unified view of their security and compliance posture across globally-distributed IT infrastructures.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements and condensed footnotes have been prepared by the Company in accordance with accounting principles generally accepted in the United States ("U.S. GAAP") for interim financial information as well as the instructions to Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in the financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations. The condensed consolidated balance sheet as of December 31, 2017, included herein, was derived from the audited financial statements as of that date but does not include all disclosures, including notes required by U.S. GAAP. In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of the financial position, results of operations and cash flows for the interim periods. The results of operations for the three and nine month periods ended September 30, 2018 are not necessarily indicative of the results of operations expected for the entire year ending December 31, 2018 or for any other future annual or interim periods. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, filed with the SEC on February 23, 2018.

Use of Estimates

The preparation of the unaudited condensed consolidated financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of assets and liabilities at the date of the condensed consolidated financial statements and the reported results of operations during the reporting period. The Company’s management regularly assesses these estimates, which primarily affect revenue recognition, the valuation of accounts receivable, goodwill and intangible assets, capitalization of new internally developed software, stock-based compensation and the provision for income taxes. Actual results could differ from those estimates and such differences may be material to the accompanying unaudited condensed consolidated financial statements.

Internally Developed Software Costs

The Company capitalizes costs incurred to develop new internal-use software. Capitalized costs include salaries, benefits, and stock-based compensation charges for employees that are directly involved in developing its cloud security platform during the application development stage. These capitalized costs are included in other noncurrent assets on the accompanying condensed consolidated balance sheets. Such costs are amortized on a straight-line basis over its estimated useful life of three years. Amortization of product related to new internal-use software is recorded to cost of revenues. Capitalization of new internally developed software cost was $0.8 million for the nine months ended September 30, 2018. Unamortized cost for capitalized new internally developed software was $0.7 million at September 30, 2018. Amortization expense for capitalized new internally developed software was less

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

than $0.1 million for the three and nine months ended September 30, 2018. Management evaluates the useful lives of these assets on an annual basis and tests for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets.

Cost Method Investments

In the second quarter of fiscal 2018, the Company invested $2.5 million in a privately-held company. The Company used the cost method of accounting to account for the investment because it does not hold a controlling interest in this entity and the Company does not have the ability to exercise significant influence over the entity's operating and financial policies. The investment is included in long term assets on the accompanying condensed consolidated balance sheets. The Company's cost method investment is assessed for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. The Company has not recorded any dividends or other-than-temporary impairment charges related to its cost method investment. The fair value of the investment is not readily available, and there are no quoted market prices for the investment.

Recently Adopted Accounting Pronouncements

Except for the changes below, the Company has consistently applied the accounting policies, described in its Annual Report on Form 10-K for the year ended December 31, 2017, to all periods presented in the condensed consolidated financial statements.

The Company adopted Accounting Standards Codification ("ASC") 606 Revenue from Contracts with Customers with a date of initial application of January 1, 2018. The Company adopted ASC 606 using the modified retrospective method and recognized the cumulative effect as an adjustment to the opening balance of equity at January 1, 2018. Therefore, the comparative information from the prior period has not been adjusted and continues to be reported under ASC 605. The impact of adopting ASC 606 was related to the deferral of sales commission costs for new business and when customers increase their renewal orders (“upsells”). The Company previously expensed sales commissions as incurred. Under ASC 606, sales commissions cost related to new business and upsells are recorded as an asset. The Company amortizes the capitalized commission cost as a selling expense on a straight-line basis over a period of five years. Five years represents the estimated life of the customer relationship taking into account factors such as peer estimates of technology lives and customer lives as well as the Company's own historical data. Applying the practical expedient in ASC 340-40-25-4, the Company expenses commissions related to its contract renewals. The current and noncurrent portions of deferred commissions are included in prepaid expenses and other current assets, and other noncurrent assets, respectively, in its condensed consolidated balance sheets.

On January 1, 2018, the Company recorded an increase to retained earnings of $2.7 million which was the net cumulative impact associated with the capitalization of sales commissions. Additionally, the Company recorded a corresponding commission asset balance of $3.5 million and a related deferred tax liability of $0.8 million. There was no impact to the Company's revenues as a result of adopting ASC 606. Without the adoption of ASC 606, commission expenses would have been $0.5 million higher for the three months ended September 30, 2018. See Note 4, “Revenue from Contracts with Customers”, for additional information regarding the impact on the Company's condensed consolidated financial statements.

In January 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which impacts certain aspects of recognition, measurement, presentation and disclosure of financial instruments. The ASU impacts the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. The Company adopted this ASU in its first quarter of 2018. The adoption of this ASU did not have a material impact on the Company's condensed consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force), to provide guidance on the presentation of certain cash receipts and cash payments in the statement of cash flows in order to reduce diversity in existing practice. The Company adopted

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

this ASU in its first quarter of 2018. The adoption of this ASU did not have a material impact on the Company's condensed consolidated financial statements.

In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash. The update provides guidance on the presentation of restricted cash or restricted cash equivalents in the statement of cash flows. The Company adopted this ASU retrospectively in its first quarter of 2018. The Company reclassified restricted cash of $1.2 million for each of the nine months ended September 30, 2018 and 2017, in the condensed consolidated statements of cash flows.

In January 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business, which revises the definition of a business and provides new guidance in evaluating when a set of transferred assets and activities is a business. The Company adopted this ASU prospectively in its first quarter of 2018. The adoption of this ASU did not have a material impact on the Company's condensed consolidated financial statements.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Recently Issued Accounting Pronouncements Not Yet Adopted

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which requires lessees to recognize all leases, including operating leases, on the balance sheet as a lease asset and lease liability, unless the lease is a short-term lease. ASU 2016-02 also requires additional disclosures regarding leasing arrangements. ASU 2016-02 is effective for the Company beginning in the first quarter of fiscal 2019 and early adoption is permitted. In July 2018, the FASB issued ASU 2018-11, Targeted Improvements - Leases (Topic 842). This update provides an optional transition method that allows entities to elect to apply the standard prospectively at its effective date, versus recasting the prior periods presented. If elected, an entity would recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. Pursuant to the leasing criteria, most of the Company's leased space and equipment leases will be required to be accounted for as right-of-use assets on the balance sheet with offsetting financing obligations. In the statement of operations, what was formerly rent expense for operating leases will be lease expense; and finance leases will be bifurcated into amortization of right-of-use assets and interest on lease liabilities. The Company plans to adopt the ASU utilizing the cumulative-effect adjustment methodology on January 1, 2019, and is currently evaluating the impact and expects the ASU will have a material impact on its condensed consolidated financial statements.

In January 2017, the FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment (Topic 350). This standard eliminates Step 2 from the goodwill impairment test, instead requiring an entity to recognize a goodwill impairment charge for the amount by which the goodwill carrying amount exceeds the reporting unit’s fair value. This ASU is effective for interim and annual goodwill impairment tests in fiscal years beginning after December 15, 2019 with early adoption permitted. This ASU must be applied on a prospective basis. The adoption of this ASU is not expected to have a material impact on the Company's condensed consolidated financial statements.

In February 2018, the FASB issued ASU 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASU eliminates the stranded tax effects in other comprehensive income resulting from the Tax Cuts and Jobs Act (the "2017 Tax Act”). Because the amendments only relate to the reclassification of the income tax effects of the 2017 Tax Act, the underlying guidance that requires that the effect of a change in tax laws or rates be included in income from continuing operations is not affected. ASU 2018-02 is effective for the Company beginning in the first quarter of fiscal 2019 and early adoption is permitted. The Company is currently evaluating the impact of this ASU on its condensed consolidated financial statements.

In June 2018, the FASB issued ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. This ASU expands the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. ASU 2018-07 is effective for the Company beginning in the first quarter of fiscal 2019 and early adoption is permitted. The Company is currently evaluating the impact of this ASU on its condensed consolidated financial statements.

In August 2018, the FASB issued ASU 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. This ASU aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs related to internal-use software. ASU 2018-15 is effective for the Company beginning in the first quarter of fiscal 2020 and early adoption is permitted. The Company is currently evaluating the impact of this ASU on its condensed consolidated financial statements.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)


NOTE 2.	Fair Value of Financial Instruments

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. For certain of the Company’s financial instruments, including certain cash equivalents, accounts receivable, accounts payable, and other current liabilities, the carrying amounts approximate their fair values due to the relatively short maturity of these balances.

The Company measures and reports certain cash equivalents, marketable securities and derivative foreign currency forward contracts at fair value in accordance with the provisions of the authoritative accounting guidance that addresses fair value measurements. This guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. The hierarchy is broken down into three levels based on the reliability of inputs as follows:

Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities.

Level 2—Valuations based on other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Valuations based on inputs that are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability.

The Company's financial instruments consist of assets and liabilities measured using Level 1 and 2 inputs. Level 1 assets include a highly liquid money market fund, which is valued using unadjusted quoted prices that are available in an active market for an identical asset. Level 2 assets include fixed-income U.S. government agency securities, commercial paper, corporate bonds, asset-backed securities and derivative financial instruments consisting of foreign currency forward contracts. The securities, bonds and commercial paper are valued using prices from independent pricing services based on quoted prices in active markets for similar instruments or on industry models using data inputs such as interest rates and prices that can be directly observed or corroborated in active markets. The foreign currency forward contracts are valued using observable inputs, such as quotations on forward foreign exchange points and foreign interest rates.

The Company's cash and cash equivalents, and marketable securities consist of the following:

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)



	September 30, 2018
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
	(in thousands)
Cash and cash equivalents:
Cash	$	91,439	$	—	$	—		$	91,439
Money market funds	3,777		—		—			3,777
Commercial paper	2,749		—		(1		)	2,748
Total	97,965		—		(1		)	97,964
Short-term marketable securities:
Commercial paper	1,497		—		(1		)	1,496
Treasury bills	6,993		—		—			6,993
Corporate bonds	37,366		1		(96		)	37,271
Asset-backed securities	10,261		—		(7		)	10,254
U.S. government agencies	172,716		—		(188		)	172,528
Total	228,833		1		(292		)	228,542
Long-term marketable securities:
Asset-backed securities	16,381		—		(25		)	16,356
U.S. government agencies	18,694		—		(112		)	18,582
Corporate bonds	29,439		4		(278		)	29,165
Total	64,514		4		(415		)	64,103
Total	$	391,312	$	5	$	(708	)	$	390,609



	December 31, 2017
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
	(in thousands)
Cash and cash equivalents:
Cash	$	86,500	$	—	$	—		$	86,500
Money market funds	91		—		—			91
Total	86,591		—		—			86,591
Short-term marketable securities:
Commercial paper	12,623		—		(3		)	12,620
Corporate bonds	38,425		1		(64		)	38,362
U.S. government agencies	151,058		—		(217		)	150,841
Total	202,106		1		(284		)	201,823
Long-term marketable securities:
Asset-backed securities	4,998		—		(12		)	4,986
U.S. government agencies	24,269		—		(54		)	24,215
Corporate bonds	38,198		—		(175		)	38,023
Total	67,465		—		(241		)	67,224
Total	$	356,162	$	1	$	(525	)	$	355,638

The following table shows the changes to accumulated other comprehensive loss for the nine months ended September 30, 2018 (in thousands):



	Unrealized (Loss) Gain, net
Balance at December 31, 2017	$	(574	)
Change in net unrealized loss on available-for-sale marketable securities, net of tax	(427		)
Amounts reclassified for net realized gain included in net income, net of tax	249
Other comprehensive loss, net of tax	(178		)
Balance at September 30, 2018	$	(752	)

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The following table sets forth by level within the fair value hierarchy the fair value of the Company's available-for-sale marketable securities measured on a recurring basis, excluding cash and money market funds:



	September 30, 2018
	Level 1		Level 2		Level 3		Fair Value
	(in thousands)
Commercial paper	$	—	$	4,244	$	—	$	4,244
Treasury bills	—		6,993		—		6,993
U.S. government agencies	—		191,110		—		191,110
Corporate bonds	—		66,436		—		66,436
Asset-backed securities	—		26,610		—		26,610
Total	$	—	$	295,393	$	—	$	295,393



	December 31, 2017
	Level 1		Level 2		Level 3		Fair Value
	(in thousands)
Commercial paper	$	—	$	12,620	$	—	$	12,620
U.S. government agencies	—		175,056		—		175,056
Corporate bonds	—		76,385		—		76,385
Asset-backed securities	—		4,986		—		4,986
Total	$	—	$	269,047	$	—	$	269,047

There were no transfers between Level 1, Level 2 or Level 3 of the fair value hierarchy, as determined at the end of each reporting period.

The following summarizes the fair value of marketable securities classified as available-for-sale by contractual, or effective, maturity:



	September 30, 2018
	Mature within One Year		Mature after One Year through Two Years		Mature over Two Years		Fair Value
	(in thousands)
Commercial paper	$	4,244	$	—	$	—	$	4,244
Treasury bills	6,993		—		—		$	6,993
U.S. government agencies	172,528		18,582		—		191,110
Corporate bonds	37,271		26,462		2,703		66,436
Asset-backed securities	22,755		3,855		—		26,610
Total	$	243,791	$	48,899	$	2,703	$	295,393

Derivative Financial Instruments

Derivative financial instruments are utilized by the Company to reduce foreign currency exchange risks. The Company uses foreign currency forward contracts to mitigate the impact of foreign currency fluctuations of certain non-U.S. dollar denominated asset positions, primarily cash and accounts receivable. These contracts are recorded within prepaid expenses and other current assets or accrued liabilities in the condensed consolidated balance sheets. Gains and losses resulting from currency exchange rate movements on these forward contracts are recognized in other income (expense) in the accompanying condensed consolidated statements of operations in the period in which the

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exchange rates change and offset the foreign currency gains and losses on the underlying exposure being hedged. The Company does not enter into derivative financial instruments for trading or speculative purposes.

At September 30, 2018, the Company had two outstanding forward contracts with notional amounts of 5.8 million Euros and 5.0 million British Pounds, respectively, which expired on October 31, 2018. At December 31, 2017, the Company had two outstanding forward contracts with notional amounts of 7.0 million Euros and 4.8 million British Pounds, respectively, which expired on January 31, 2018. These forward contracts were entered into at the end of each month, and thus the fair value of these contracts was $0 at September 30, 2018 and December 31, 2017. These derivatives did not meet the criteria to be designated as hedges. These instruments were valued using Level 2 inputs.

The following summarizes the gains (losses) recognized in Other income (expense), net on the condensed consolidated statement of operations, from forward contracts and other foreign currency transactions:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2018			2017			2018			2017
	(in thousands)
Net (loss) gain from forward contracts	$	(61	)	$	(463	)	$	292		$	(1,585	)
Other foreign currency transactions (loss) gain	(378		)	431			(966		)	1,424
Total foreign exchange loss, net	$	(439	)	$	(32	)	$	(674	)	$	(161	)


NOTE 3.	Property and Equipment, Net

Property and equipment, net, which includes assets under capital lease, consists of the following:



	September 30,			December 31,
	2018			2017
	(in thousands)
Computer equipment	$	90,739		$	77,883
Computer software	26,003			20,447
Furniture, fixtures and equipment	5,628			5,075
Assets under capital lease	3,503			—
Scanner appliances	15,167			14,325
Leasehold improvements	16,380			16,067
Total property and equipment	157,420			133,797
Less: accumulated depreciation and amortization	(92,917		)	(75,240		)
Property and equipment, net	$	64,503		$	58,557

Physical scanner appliances and other computer equipment that are or will be subject to leases by customers have a net carrying value of $8.8 million and $6.8 million at September 30, 2018 and December 31, 2017, respectively, including assets that have not been placed in service of $2.6 million and $0.9 million, respectively. Depreciation and amortization expense relating to property and equipment, including capitalized leases, was $6.1 million and $5.1 million for the three months ended September 30, 2018 and 2017, respectively, and $18.9 million and $14.7 million for the nine months ended September 30, 2018 and 2017, respectively. Accumulated depreciation under capital leases was $0.7 million at September 30, 2018.

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NOTE 4.	Revenue from Contracts with Customers

In May 2014, the FASB issued a new standard related to revenue recognition. Under the standard, revenue is recognized when a customer obtains control of promised goods or services in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.

On January 1, 2018, the Company adopted ASC 606 using the modified retrospective method applied to those contracts which were not completed as of that date. Results for reporting periods beginning after January 1, 2018 are presented under ASC 606, while prior period amounts are not adjusted and continue to be reported under the accounting standards in effect for the prior period. The Company implemented internal controls and key system functionality to enable the preparation of financial information on adoption. The impact of the standard on the Company's financial statements relates to the Company's accounting for sales commissions. The Company previously expensed sales commissions as incurred. Under ASC 606, the Company is required to capitalize certain contract acquisition costs consisting primarily of commissions paid related to new business and upsells. Applying the practical expedient in ASC 340-40-25-4, the Company expenses commissions related to its contract renewals.

As a result of the adoption, the Company recorded an increase to retained earnings of $2.7 million as of January 1, 2018 which was the net cumulative impact associated with the capitalization of sales commissions. Additionally, the Company recorded a corresponding commission asset balance of $3.5 million and a related deferred tax liability of $0.8 million as of January 1, 2018. There was no impact to the Company's revenues as a result of adopting ASC 606.

Incremental direct costs of obtaining a contract, which consist of sales commissions primarily for new business and upsells, are deferred and amortized over the estimated life of the customer relationship if renewals are expected and the renewal commission is not commensurate with the initial commission. The Company amortizes the capitalized commission cost as a selling expense on a straight-line basis over a period of five years. The Company classifies deferred commissions as current or noncurrent based on the timing of when it expects to recognize the expense. The current and noncurrent portions of deferred commissions are included in prepaid expenses and other current assets and other noncurrent assets, respectively, in its condensed consolidated balance sheets. Applying the practical expedient in ASC 340-40-25-4, the Company expenses commissions related to its contract renewals.

Commission asset balances are as follows (in thousands):



	September 30, 2018		January 1, 2018
Commission asset, current	$	1,175	$	704
Commission asset, noncurrent	$	3,867	$	2,819

For the three and nine months ended September 30, 2018, the Company recognized $0.3 million and $0.8 million, respectively, of commission expense from amortization of its commission assets. During the same periods, there was no impairment loss related to capitalized costs. No contract costs were capitalized in the three and nine months ended September 30, 2017.

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Contract liabilities (deferred revenue) balances are as follows (in thousands):



	September 30, 2018
	ASC 606		Operating Leases		Total
Deferred revenue, current	$	142,336	$	12,779	$	155,115
Deferred revenue, noncurrent	15,681		1,877		17,558
Total	$	158,017	$	14,656	$	172,673

	January 1, 2018
	ASC 606		Operating Leases		Total
Deferred revenue, current	$	130,579	$	12,607	$	143,186
Deferred revenue, noncurrent	15,419		1,717		17,136
Total	$	145,998	$	14,324	$	160,322

The Company records deferred revenue when cash payments are received or due in advance of its performance. The increase in the Company's deferred revenue balances is primarily driven by cash payments received or due in advance of satisfying the Company's performance obligations, offset by revenue recognized in the period. $61.1 million and $50.2 million of subscription services revenue was recognized during the three months ended September 30, 2018 and September 30, 2017, respectively, which amounts were included in the unearned revenue balances as of June 30, 2018 and June 30, 2017, respectively. $126.6 million and $101.1 million of subscription revenue was recognized during the nine months ended September 30, 2018 and September 30, 2017, respectively, which amounts were included in the unearned revenue balances as of December 31, 2017 and December 31, 2016, respectively.

The Company's performance obligations are typically satisfied ratably over the subscription term as its cloud-based offerings are delivered to customers electronically and over time. In addition, the Company recognizes revenues for certain limited scan arrangements on an as-used basis. The Company recognizes revenue related to the professional services as they are performed.

The Company allocates the transaction price to all separate performance obligations, including transactions that are comprised of lease revenue, in proportion to the standalone selling prices ("SSP") of the goods or services underlying each of those performance obligations at contract inception. If a SSP is not directly observable, the Company determines the SSP using information that may include market conditions and other observable inputs. The Company typically has more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, the Company may use information such as the size of the customer and volume purchased in determining the SSP. The Company's transaction prices are typically a fixed amount for a specific period of time, and the majority of contracts are twelve months with certain customers signing longer term deals. In general, the Company does not offer rights of return, performance bonuses, customer loyalty programs, payments via non-cash methods, refunds, volume rebates, incentive payments, penalties, price concessions or payments or discounts contingent on future events. Consideration is fixed at the time of the contract, and governed by the price list to which that particular customer is subject. The Company’s customer and partner-specific pricing is negotiated and agreed upon via individual customer contracts. In some of its contracts, the Company incorporates tiered pricing based on the number of IP addresses the customer can scan. As customers are required to purchase larger quantities to qualify for the lower-priced tiers, the Company does not grant its customers any material rights. When customers increase their purchased quantities, the Company accounts for the additional purchased quantities and related price change prospectively as the pricing does not impact subscription services previously provided. Physical equipment (scanners and private cloud platforms) are accounted for as operating leases and revenue is recognized over the subscription term.

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Accounts receivable, net, consists of the following (in thousands):



	September 30, 2018			January 1, 2018
ASC 606 receivables	$	54,632		$	60,984
Operating lease receivables	4,744			4,244
Less: allowance for doubtful accounts	(764		)	(816		)
Total accounts receivable, net	$	58,612		$	64,412

The Company's payment terms vary by the type and location of its customer and the products or services offered. The term between invoicing and when payment is due is not significant. For certain products or services and customer types, the Company requires payment before the products or services are delivered to the customer.

The following table sets forth the expected revenue from all remaining performance obligations as of September 30, 2018 (in thousands):



	ASC 606 Expected Revenue		Operating Lease Expected Revenue		Total Expected Revenue
2018 (remaining three months)	$	12,755	$	2,063	$	14,818
2019	36,624		4,322		40,946
2020	18,791		1,536		20,327
2021	6,562		621		7,183
2022	976		39		1,015
2023 and thereafter	278		9		287
Total	$	75,986	$	8,590	$	84,576

Revenue allocated to remaining performance obligations represents contracted revenue that has not yet been recognized, which includes deferred revenue from open contracts and the amounts that will be invoiced and recognized as revenue in future periods. Remaining performance obligations represent the transaction price of firm orders for which service has not been performed and excludes unexercised renewals. The Company applied the short-term contract exemption to exclude the remaining performance obligations that are part of a contract that has an original expected duration of one year or less.

From time to time, the Company enters into contracts with customers that extend beyond one year, with certain of its customers electing to pay for more than one year of services upon contract execution. For any discounts associated with these multiple year contracts, the Company does not consider these contracts to contain a financing component as its customers typically initiate the longer terms, and the Company's reasoning for entering into the longer terms is not based on financing.

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Revenues by sales channel are as follows (in thousands):



	Three Months Ended September 30, 2018						Nine Months Ended September 30, 2018
	ASC 606 Revenue		Operating Lease Revenue		Total Revenue		ASC 606 Revenue		Operating Lease Revenue		Total Revenue
Direct	$	33,191	$	3,249	$	36,440	$	100,055	$	10,389	$	110,444
Partner	32,428		2,790		35,218		86,993		7,252		94,245
Total	$	65,619	$	6,039	$	71,658	$	187,048	$	17,641	$	204,689

	Three Months Ended September 30, 2017						Nine Months Ended September 30, 2017
	ASC 605 Revenue		Operating Lease Revenue		Total Revenue		ASC 605 Revenue		Operating Lease Revenue		Total Revenue
Direct	$	27,639	$	3,335	$	30,974	$	84,403	$	10,268	$	94,671
Partner	26,198		2,318		28,516		67,297		5,945		73,242
Total	$	53,837	$	5,653	$	59,490	$	151,700	$	16,213	$	167,913

The Company utilizes partners to enable and accelerate the adoption of its cloud platform by increasing its distribution capabilities and market awareness of its cloud platform as well as by targeting geographic regions outside the reach of its direct sales force. The Company's channel partners maintain relationships with their customers throughout the territories in which they operate and provide their customers with services and third-party solutions to help meet those customers’ evolving security and compliance requirements. As such, these partners may offer the Company's IT security and compliance solutions in conjunction with one or more of their own products or services and act as a conduit through which the Company can connect with these prospective customers to offer its solutions. For sales involving a channel partner, the channel partner engages with the prospective customer directly and involves the Company's sales team as needed to assist in developing and closing an order. When a channel partner secures a sale, the Company sells the associated subscription to the channel partner who in turn resells the subscription to the customer. Sales to channel partners are made at a discount and revenues are recorded at this discounted price over the subscription terms. The Company does not have any influence or specific knowledge of its partners' selling terms with their customers. See Note 12, "Segment Information and Information about Geographic Area" for disaggregation of revenue by geographic area.

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NOTE 5.	Business Combination

On April 1, 2018, the Company acquired the assets of 1Mobility Private Limited ("1Mobility"), a Singapore-based company. The acquisition allows the Company to provide enterprises of all sizes with the ability to create and continuously update an inventory of mobile devices on all versions of Android, iOS and Windows Mobile in their environment; and to continuously assess their security and compliance posture, while quarantining devices that are compromised or out-of-compliance. Total purchase consideration was $4.0 million, including $0.6 million of deferred consideration due eighteen months from the closing date of the acquisition, subject to potential adjustment from possible indemnity claims. Pro forma financial information for this acquisition has not been presented because it is not material to the Company's condensed consolidated financial statements.

The Company accounted for this transaction as a business combination and allocated $3.7 million of the purchase price to technology-based intangible assets and $0.3 million to goodwill. The acquired intangible assets relating to 1Mobility's developed technology are being amortized over the estimated useful lives of approximately four years. Goodwill arising from the 1Mobility acquisition is deductible for tax purposes over 15 years.


NOTE 6.	Goodwill and Intangible Assets, Net

Intangible assets consist primarily of developed technology and patent licenses acquired in business combinations. Acquired intangibles are amortized on a straight-line basis over the respective estimated useful lives of the assets.

The carrying values of intangible assets are as follows (in thousands, except for years):



					September 30, 2018
	Weighted Average Life (Years)	Weighted Average Remaining Life (Years)	Cost		Accumulated Amortization			Net Book Value
Developed technology	5	3.9	$	15,856	$	(2,746	)	$	13,110
Patent licenses	14	5.9	1,388		(797		)	591
Total intangibles subject to amortization			$	17,244	$	(3,543	)	13,701
Intangible assets not subject to amortization								40
Total intangible assets, net								$	13,741

					December 31, 2017
	Weighted Average Life (Years)	Weighted Average Remaining Life (Years)	Cost		Accumulated Amortization			Net Book Value
Developed technology	5	4.8	$	14,067	$	(2,371	)	$	11,696
Patent Licenses	14	6.7	1,388		(723		)	665
Total intangibles subject to amortization			$	15,455	$	(3,094	)	12,361
Intangible assets not subject to amortization								40
Total intangible assets, net								$	12,401

Intangible asset amortization expense was $0.9 million and $0.2 million for the three months ended September 30, 2018 and 2017, respectively, and $2.4 million and $0.4 million for the nine months ended September 30, 2018 and 2017, respectively.

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As of September 30, 2018, the Company expects amortization expense in future periods to be as follows (in thousands):



2018 (remaining three months)	$	864
2019	3,456
2020	3,456
2021	3,457
2022	2,302
2023 and thereafter	166
Total expected future amortization expense	$	13,701

Goodwill, which is not subject to amortization, totaled $1.8 million and $1.5 million as of September 30, 2018 and December 31, 2017, respectively.

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NOTE 7.	Commitments and Contingencies

Leases

The Company leases certain computer equipment and its corporate office and data center facilities under non-cancelable operating leases for varying periods through 2028. In January 2018, the Company entered into a $3.5 million financing arrangement for data center storage equipment, accounted for as a capital lease, with an implied interest rate of 5%.

The following are the minimum annual lease payments due under these leases at September 30, 2018 (in thousands):



	Operating Leases		Capital Leases
	(in thousands)
2018 (remaining three months)	$	1,699	$	443
2019	6,169		1,770
2020	5,752		130
2021	5,022		54
2022	4,536		—
2023 and thereafter	23,609		—
Total minimum lease payments	$	46,787	2,397
Less: amount representing interest			(97		)
Present value of minimum payments			2,300
Less: current portion			(1,688		)
Capital lease obligations, noncurrent			$	612

Rent expense was $2.5 million and $2.4 million for the three months ended September 30, 2018 and 2017, respectively, and $7.1 million and $4.3 million for the nine months ended September 30, 2018 and 2017, respectively. Although certain of the operating lease agreements provide for rent free periods or escalating rent payments over the terms of the leases, rent expense under these agreements is recognized on a straight-line basis over the term of the lease, starting when the Company takes possession of the property from the landlord. As of September 30, 2018 and December 31, 2017, the Company had accrued $10.9 million and $9.5 million, respectively, of deferred rent related to these agreements, which is reflected in accrued liabilities and other non-current liabilities in the accompanying condensed consolidated balance sheets.

On October 14, 2016, the Company entered into a lease agreement for its new headquarters office facility. The lease payments commenced on May 1, 2018 and the lease has a ten-year term through April 30, 2028. The total commitment of $38.6 million is payable monthly with escalating rental payments throughout the lease term. In connection with this lease, the Company provided the landlord with a $1.2 million standby letter of credit to secure the Company’s obligations through the end of the lease term, which was classified as restricted cash in the accompanying condensed consolidated balance sheets.

Indemnifications

The Company from time to time enters into certain types of contracts that contingently require it to indemnify various parties against claims from third parties. These contracts primarily relate to (i) the Company's by-laws, under which it must indemnify directors and executive officers, and may indemnify other officers and employees, for liabilities arising out of their relationship, (ii) contracts under which the Company must indemnify directors and certain officers for liabilities arising out of their relationship, and (iii) contracts under which the Company may be required to indemnify customers or resellers from certain liabilities arising from potential infringement of intellectual property rights, as well as potential damages caused by limited product defects. To date, the Company has not incurred and has not recorded any liability in connection with such indemnifications.

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The Company maintains director and officer insurance, which may cover certain liabilities arising from its obligation to indemnify its directors.

Contingencies

The Company regularly licenses technology from various third party licensors. From time to time, the Company is audited by its licensors for compliance with the terms of the license agreements. During the quarter ended March 31, 2018, the Company commenced discussions with one of its vendors with respect to compliance with the terms of the applicable license agreement. During the three months ended June 30, 2018, the audit was completed and the Company reached a resolution with its licensor. Management sufficiently accrued for licensing agreement matters in the first quarter of 2018.


NOTE 8.	Stock-based Compensation

Equity Incentive Plans

2012 Equity Incentive Plan

Under the 2012 Equity Incentive Plan (the "2012 Plan"), the Company is authorized to grant to eligible participants incentive stock options (“ISOs”), non-statutory stock options (“NSOs”), stock appreciation rights ("SARs"), restricted stock awards ("RSAs"), restricted stock units ("RSUs"), performance units and performance shares equivalent to up to 11,791,139 shares of common stock. Options may be granted with an exercise price that is at least equal to the fair market value of the Company's stock at the date of grant and are exercisable when vested. As of September 30, 2018, 4,191,846 shares were available for grant under the 2012 Plan.

2000 Equity Incentive Plan

Under the 2000 Equity Incentive Plan (the "2000 Plan"), the Company was authorized to grant to eligible participants either ISOs or NSOs. The 2000 Plan was terminated in connection with the closing of the Company's initial public offering, and accordingly, no shares are currently available for grant under the 2000 Plan. The 2000 Plan continues to govern outstanding awards granted thereunder.

Stock-based Compensation

The following table shows a summary of the stock-based compensation expense included in the condensed consolidated statements of operations for the three and nine months ended September 30, 2018 and 2017:



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2018		2017		2018		2017
	(in thousands)
Cost of revenues	$	625	$	532	$	1,888	$	1,569
Research and development	1,937		1,503		5,754		4,229
Sales and marketing	1,163		1,231		3,669		3,444
General and administrative	3,033		4,477		11,361		9,280
Total stock-based compensation	$	6,758	$	7,743	$	22,672	$	18,522

As of September 30, 2018, the Company had $14.2 million of total unrecognized stock-based compensation cost related to unvested options that it expects to recognize over a weighted-average period of 2.1 years, and $40.8 million of unrecognized stock-based compensation cost related to unvested awards that it expects to recognize over a weighted-average period of 2.6 years. Compensation cost is recognized on a straight-line basis over the service

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period. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Stock Option Plan Activity

A summary of the Company’s stock option activity is as follows:



	Outstanding Options		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (Years)	Aggregate Intrinsic Value
						(in thousands)
Balance as of December 31, 2017	4,495,891		$	25.29	6.6	$	153,129
Granted	263,911		$	81.19
Exercised	(1,042,279	)	$	20.05
Canceled	(215,312	)	$	39.32
Balance as of September 30, 2018	3,502,211		$	30.20	6.5	$	206,931
Vested and expected to vest - September 30, 2018	3,323,825		$	28.88	6.4	$	200,599
Exercisable - September 30, 2018	2,465,495		$	24.67	5.8	$	158,857

Restricted Stock

A summary of the Company’s RSU and RSA activity is as follows:



	Outstanding RSUs and RSAs		Weighted Average Grant Date Fair Value Per Share

Balance as of December 31, 2017	1,410,588		$	40.34
Granted	242,046		$	76.39
Vested	(433,525	)	$	39.08
Canceled	(178,938	)	$	41.84
Balance as of September 30, 2018	1,040,171		$	49.00
Outstanding and expected to vest - September 30, 2018	904,092		$	48.39

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NOTE 9.	Net Income Per Share

The computations for basic and diluted net income per share are as follows:



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2018		2017		2018		2017
	(in thousands, except per share data)
Numerator:
Net income	$	23,469	$	8,452	$	42,904	$	37,584
Denominator:
Weighted-average shares used in computing net income per share:
Basic	39,170		37,703		38,907		37,162
Effect of potentially dilutive securities:
Common stock options	2,463		2,199		2,555		2,161
Restricted stock units	564		397		651		278
Diluted	42,197		40,299		42,113		39,601
Net income per share:
Basic	$	0.60	$	0.22	$	1.10	$	1.01
Diluted	$	0.56	$	0.21	$	1.02	$	0.95

Potentially dilutive securities not included in the calculation of diluted net income per share because doing so would be antidilutive are as follows:



	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2018	2017	2018	2017
	(in thousands)
Common stock options	167	651	129	1,244
Restricted stock units	39	—	18	—
	206	651	147	1,244

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NOTE 10.	Stockholder's Equity

Share Repurchase Program

On February 5, 2018, the Company's Board of Directors authorized a $100.0 million two-year share repurchase program, which was announced on February 12, 2018. The Company's stock repurchases may be effected from time to time through open market purchases. Repurchased shares are retired and reclassified as authorized and unissued shares of common stock. On retirement of the repurchased shares, common stock is reduced by an amount equal to the number of shares being retired multiplied by the par value. The excess of the cost of treasury stock that is retired over its par value is first allocated as a reduction to additional paid-in capital based on the initial public offering price of the stock, with the remaining excess to retained earnings.

During the nine months ended September 30, 2018, the Company repurchased 567,642 shares of its common stock for approximately $46.5 million. All share repurchases were made using cash resources. As of September 30, 2018, approximately $53.5 million remained available for share repurchases pursuant to the Company's share repurchase program.

On October 25, 2018, the Company's Board of Directors authorized an additional $100.0 million two-year share repurchase program, which was announced on October 30, 2018.

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NOTE 11.	Income Taxes

The Company's provision for income taxes for interim periods is determined using an estimate of its annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, the Company updates its estimate of the annual effective tax rate, and if the estimated annual effective tax rate changes, the Company makes a cumulative adjustment in such period.

The Company's quarterly tax provision, and estimate of its annual effective tax rate, is subject to variation due to several factors, including variability in pre-tax income (or loss), the mix of jurisdictions to which such income relates, changes in how the Company does business, and tax law developments. The Company's estimated effective tax rate for the year differs from the U.S. statutory rate of 21% primarily due to non-deductible stock-based compensation expense, state taxes, foreign income subject to different tax rates than the U.S., and the benefit of U.S. federal income tax credits.

The Company recorded an income tax benefit of $4.2 million and income tax provision of $3.1 million for the three months ended September 30, 2018 and 2017, respectively, resulting in an effective tax rate of (22.0)% and 26.6%, respectively. The tax benefit for the three months ended September 30, 2018 as compared to the tax provision for the three months ended September 30, 2017 changed primarily due to the benefit of the lower U.S. federal tax rate that became effective in 2018 as well as the tax benefit of excess stock-based compensation deductions.

The Company recorded an income tax benefit of $2.2 million and $8.6 million for the nine months ended September 30, 2018 and 2017, respectively, resulting in an effective tax rate of (5.5)% and (29.6)%, respectively. The tax benefit for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 decreased as a result of a reduction in the amount of excess benefits of stock-based compensation realized.

On December 22, 2017, the 2017 Tax Act was enacted into law. The new legislation contains significant tax provisions that affect the Company, including a one-time repatriation tax on accumulated foreign earnings, a reduction of the corporate income tax rate from 35% to 21%, which was effective January 1, 2018, and a change from a worldwide tax system to a modified territorial system.

In accordance with Staff Accounting Bulletin No. 118 ("SAB 118"), the effects of the 2017 Tax Act may be adjusted within a one-year measurement period from the enactment date of the 2017 Tax Act for items that were previously reported as provisional estimates, or where a provisional estimate could not be made. The income tax provision for the nine months ended September 30, 2018, does not reflect any adjustment to the provisional estimates recorded in the year ended December 31, 2017. The Company will continue to assess forthcoming guidance and accounting interpretations on the effects of the 2017 Tax Act and expects to complete its analysis in the fourth quarter of fiscal 2018, which timing is in accordance with the SEC guidance. Such analysis includes both the accounting policy election related to the Global Intangible Low-Taxed Income, as well as the detailed analysis of historical foreign earnings for purposes of the one-time transition tax.

As of September 30, 2018, the Company had unrecognized tax benefits of $6.0 million, of which $3.3 million, if recognized, would favorably impact the Company's effective tax rate. As of December 31, 2017, the Company had unrecognized tax benefits of $5.1 million, of which $2.8 million, if recognized, would favorably impact the Company's effective tax rate. The Company does not anticipate a material change in its unrecognized tax benefits in the next 12 months.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)


NOTE 12.	Segment Information and Information about Geographic Area

The Company operates in one segment. The Company determines its reportable operating segments in accordance with the provisions in the FASB guidance on segment reporting, which establishes standards for, and requires disclosure of, certain financial information related to reportable operating segments and geographic regions. The Company’s chief operating decision maker is the Chairman, President and Chief Executive Officer, who makes operating decisions, assesses performance and allocates resources on a consolidated basis. All of the Company’s principal operations and decision-making functions are located in the United States.

Revenues by geographic area, based on the location of the customer, are as follows (in thousands):



	Three Months Ended September 30, 2018						Nine Months Ended September 30, 2018
	ASC 606 Revenue		Operating Lease Revenue		Total Revenue		ASC 606 Revenue		Operating Lease Revenue		Total Revenue
United States	$	43,240	$	4,096	$	47,336	$	125,223	$	12,226	$	137,449
Foreign	22,379		1,943		24,322		61,825		5,415		67,240
Total	$	65,619	$	6,039	$	71,658	$	187,048	$	17,641	$	204,689

	Three Months Ended September 30, 2017						Nine Months Ended September 30, 2017
	ASC 605 Revenue		Operating Lease Revenue		Total Revenue		ASC 605 Revenue		Operating Lease Revenue		Total Revenue
United States	$	38,191	$	4,096	$	42,287	$	107,341	$	11,445	$	118,786
Foreign	15,646		1,557		17,203		44,359		4,768		49,127
Total	$	53,837	$	5,653	$	59,490	$	151,700	$	16,213	$	167,913

Property and equipment, net, by geographic area, are as follows:



	September 30,		December 31,
	2018		2017
	(in thousands)
United States	$	54,837	$	50,785
Foreign	9,666		7,772
Total property and equipment, net	$	64,503	$	58,557

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)


NOTE 13.	Subsequent Event

On October 16, 2018, the Company completed the acquisition of Layered Insight, a pioneer and global leader in container native application protection, providing accurate insight into container images, adaptive analysis of running containers, and automated enforcement of the container environment. Total consideration related to the acquisition was $12.0 million in cash, of which $1.6 million is payable in the future subject to terms and conditions of the purchase agreement. The Company also agreed to pay up to an additional $4.0 million if the acquired business achieves certain financial milestones for the annual period ending December 31, 2019. Shareholders of Layered Insight will receive $4.0 million in future payments if certain key employees continue their employment with the Company through December 31, 2019. The Company expects to account for this acquisition as a business combination and is currently determining the impact on its financial statements.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q, including this Management’s Discussion and Analysis of Financial Condition and Results of Operations, should be read in conjunction with (1) our condensed consolidated financial statements (unaudited) and the related notes included elsewhere in this report, and (2) the audited consolidated financial statements and the related notes and management’s discussion and analysis of financial condition and results of operations included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2017, filed with the Securities and Exchange Commission, or SEC, on February 23, 2018.

In addition to historical information, this Quarterly Report on Form 10-Q contains “forward-looking” statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Forward-looking statements generally relate to future events or our future financial or operating performance. In some cases, it is possible to identify forward-looking statements because they contain words such as “anticipates,” “believes,” “contemplates,” “continue,” “could,” “estimates,” “expects,” “future,” “intends,” “likely,” “may,” “plans,” “potential,” “predicts,” “projects,” “seek,” “should,” “target,” or “will,” or the negative of these words or other similar terms or expressions that concern our expectations, strategy, plans or intentions. Forward-looking statements contained in this Quarterly Report on Form 10-Q include, but are not limited to, statements about:


•	our financial performance, including our revenues, costs, expenditures, growth rates, operating expenses and ability to generate positive cash flow to fund our operations and sustain profitability;


•	anticipated technology trends, such as the use of cloud solutions;


•	our ability to adapt to changing market conditions;


•	economic and financial conditions, including volatility in foreign exchange rates;


•	our ability to diversify our sources of revenues, including selling additional solutions to our existing customers and our ability to pursue new customers;


•	the effects of increased competition in our market;


•	our ability to innovate and enhance our cloud solutions and platform and introduce new solutions;


•	our ability to effectively manage our growth;


•	our anticipated investments in sales and marketing, our infrastructure, new solutions, and research and development, and acquisitions;


•	maintaining and expanding our relationships with channel partners;


•	our ability to maintain, protect and enhance our brand and intellectual property;


•	costs associated with defending intellectual property infringement and other claims;


•	our ability to attract and retain qualified employees and key personnel, including sales and marketing personnel;


•	our ability to successfully enter new markets and manage our international expansion;


•	our expectations, assumptions and conclusions related to our provision for income taxes, our deferred tax assets and our effective tax rate; and


•	other factors discussed in this Quarterly Report on Form 10-Q in the sections titled “Risk Factors” and “Management's Discussion and Analysis of Financial Condition and Results of Operations.”

We have based the forward-looking statements contained in this Quarterly Report on Form 10-Q primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, results of operations and prospects. The results, events and circumstances reflected in these forward-looking statements are subject to risks, uncertainties, assumptions, and other factors including those described in Part II, Item 1A (Risk Factors) of this Quarterly Report and those discussed in other documents we file with the SEC. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time, and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements used herein. We cannot provide assurance that the results, events, and circumstances reflected in the forward-looking statements will be achieved or occur, and actual results, events or circumstances could differ materially from those described in the forward-looking statements.

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Overview

We are a pioneer and leading provider of a cloud-based platform delivering security and compliance solutions that enable organizations to identify security risks to their information technology (IT) infrastructures, help protect their IT systems and applications from ever-evolving cyber-attacks and achieve compliance with internal policies and external regulations. Our cloud solutions address the growing security and compliance complexities and risks that are amplified by the dissolving boundaries between internal and external IT infrastructures and web environments, the rapid adoption of cloud computing and the proliferation of geographically dispersed IT assets. Our integrated suite of security and compliance solutions delivered on our Qualys cloud platform enables our customers to identify their IT assets, collect and analyze large amounts of IT security data, discover and prioritize vulnerabilities, recommend remediation actions and verify the implementation of such actions. Organizations use our integrated suite of solutions delivered on our Qualys cloud platform to cost-effectively obtain a unified view of their security and compliance posture across globally-distributed IT infrastructures as our solution offers a single platform for information security, application security, endpoint, developer security and cloud teams.

We were founded and incorporated in December 1999 with a vision of transforming the way organizations secure and protect their IT infrastructure and applications and initially launched our first cloud solution, Vulnerability Management (VM), in 2000. As VM gained acceptance, we introduced new solutions to help customers manage increasing IT security and compliance requirements. Today, the suite of solutions offered on our cloud platform, which we refer to as the Qualys Cloud Apps, includes: Asset Inventory (AI), CMDB Sync (SYN), VM, Continuous Monitoring (CM), Cloud Agent Platform (CAP), Container Security (CS), Cloud Inventory (CI), Cloud Security Assessment (CSA), Certificate Inventory (CRI), Certificate Assessment (CRA), Threat Protection (TP), Security Configuration Assessment (SCA), Indication of Compromise (IOC), Policy Compliance (PC), PCI Compliance (PCI), Security Assessment Questionnaire (SAQ), File Integrity Monitoring (FIM), Web Application Scanning (WAS) and Web Application Firewall (WAF). Our VM solutions (including VM, AI, SYN, CM, TP, Cloud Agent for VM, allocated scanner revenue and Qualys Private Cloud Platform) have provided a substantial majority of our revenues to date, representing 75% of our revenues for the nine months ended September 30, 2018.

We provide our solutions through a software-as-a-service model, primarily with renewable annual subscriptions. These subscriptions require customers to pay a fee in order to access our cloud solutions. We invoice our customers for the entire subscription amount at the start of the subscription term, and the invoiced amounts are treated as deferred revenues and are recognized ratably over the term of each subscription. We continue to experience significant revenue growth from existing customers as they renew and purchase additional subscriptions.

Our revenues increased to $204.7 million in the nine months ended September 30, 2018 from $167.9 million for the comparable period in 2017, representing an increase of $36.8 million or 22%.

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Key Metric

In addition to measures of financial performance presented in our condensed consolidated financial statements, we monitor the key metric set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies.



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2018			2017			2018			2017
	(in thousands, except percentages)
Adjusted EBITDA	$	31,887		$	23,863		$	83,239		$	61,090
Percentage of revenues	44		%	40		%	41		%	36		%

Adjusted EBITDA

We monitor Adjusted EBITDA, a non-GAAP financial measure, to analyze our financial results and believe that it is useful to investors, as a supplement to U.S. GAAP measures, in evaluating our ongoing operational performance and enhancing an overall understanding of our past financial performance. We believe that Adjusted EBITDA helps illustrate underlying trends in our business that could otherwise be masked by the effect of the income or expenses that we exclude in Adjusted EBITDA. Furthermore, we use this measure to establish budgets and operational goals for managing our business and evaluating our performance. We also believe that Adjusted EBITDA provides an additional tool for investors to use in comparing our recurring core business operating results over multiple periods with other companies in our industry.

Adjusted EBITDA should not be considered in isolation from, or as a substitute for, financial information prepared in accordance with U.S. GAAP. We calculate Adjusted EBITDA as net income before (1) other (income) expense, net, which includes interest income, interest expense and other income and expense, (2) provision for (benefit from) income taxes, (3) depreciation and amortization of property and equipment, (4) amortization of intangible assets, (5) stock-based compensation, (6) non-recurring expenses and (7) acquisition-related expenses that do not reflect ongoing costs of operating the business.

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The following unaudited table presents the reconciliation of net income to Adjusted EBITDA for the three and nine months ended September 30, 2018 and 2017:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2018			2017			2018			2017
	(in thousands)						(in thousands)
Net income	$	23,469		$	8,452		$	42,904		$	37,584
Depreciation and amortization of property and equipment	6,110			5,098			18,862			14,662
Amortization of intangible assets	864			173			2,361			392
Interest expense	35			—			112			3
(Benefit from) provision for income taxes	(4,236		)	3,068			(2,241		)	(8,586		)
EBITDA	26,242			16,791			61,998			44,055
Stock-based compensation	6,758			7,743			22,672			18,522
Other income, net	(1,151		)	(671		)	(3,357		)	(1,487		)
Acquisition-related expense⁽¹⁾	38			—			1,926			—
Adjusted EBITDA	$	31,887		$	23,863		$	83,239		$	61,090

(1) Adjusted EBITDA for the three and nine months ended September 30, 2018 excludes approximately less than $0.1 million and $1.9 million, respectively, of compensation expense from the acquisition of NetWatcher.

Limitations of Adjusted EBITDA

Adjusted EBITDA, a non-GAAP financial measure, has limitations as an analytical tool, and should not be considered in isolation from or as a substitute for the measures presented in accordance with U.S. GAAP. Some of these limitations are:


•	Adjusted EBITDA does not reflect certain cash and non-cash charges that are recurring;


•	Adjusted EBITDA does not reflect income tax payments that reduce cash available to us;


•	Adjusted EBITDA excludes depreciation and amortization of property and equipment and, although these are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future; and


•	Other companies, including companies in our industry, may calculate Adjusted EBITDA differently or not at all, which reduces its usefulness as a comparative measure.

Because of these limitations, Adjusted EBITDA should be considered alongside other financial performance measures, including revenues, net income, cash flows from operating activities and our financial results presented in accordance with U.S. GAAP.

Key Components of Results of Operations

Revenues

We derive revenues from the sale of subscriptions to our security and compliance solutions, which are delivered on our cloud platform. Subscriptions to our solutions allow customers to access our cloud-based security and compliance solutions through a unified, web-based interface. Customers generally enter into one year renewable subscriptions. The subscription fee entitles the customer to an unlimited number of scans for a specified number of devices or web applications and, if requested by a customer as part of their subscription, a specified number of physical or virtual scanner appliances. Our physical and virtual scanner appliances are requested by certain customers as part of their subscriptions in order to scan IT infrastructures within their firewalls and do not function without, and are not sold separately from, subscriptions for our solutions. In some limited cases, we also provide certain computer equipment used to extend our Qualys cloud platform into our customers’ private cloud environment. Customers are required to return physical scanner appliances and computer equipment if they do not renew their subscriptions.

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We typically invoice our customers for the entire subscription amount at the start of the subscription term. Invoiced amounts are reflected on our condensed consolidated balance sheets as accounts receivable or as cash when collected, and as deferred revenues until earned and recognized ratably over the subscription period. Accordingly, deferred revenues represent the amount billed to customers that has not yet been earned or recognized as revenues, pursuant to subscriptions entered into in current and prior periods.

Cost of Revenues

Cost of revenues consists primarily of personnel expenses, comprised of salaries, benefits, amortization of internal-use software, performance-based compensation and stock-based compensation, for employees who operate our data centers and provide support services to our customers. Other expenses include depreciation of data center equipment and physical scanner appliances and computer hardware provided to certain customers as part of their subscriptions, expenses related to the use of third-party data centers, amortization of third-party technology licensing fees, amortization of technology-based intangibles related to acquisitions, maintenance support, fees paid to contractors who supplement or support our operations center personnel and overhead allocations. We expect to continue to make capital investments to expand and support our data center operations, which will increase the cost of revenues in absolute dollars.

Operating Expenses

Research and Development

Research and development expenses consist primarily of personnel expenses, comprised of salaries, benefits, performance-based compensation and stock-based compensation, for our research and development teams. Other expenses include third-party contractor fees, amortization of intangibles related to acquisitions and overhead allocations. All research and development costs are expensed as incurred, except for capitalized cost related to new products' internal-use software development. For new products' internal-use software, after completing the preliminary project stage, research and development expense are capitalized from application development start stage to post implementation-operation stage. We expect to continue to devote substantial resources to research and development in an effort to continuously improve our existing solutions as well as develop new solutions and capabilities and expect that research and development expenses will increase in absolute dollars.

Sales and Marketing

Sales and marketing expenses consist primarily of personnel expenses, comprised of salaries, benefits, sales commissions, performance-based compensation and stock-based compensation for our worldwide sales and marketing teams. Other expenses include marketing and promotional events, lead-generation marketing programs, public relations, travel, software licenses and overhead allocations. Sales commissions cost related to new business and upsells are capitalized as an asset. We amortize the capitalized commission cost as a selling expense on a straight-line basis over a period of five years. We expense sales commissions related to its contract renewals. Our new sales personnel are typically not immediately productive, and the resulting increase in sales and marketing expenses we incur when we add new personnel may not result in increased revenues if these new sales personnel fail to become productive. The timing of our hiring of sales personnel, or the participation in new marketing events or programs, and the rate at which these generate incremental revenues, may affect our future operating results. We expect to continue to significantly invest in additional sales personnel worldwide and also in more marketing programs to support new solutions on our platform, which will increase sales and marketing expenses in absolute dollars.

General and Administrative

General and administrative expenses consist primarily of personnel expenses, comprised of salaries, benefits, performance-based compensation and stock-based compensation, for our executive, finance and accounting, legal and human resources teams, as well as professional services, insurance, fees, and software licenses. We expect that general and administrative expenses will increase in absolute dollars, as we continue to add personnel and incur professional services to support our growth and compliance with legal requirements.

Other Income (Expense), Net

Our other income (expense), net consists primarily of interest and investment income from our short-term and long-term marketable securities; foreign exchange gains and losses, the majority of which result from fluctuations between the U.S. dollar and the Euro, British Pound and Indian Rupee; losses on disposal of property and equipment; and impairment of long-lived assets.

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Provision for Income Taxes

We are subject to federal, state and foreign income taxes for jurisdictions in which we operate, and we use estimates in determining our provision for these income taxes and deferred tax assets. Earnings from our non-U.S. activities are subject to income taxes in the local country which are generally higher than U.S. tax rates, and may be subject to U.S. income taxes.

Our tax provision for income taxes for interim periods is determined using an estimate of our annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, we update our estimate of the annual effective tax rate, and if the estimated annual effective tax rate changes, we make a cumulative adjustment in such period. Our estimated effective rate for the year differs from the U.S. statutory rate of 21% primarily due to non-deductible stock-based compensation expense, state taxes, foreign income subject to different tax rates than the U.S., and the benefit of U.S. federal income tax credits.

On December 22, 2017, the Tax Cuts and Jobs Act (the “2017 Tax Act”) was enacted into law. The new legislation contains significant tax provisions that affect us, including a one-time repatriation tax on accumulated foreign earnings, a reduction of the corporate income tax rate from 35% to 21%, which was effective January 1, 2018, and a change from a worldwide tax system to a modified territorial system.

In accordance with Staff Accounting Bulletin No. 118 ("SAB 118"), the effects of the 2017 Tax Act may be adjusted within a one-year measurement period from the enactment date of the 2017 Tax Act for items that were previously reported as provisional estimates, or where a provisional estimate could not be made. The income tax provision for the nine months ended September 30, 2018 does not reflect any adjustment to the provisional estimates recorded in the year ended December 31, 2017. We will continue to assess forthcoming guidance and accounting interpretations on the effects of the 2017 Tax Act and expect to complete our analysis in the fourth quarter of fiscal 2018, which timing is in accordance with the SEC guidance. Such analysis includes both the accounting policy election related to the Global Intangible Low-Taxed Income, as well as the detailed analysis of historical foreign earnings for purposes of the one-time transition tax.

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the tax impact of timing differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using statutory tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period when the statutory rate change is enacted into law.

We assess the likelihood that deferred tax assets will be realized, and we recognize a valuation allowance if it is more likely than not that some portion of the deferred tax assets will not be recognized. This assessment requires judgment as to the likelihood and amounts of future taxable income.

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Results of Operations

The following tables set forth selected condensed consolidated statements of operations data for each of the periods presented.



	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2018			2017		2018			2017
	(in thousands)
Condensed Consolidated Statements of Operations data:
Revenues	$	71,658		$	59,490	$	204,689		$	167,913
Cost of revenues ⁽¹⁾	16,511			12,728		48,660			37,175
Gross profit	55,147			46,762		156,029			130,738
Operating expenses:
Research and development ⁽¹⁾	12,501			10,892		38,182			31,240
Sales and marketing ⁽¹⁾	15,489			15,475		50,698			46,872
General and administrative ⁽¹⁾	9,040			9,546		29,731			25,112
Total operating expenses	37,030			35,913		118,611			103,224
Income from operations	18,117			10,849		37,418			27,514
Other income, net	1,116			671		3,245			1,484
Income before income taxes	19,233			11,520		40,663			28,998
(Benefit from) provision for income taxes	(4,236		)	3,068		(2,241		)	(8,586