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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, 2016

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)

1600 Bridge Parkway, Redwood City, California 94065
(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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files).    Yes  x    No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
x
 
Accelerated filer
o
 
Non-accelerated filer
o
 
Smaller reporting company
o
 
 
 
 
 
 
(Do not check if a smaller reporting company)
 
 
 

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 31, 2016 was 35,692,293.

Table of Contents

Qualys, Inc.
TABLE OF CONTENTS
 
 
Page
PART I – FINANCIAL INFORMATION
Item 1.
 
 
 
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
PART II – OTHER INFORMATION
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 



2
Table of Contents

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,
2016
 
December 31, 2015
 
 
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
98,299

 
$
91,698

Short-term investments
111,678

 
87,268

Accounts receivable, net of allowance of $744 and $769 as of September 30, 2016 and December 31, 2015, respectively
41,910

 
42,325

Prepaid expenses and other current assets
9,072

 
7,945

Total current assets
260,959

 
229,236

Long-term investments
64,930

 
43,277

Property and equipment, net
40,670

 
31,329

Deferred tax assets, net
15,141

 
16,079

Intangible assets, net
1,080

 
1,360

Goodwill
317

 
317

Other noncurrent assets
1,939

 
1,916

Total assets
$
385,036

 
$
323,514

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
1,491

 
$
2,368

Accrued liabilities
16,324

 
11,786

Deferred revenues, current
109,026

 
98,025

Total current liabilities
126,841

 
112,179

Deferred revenues, noncurrent
14,416

 
14,564

Other noncurrent liabilities
2,386

 
1,205

Total liabilities
143,643

 
127,948

Commitments and contingencies (Note 5)


 


Stockholders’ equity:
 
 
 
Preferred stock, $0.001 par value; 20,000,000 shares authorized, no shares issued and outstanding at September 30, 2016 and December 31, 2015
—

 
—

Common stock, $0.001 par value; 1,000,000,000 shares authorized; 35,680,925 and 34,414,631 shares issued and outstanding at September 30, 2016 and December 31, 2015, respectively
36

 
34

Additional paid-in capital
255,509

 
223,228

Accumulated other comprehensive income (loss)
16

 
(211
)
Accumulated deficit
(14,168
)
 
(27,485
)
Total stockholders’ equity
241,393

 
195,566

Total liabilities and stockholders’ equity
$
385,036

 
$
323,514


See accompanying Notes to Condensed Consolidated Financial Statements


3
Table of Contents

Qualys, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share data)

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
Revenues
$
50,987

 
$
42,469

 
$
145,701

 
$
119,839

Cost of revenues
11,288

 
8,762

 
30,796

 
24,883

Gross profit
39,699

 
33,707

 
114,905

 
94,956

Operating expenses:
 
 
 
 
 
 
 
Research and development
9,405

 
7,564

 
26,382

 
21,919

Sales and marketing
14,240

 
12,282

 
42,624

 
36,501

General and administrative
8,067

 
6,983

 
24,603

 
19,426

Total operating expenses
31,712

 
26,829

 
93,609

 
77,846

Income from operations
7,987

 
6,878

 
21,296

 
17,110

Other income (expense), net:
 
 
 
 
 
 
 
Interest expense
(9
)
 
—

 
(23
)
 
(4
)
Interest income
363

 
153

 
903

 
386

Other expense, net
(124
)
 
(307
)
 
(442
)
 
(485
)
Total other income (expense), net
230

 
(154
)
 
438

 
(103
)
Income before income taxes
8,217

 
6,724

 
21,734

 
17,007

Provision for income taxes
3,221

 
2,601

 
8,417

 
6,566

Net income
$
4,996

 
$
4,123

 
$
13,317

 
$
10,441

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.14

 
$
0.12

 
$
0.38

 
$
0.31

Diluted
$
0.13

 
$
0.11

 
$
0.35

 
$
0.27

Weighted average shares used in computing net income per share:
 
 
 
 
 
 
 
Basic
35,477

 
34,119

 
35,074

 
33,967

Diluted
38,712

 
37,938

 
38,205

 
38,202


See accompanying Notes to Condensed Consolidated Financial Statements


4
Table of Contents

Qualys, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
(in thousands)

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
Net income
$
4,996

 
$
4,123

 
$
13,317

 
$
10,441

Available-for-sale investments:
 
 
 
 
 
 
 
Change in net unrealized gain (loss) on investments, net of tax
(58
)
 
15

 
140

 
25

Less: reclassification adjustment for net realized gain (loss) included in net income
(38
)
 
(5
)
 
87

 
2

Net change, net of tax
(96
)
 
10

 
227

 
27

Other comprehensive income (loss), net
(96
)
 
10

 
227

 
27

Comprehensive income
$
4,900

 
$
4,133

 
$
13,544

 
$
10,468


See accompanying Notes to Condensed Consolidated Financial Statements



5
Table of Contents

Qualys, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)

 
Nine Months Ended
 
September 30,
 
2016
 
2015
Cash flows from operating activities:
 
 
 
Net income
$
13,317

 
$
10,441

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization expense
12,364

 
10,424

Bad debt expense
152

 
629

Loss on disposal of property and equipment
39

 
9

Stock-based compensation
15,122

 
12,678

Amortization of premiums and accretion of discounts on investments
617

 
429

Excess tax benefits from stock-based compensation
(4,832
)
 
(315
)
Deferred income taxes
931

 
5,105

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
263

 
(5,512
)
Prepaid expenses and other assets
(1,196
)
 
(2,143
)
Accounts payable
(877
)
 
(3,606
)
Accrued liabilities
6,763

 
2,735

Deferred revenues
10,853

 
10,612

Other noncurrent liabilities
1,188

 
182

Net cash provided by operating activities
54,704

 
41,668

Cash flows from investing activities:
 
 
 
Purchases of investments
(180,161
)
 
(88,694
)
Sales and maturities of investments
133,708

 
73,340

Purchases of property and equipment
(18,809
)
 
(14,865
)
Capitalized software development costs
—

 
(99
)
Net cash used in investing activities
(65,262
)
 
(30,318
)
Cash flows from financing activities:
 
 
 
Proceeds from exercise of stock options
12,529

 
6,594

Excess tax benefits from stock-based compensation
4,832

 
315

Payments for taxes related to net share settlement of equity awards
(202
)
 
—

Net cash provided by financing activities
17,159

 
6,909

Net increase in cash and cash equivalents
6,601

 
18,259

Cash and cash equivalents at beginning of period
91,698

 
76,504

Cash and cash equivalents at end of period
$
98,299

 
$
94,763

 
 
 
 
Non-cash investing and financing activities:
 
 
 
Purchases of property and equipment recorded in accrued liabilities
$
2,606

 
$
—

Vesting of early exercised common stock options
$
—

 
$
16


See accompanying Notes to Condensed Consolidated Financial Statements



6
Table of Contents
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”) was incorporated in the state of Delaware on December 30, 1999. The Company is headquartered in Redwood City, California and has majority-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, 2015, 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, 2016 are not necessarily indicative of the results of operations expected for the entire year ending December 31, 2016 or for any other future annual or interim period. 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, 2015 filed with the SEC on February 26, 2016.

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant intercompany transactions and balances have been eliminated upon consolidation.

Use of Estimates

The preparation of the 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 contingent 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, 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 condensed consolidated financial statements.



7
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Concentration of Credit Risk

The Company invests its cash and cash equivalents with major financial institutions. Cash balances with any one institution at times may be in excess of federally insured limits. Cash equivalents are invested in high-quality investment grade financial instruments and are diversified. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk.

Credit risk with respect to accounts receivable is dispersed due to the large number of customers. Collateral is not required for accounts receivable. The Company maintains an allowance for potential credit losses based upon the expected collectability of accounts receivable. The Company writes off its receivables once collection efforts are unsuccessful. As of September 30, 2016, there is one customer with a multi-year contract that accounted for approximately 10% of the Company's accounts receivable balance. As of December 31, 2015, no customer or channel partner accounted for more than 10% of the Company's accounts receivable balance.

Cash, Cash Equivalents, Short-Term and Long-Term Investments

Cash and cash equivalents include cash held in banks, highly liquid money market funds, commercial paper and fixed-income U.S. government agency securities, all with original maturities of three months or less when acquired. The Company’s investments consist of fixed-income U.S. government agency securities, corporate bonds, asset-backed securities, and commercial paper. Management determines the appropriate classification of the Company's investments at the time of purchase and reevaluates such designation at each balance sheet date. The Company classifies its investments as either short-term or long-term based on each instrument's underlying contractual maturity date.

Cash equivalents are stated at cost, which approximates fair market value. Short-term and long-term investments are classified as available-for-sale and are carried at fair value. Unrealized gains and losses in fair value are reported in other comprehensive income (loss). When the available-for-sale securities are sold, cost is based on the specific identification method, and the realized gains and losses are included in other income (expense) in the condensed consolidated statements of operations. Short-term and long-term investments are reviewed quarterly for impairment that is deemed to be other-than-temporary. An investment is considered other-than-temporarily impaired when its fair value is below its amortized cost and (1) there is an intent to sell the security, (2) it is “more likely than not” that the security will be sold before recovery of its amortized cost basis or (3) the present value of expected cash flows from the investment is not expected to recover the entire amortized cost basis. Declines in value that are considered to be other-than-temporary and adjustments to amortized cost for the amortization of premiums and the accretion of discounts are recorded in other income (expense). Interest and dividends are recorded in interest income as earned.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued an Accounting Standard Update (“ASU”) amending revenue recognition guidance and requiring more detailed disclosures to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The ASU will be effective for fiscal years, and interim periods within those years, beginning after December 15, 2017, but entities will be permitted to early adopt the standard only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The new revenue standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized on date of adoption. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements.

In January 2016, the FASB issued an ASU that will impact certain aspects of recognition, measurement, presentation and disclosure of financial instruments. This guidance is effective for public business entities in fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements.



8
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


In February 2016, the FASB issued an ASU which requires, among other things, lease assets and lease liabilities arising from leases, including operating leases, to be recognized on the balance sheet. In addition, the ASU requires disclosing key information about leasing arrangements. This guidance supersedes existing lease guidance and is effective for public business entities in fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements.

In March 2016, the FASB issued an ASU intended to simplify and improve various aspects related to how employee-share based payment transactions are accounted for and presented in the financial statements. The ASU addresses income tax consequences, classification of awards as either equity or liabilities, classification on the statement of cash flows and forfeiture rate calculations. This guidance is effective for public business entities in fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements.

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, investments 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.



9
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


The Company's cash and cash equivalents, short-term investments, and long-term investments consist of the following:

 
September 30, 2016
  
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
 
(in thousands)
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash
$
58,277

 
$
—

 
$
—

 
$
58,277

Money market funds
19,713

 
—

 
—

 
19,713

Commercial paper
20,308

 
1

 
—

 
20,309

Total
98,298

 
1

 
—

 
98,299

Short-term investments:
 
 
 
 
 
 
 
Commercial paper
6,863

 
1

 
—

 
6,864

Corporate bonds
11,173

 
6

 
(9
)
 
11,170

Asset-backed securities
256

 
—

 
—

 
256

U.S. government agencies
93,372

 
26

 
(10
)
 
93,388

Total
111,664

 
33

 
(19
)
 
111,678

Long-term investments:
 
 
 
 
 
 
 
Asset-backed securities
5,696

 
9

 
—

 
5,705

U.S. government agencies
43,776

 
25

 
(26
)
 
43,775

Corporate bonds
15,457

 
6

 
(13
)
 
15,450

Total
64,929

 
40

 
(39
)
 
64,930

Total
$
274,891

 
$
74

 
$
(58
)
 
$
274,907


 
December 31, 2015
  
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
 
(in thousands)
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash
$
61,372

 
$
—

 
$
—

 
$
61,372

Money market funds
3,980

 
—

 
—

 
3,980

U.S. government agencies
8,999

 
1

 
—

 
9,000

Commercial paper
17,345

 
1

 
—

 
17,346

Total
91,696

 
2

 
—

 
91,698

Short-term investments:
 
 
 
 
 
 
 
Commercial paper
10,447

 
1

 
—

 
10,448

Corporate bonds
12,448

 
—

 
(13
)
 
12,435

U.S. government agencies
64,422

 
3

 
(40
)
 
64,385

Total
87,317

 
4

 
(53
)
 
87,268

Long-term investments:
 
 
 
 
 
 
 
Asset-backed securities
7,007

 
—

 
(18
)
 
6,989

U.S. government agencies
32,683

 
—

 
(142
)
 
32,541

Corporate bonds
3,751

 
—

 
(4
)
 
3,747

Total
43,441

 
—

 
(164
)
 
43,277

Total
$
222,454

 
$
6

 
$
(217
)
 
$
222,243




10
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)



The following table shows the changes to accumulated other comprehensive income for the nine months ended September 30, 2016:

 
Unrealized Gain (Loss) on Investments
Balance at December 31, 2015
$
(211
)
Change in net realized gain (loss) on investments
140

Amounts reclassified for net realized gain (loss) included in net income
87

Other comprehensive income
227

Balance at September 30, 2016
$
16


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

 
September 30, 2016
 
Level 1
 
Level 2
 
Level 3
 
Fair Value
 
(in thousands)
Commercial paper
$
—

 
$
27,173

 
$
—

 
$
27,173

U.S. government agencies
—

 
137,163

 
—

 
137,163

Corporate bonds
—

 
26,620

 
—

 
26,620

Asset-backed securities
—

 
5,961

 
—

 
5,961

Total
$
—

 
$
196,917

 
$
—

 
$
196,917


 
December 31, 2015
 
Level 1
 
Level 2
 
Level 3
 
Fair Value
 
(in thousands)
Commercial paper
$
—

 
$
27,794

 
$
—

 
$
27,794

U.S. government agencies
—

 
105,926

 
—

 
105,926

Corporate bonds
—

 
16,182

 
—

 
16,182

Asset-backed securities
—

 
6,989

 
—

 
6,989

Total
$
—

 
$
156,891

 
$
—

 
$
156,891


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.



11
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


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

 
September 30, 2016
 
Mature within One Year
 
After One Year through Two Years
 
Over Two Years
 
Fair Value
 
(in thousands)
Commercial paper
$
27,173

 
$
—

 
$
—

 
$
27,173

U.S. government agencies
97,192

 
39,971

 
—

 
137,163

Corporate bonds
12,833

 
13,787

 
—

 
26,620

Asset-backed securities
5,961

 
—

 
—

 
5,961

Total
$
143,159

 
$
53,758

 
$
—

 
$
196,917

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 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, 2016, the Company had two outstanding forward contracts with notional amounts of 7.5 million Euros and 4.5 million British Pounds, which expired on October 31, 2016. At December 31, 2015, the Company had two outstanding forward contracts with notional amounts of 6.1 million Euros and 2.6 million British Pounds, which expired on January 31, 2016. 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, 2016 and December 31, 2015. 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 from forward contracts and other foreign currency transactions:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Net gain (loss) from forward contracts
$
(82
)
 
$
109

 
$
(9
)
 
$
498

Other foreign currency transactions losses
(2
)
 
(377
)
 
(276
)
 
(890
)
Total foreign exchange loss, net
$
(84
)
 
$
(268
)
 
$
(285
)
 
$
(392
)



12
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


NOTE 3.
Property and Equipment, Net

Property and equipment consists of the following:
                                                                                              
 
September 30,
 
December 31,
 
2016
 
2015
 
(in thousands)
Computer equipment
$
59,142

 
$
48,192

Computer software
19,621

 
12,484

Furniture, fixtures and equipment
3,200

 
2,804

Scanner appliances
24,491

 
22,627

Leasehold improvements
3,521

 
3,367

Total property and equipment
109,975

 
89,474

Less: accumulated depreciation and amortization
(69,305
)
 
(58,145
)
Property and equipment, net
$
40,670

 
$
31,329


Physical scanner appliances and other computer equipment that are or will be subject to subscriptions by customers have a net carrying value of $8.8 million and $8.4 million at September 30, 2016 and December 31, 2015, respectively, including assets that have not been placed in service of $1.6 million and $1.4 million, respectively. Other fixed assets not placed in service at September 30, 2016 and December 31, 2015, included in computer equipment and leasehold improvements, are approximately $2.8 million and $4.3 million, respectively. Depreciation and amortization expense relating to property and equipment was $4.4 million and $3.7 million for the three months ended September 30, 2016 and 2015, respectively, and $12.0 million and $10.1 million for the nine months ended September 30, 2016 and 2015, respectively.

NOTE 4.
Goodwill and Intangible Assets, Net

Intangible assets consist primarily of existing technology and a patent license 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):

 
 
 
 
 
September 30, 2016
 
December 31, 2015
 
Estimated Lives
 
Cost
 
Accumulated Amortization
 
Net Book Value
 
Accumulated Amortization
 
Net Book Value
Existing technology
7 years
 
$
1,910

 
$
(1,660
)
 
$
250

 
$
(1,456
)
 
$
454

Patent license
14 years
 
1,388

 
(598
)
 
790

 
(522
)
 
866

     Total intangibles subject to amortization
 
 
$
3,298

 
$
(2,258
)
 
1,040

 
$
(1,978
)
 
1,320

Intangible assets not subject to amortization
 
 
 
 
 
 
40

 
 
 
40

     Total intangible assets, net
 
 
 
 
 
 
$
1,080

 
 
 
$
1,360


Intangibles amortization expense was $0.1 million for the three months ended September 30, 2016 and 2015 and $0.3 million for the nine months ended September 30, 2016 and 2015.



13
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


As of September 30, 2016, the Company expects amortization expense in future periods to be as follows (in thousands):

Remainder of 2016
$
93

2017
282

2018
100

2019
100

2020
100

2021 and thereafter
365

Total expected future amortization expense
$
1,040


Goodwill, which is not subject to amortization, totaled $0.3 million as of September 30, 2016 and December 31, 2015.
 
NOTE 5.
Commitments and Contingencies
Leases
The Company leases certain computer equipment and its corporate office and data center facilities under noncancelable operating leases for varying periods through 2022.

The following are the minimum annual lease payments due under operating leases at September 30, 2016 (in thousands):
Remainder of 2016
$
1,211

2017
3,474

2018
1,495

2019
1,175

2020
961

2021 and thereafter
712

Total minimum lease payments
$
9,028


Rent expense was $1.8 million and $1.6 million for the three months ended September 30, 2016 and 2015, respectively, and $5.3 million and $4.8 million for the nine months ended September 30, 2016 and 2015, respectively. Although certain of the operating lease agreements provide for escalating rent payments over the terms of the leases, rent expense under these agreements is recognized on a straight-line basis. As of September 30, 2016 and December 31, 2015, the Company has accrued $0.4 million and $0.5 million, respectively, of deferred rent related to these agreements, which is reflected in accrued liabilities and other noncurrent liabilities 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.

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


14
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)



Contingencies
From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of its business activities. The Company accrues a liability for such matters when it is probable a loss has been incurred and such loss can be reasonably estimated. At September 30, 2016, the Company has not recorded any material liabilities in accordance with accounting for contingencies.

NOTE 6.
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 8,069,184 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, 2016, 1,478,776 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 initial public offering ("IPO"), 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 operation for the three and nine months ended September 30, 2016 and 2015.

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Cost of revenues
$
516

 
$
333

 
$
1,318

 
$
1,005

Research and development
1,585

 
1,294

 
4,373

 
3,584

Sales and marketing
821

 
1,015

 
3,459

 
2,806

General and administrative
2,181

 
1,779

 
5,972

 
5,283

Total stock-based compensation
$
5,103

 
$
4,421

 
$
15,122

 
$
12,678


As of September 30, 2016, the Company had $25.1 million of total unrecognized employee compensation cost related to unvested option awards that it expects to recognize over a weighted-average period of 2.9 years, and $9.2 million of unrecognized compensation cost related to unvested RSUs that it expects to recognize over a weighted-average period of 3.4 years. Compensation cost is recognized on a straight-line basis over the service period. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.



15
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Stock Options

Employee Stock-based Compensation

The fair value of each option granted to employees is estimated on the date of grant using the Black-Scholes option-pricing model based on the following assumptions:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
Expected term (in years)
5.0 to 5.9
 
4.9 to 5.9
 
5.0 to 5.9
 
4.9 to 5.9
Volatility
49%
 
46%
 
45% to 49%
 
45% to 48%
Risk-free interest rate
1.1%
 
1.6%
 
1.1% to 1.3%
 
1.3% to 1.65%
Dividend yield
—%
 
—%
 
—%
 
—%

The expected term of the options is based on evaluations of historical and expected future employee exercise behavior. The risk-free interest rate is based on the U.S. Treasury rates at the date of grant with maturity dates approximately equal to the expected term at the grant date. Volatility is based on a combination of the historical volatility of the Company and of several public entities that are similar to the Company. The Company bases volatility on this combination because it does not have sufficient historical transactions in its own shares on which to solely base expected volatility. The Company has not historically declared any dividends and does not expect to in the future.

Non-Employee Stock-based Compensation

The Company records compensation representing the fair value of stock options granted to non-employees. Non-employee stock-based compensation is recognized over the vesting periods of the options. The value of options granted to non-employees is remeasured as they vest over their respective performance period.

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)
December 31, 2015
7,579,058

 
$
16.88

 
5.9
 
$
131,345

Granted
2,007,683

 
$
26.06

 
 
 
 
Exercised
(1,250,532
)
 
$
10.02

 
 
 
 
Canceled
(651,821
)
 
$
31.63

 
 
 
 
September 30, 2016
7,684,388

 
$
19.15

 
6.3
 
$
149,030

Vested and expected to vest - September 30, 2016
7,085,321

 
$
18.25

 
6.0
 
$
143,568

Exercisable - September 30, 2016
4,955,900

 
$
13.69

 
4.7
 
$
122,586




16
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Restricted Stock

The terms and conditions of RSUs and RSAs, including vesting criteria and timing are set by the board of directors. The cost of RSUs and RSAs is determined using the fair value of the Company’s common stock on the date of grant. Compensation cost is recognized on a straight-line basis over the requisite service period of each grant, adjusted for estimated forfeitures.

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

 
Outstanding RSUs and RSAs
 
Weighted Average Fair Value Per Share
 
 
 
 
December 31, 2015
47,500

 
$
37.28

Granted
588,527

 
$
27.19

Released
(22,162
)
 
$
28.23

Canceled
(78,710
)
 
$
31.89

September 30, 2016
535,155

 
$
27.35

Outstanding and expected to vest - September 30, 2016
363,539

 
$
27.41


NOTE 7.
Other Income (Expense), Net

Other income (expense), net consists of the following:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Foreign exchange gain (loss)
$
(84
)
 
$
(268
)
 
$
(285
)
 
$
(392
)
Other income (expense)
(40
)
 
(39
)
 
(157
)
 
(93
)
Other expense, net
$
(124
)
 
$
(307
)
 
$
(442
)
 
$
(485
)

NOTE 8.
Income Taxes

The Company recorded an income tax provision of $3.2 million and $2.6 million for the three months ended September 30, 2016 and 2015, respectively. The effective income tax rate was approximately 39.2% and 38.7% for the three months ended September 30, 2016 and 2015, respectively.

The Company recorded an income tax provision of $8.4 million and $6.6 million for the nine months ended September 30, 2016 and 2015, respectively. The effective income tax rate for the nine months ended September 30, 2016 and 2015 was approximately 38.7% and 38.6%, respectively.

As of September 30, 2016, the Company had unrecognized tax benefits of $4.2 million, of which $2.5 million, if recognized, would favorably impact the Company's effective tax rate. As of December 31, 2015, the Company had unrecognized tax benefits of $3.5 million, of which $2.1 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.



17
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


NOTE 9.
Segment Information and Information about Geographic Area

The Company operates in one segment. 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:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
United States
$
35,965

 
$
29,993

 
$
102,850

 
$
84,463

Foreign
15,022

 
12,476

 
42,851

 
35,376

Total revenues
$
50,987

 
$
42,469

 
$
145,701

 
$
119,839


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

 
September 30,
 
December 31,
 
2016
 
2015
 
(in thousands)
United States
$
32,429

 
$
25,623

Foreign
8,241

 
5,706

Total property and equipment, net
$
40,670

 
$
31,329


NOTE 10.
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,
 
2016
 
2015
 
2016
 
2015
 
(in thousands, except per share data)
Numerator:
 
 
 
 
 
 
 
Net income
$
4,996

 
$
4,123

 
$
13,317

 
$
10,441

Denominator:
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share:
 
 
 
 
 
 
 
Basic
35,477

 
34,119

 
35,074

 
33,967

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Common stock options
3,103

 
3,819

 
3,089

 
4,235

   Restricted stock units
132

 
—

 
42

 
—

Diluted
38,712

 
37,938

 
38,205

 
38,202

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.14

 
$
0.12

 
$
0.38

 
$
0.31

Diluted
$
0.13

 
$
0.11

 
$
0.35

 
$
0.27




18
Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


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,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Common stock options
2,881

 
1,889

 
3,594

 
1,409

Restricted stock units
—

 
—

 
38

 
—

 
2,881

 
1,889

 
3,632

 
1,409



NOTE 11.
Subsequent Event

On October 14, 2016, the Company entered into a lease agreement for its new headquarter office facility. The lease commences May 1, 2018 and has a ten-year term through April 2028. The total commitment of $37.8 million is payable monthly with escalating rental payments throughout the lease term. The Company will be provided access to the facility on or around February 1, 2017 to begin construction of certain leasehold improvements.

In connection with this lease, the Company has 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.



19
Table of Contents


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, 2015, filed with the Securities and Exchange Commission, or SEC, on February 26, 2016.

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.




20
Table of Contents

Overview

We are 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. 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.

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, Qualys Vulnerability Management (VM), in 2000. As this solution gained acceptance, we introduced new solutions to help customers manage increasing IT security and compliance requirements, including PCI Compliance, Policy Compliance, Web Application Scanning, Malware Detection Service and Qualys SECURE Seal. In 2012, we introduced our virtualized private cloud platform as an additional deployment option of our solutions for customers and partners. In 2014, we released Continuous Monitoring (CM) for internet-facing systems, which allows customers to continuously monitor their mission-critical assets and to be alerted to security vulnerabilities or misconfigurations that may make them more susceptible to a cyber-attack and in 2015, we introduced our Cloud Agent Platform (CAP), which provides customers with the ability to secure IT assets on a continuous basis regardless of where they reside, inside the enterprise, in the cloud or mobile endpoints. We continue to add new offerings, such as ThreatPROTECT, which adds functionality to our core VM and POL services and expand the scope of our capabilities. We expect the sales of multiple, fully-integrated cloud based security offerings on our platform will contribute to the continuing trend of revenue growth.

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 typically 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 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.

We market and sell our solutions to enterprises, government entities and to small and medium-sized businesses across a broad range of industries, including education, financial services, government, healthcare, insurance, manufacturing, media, retail, technology and utilities. In the nine months ended September 30, 2016, approximately 71% of our revenues were derived from customers in the United States. We sell our solutions to enterprises and government entities primarily through our field sales force and to small and medium-sized businesses through our inside sales force. We generate a significant portion of sales through our channel partners, including managed service providers, value-added resellers and consulting firms in the United States and internationally.

Our revenues increased to $145.7 million in the nine months ended September 30, 2016 from $119.8 million for the comparable period in 2015, representing an increase of $25.9 million or 22%.



21
Table of Contents

Key Metrics

In addition to measures of financial performance presented in our condensed consolidated financial statements, we monitor the key 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.

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
 
 (in thousands, except percentages)
Adjusted EBITDA
$
17,626

 
$
15,137

 
$
49,498

 
$
40,212

Percentage of revenues
35
%
 
36
%
 
34
%
 
34
%

 
Nine Months Ended
 
September 30,
 
2016
 
2015
 
 (in thousands)
Free cash flow
$
35,895

 
$
26,704


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 income taxes, (3) depreciation and amortization of property and equipment, (4) amortization of intangible assets,(5) stock-based compensation and (6) other non-recurring adjustments.



22
Table of Contents

The following unaudited table presents the reconciliation of net income to Adjusted EBITDA for the three and nine months ended September 30, 2016 and 2015:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
 
 (in thousands)
Net income
$
4,996

 
$
4,123

 
$
13,317

 
$
10,441

Other (income) expense, net 
(230
)
 
154

 
(438
)
 
103

Provision for income taxes
3,221

 
2,601

 
8,417

 
6,566

Depreciation and amortization of property and equipment
4,426

 
3,741

 
12,035

 
10,131

Amortization of intangible assets
110

 
97

 
329

 
293

Stock-based compensation
5,103

 
4,421

 
15,122

 
12,678

One-time tax related expense
—

 
—

 
716

 
—

Adjusted EBITDA (1)
$
17,626

 
$
15,137

 
$
49,498

 
$
40,212


(1) Adjusted EBITDA for the nine months ended September 30, 2016 excludes approximately $0.7 million of a non-recurring expense related to the remittance of payroll taxes from fiscal year 2013 through May 2016. During this same period, we have not excluded any amounts related to other non-recurring items from Adjusted EBITDA because we have considered such amounts to be immaterial in any given quarter during such period.

Free Cash Flow

We define free cash flow, a non-GAAP measure, as net cash provided by operating activities less purchases of property and equipment and capitalization of software development costs. We monitor free cash flow as a liquidity measure because we believe it provides useful information to management and investors about the amount of cash we generated, that, after the acquisition of property and equipment and capitalized software development costs, can be used for strategic opportunities, including investing in our business, making strategic acquisitions and strengthening the balance sheet. We also believe free cash flow provides an additional tool for investors to use in comparing our recurring core business operating results over multiple periods.

A limitation of using free cash flow as a means for evaluating liquidity is that free cash flow does not represent the total increase or decrease in cash and cash equivalents for the period because it excludes cash provided by or used in other investing and financing activities. In addition, it is important to note that other companies, including companies in our industry, may not use free cash flow, may calculate free cash flow in a different manner than we do, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a comparative measure. 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:

 
Nine Months Ended
 
September 30,
 
2016
 
2015
 
 (in thousands)
Net cash provided by operating activities
$
54,704

 
$
41,668

Less:
 
 
 
Purchases of property and equipment
(18,809
)
 
(14,865
)
Capitalized software development costs
—

 
(99
)
Free cash flow
$
35,895

 
$
26,704




23
Table of Contents

Limitations of Adjusted EBITDA and Free Cash Flow

Adjusted EBITDA and free cash flow, non-GAAP financial measures, have limitations as analytical tools, 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;
•
Free cash flow does not represent the total increase or decrease in the cash and cash equivalents for the period; and
•
Other companies, including companies in our industry, may calculate Adjusted EBITDA and free cash flow differently or not at all, which reduces their usefulness as a comparative measure.

Because of these limitations, Adjusted EBITDA and free cash flow 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.

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, 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 and related maintenance support, fees paid to contractors who supplement or support our operations center personnel and allocation of overhead costs. 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.



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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 prior acquisitions and allocation of overhead costs. All research and development costs are expensed as incurred. 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, which will increase research and development expenses 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 license and maintenance costs for sales-related software, and allocation of overhead costs. All costs are expensed as incurred, including sales commissions. Sales commissions are expensed in the quarter in which the related order is received and are paid in the month subsequent to the end of that quarter, which results in increased expenses prior to the recognition of related revenues. 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, human resources and internal information technology support teams, as well as professional services, insurance, fees, and allocation of overhead costs. 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 investments; 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; and losses on disposal of property and equipment.

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 lower than U.S. tax rates, and may be subject to U.S. income taxes. Our effective rates differ from the U.S. statutory rate primarily due to foreign income subject to different tax rates than the U.S., research and development tax credits, non-deductible stock-based compensation expense and other adjustments.

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


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Table of Contents

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.

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,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Condensed Consolidated Statements of Operations data:
 
 
 
 
 
 
 
Revenues
$
50,987

 
$
42,469

 
$
145,701

 
$
119,839

Cost of revenues (1)
11,288

 
8,762

 
30,796

 
24,883

Gross profit
39,699

 
33,707

 
114,905

 
94,956

Operating expenses:
 
 
 
 
 
 
 
Research and development (1)
9,405

 
7,564

 
26,382

 
21,919

Sales and marketing (1)
14,240

 
12,282

 
42,624

 
36,501

General and administrative (1)
8,067

 
6,983

 
24,603

 
19,426

Total operating expenses
31,712

 
26,829

 
93,609

 
77,846

Income from operations
7,987

 
6,878

 
21,296


17,110

Other income (expense), net
230

 
(154
)
 
438

 
(103
)
Income before income taxes
8,217

 
6,724

 
21,734

 
17,007

Provision for income taxes
3,221

 
2,601

 
8,417

 
6,566

Net income
$
4,996

 
$
4,123

 
$
13,317

 
$
10,441



____________________
(1) Includes stock-based compensation as follows:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Cost of revenues
$
516

 
$
333

 
$
1,318

 
$
1,005

Research and development
1,585

 
1,294

 
4,373

 
3,584

Sales and marketing
821

 
1,015

 
3,459

 
2,806

General and administrative
2,181

 
1,779

 
5,972

 
5,283

Total stock-based compensation
$
5,103

 
$
4,421

 
$
15,122

 
$
12,678



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The following table sets forth selected condensed consolidated statements of operations data for each of the periods presented as a percentage of revenues.

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
Revenues
100
%
 
100
%
 
100
%
 
100
%
Cost of revenues
22

 
21

 
21

 
21

Gross profit
78

 
79


79


79

Operating expenses:
 
 
 
 
 
 
 
Research and development
18

 
18

 
18

 
18

Sales and marketing
28

 
29

 
29

 
30

General and administrative
16

 
16

 
17

 
16

Total operating expenses
62

 
63


64


65

Income from operations
16

 
16


15


14

Other income (expense), net
0

 
0

 
0

 
0

Income before income taxes
16

 
16


15


14

Provision for income taxes
6

 
6

 
6

 
5

Net income
10
%
 
10
%

9
%

9
%

Comparison of Three Months Ended September 30, 2016 and 2015

Revenues

 
Three Months Ended
 
 
 
 
 
September 30,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Revenues
$
50,987

 
$
42,469

 
$
8,518

 
20
%

Revenues increased $8.5 million for the three months ended September 30, 2016 compared to the three months ended September 30, 2015, due to new customer subscriptions entered into after September 30, 2015 and from an increase in the purchase of subscriptions from existing customers. Of the total increase of $8.5 million, $6.0 million was from customers in the United States and the remaining $2.5 million was from customers in foreign countries. The growth in revenues reflects the continued demand for solutions.


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Table of Contents

Cost of Revenues

 
Three Months Ended
 
 
 
 
 
September 30,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Cost of revenues
$
11,288

 
$
8,762

 
$
2,526

 
29
%
Percentage of revenues
22
%
 
21
%
 
 
 
 
Gross profit percentage
78
%
 
79
%
 
 
 
 
    
Cost of revenues increased $2.5 million for the three months ended September 30, 2016 compared to the three months ended September 30, 2015, primarily due to increased personnel expenses of $0.8 million to support continued growth of our business; increased third-party software license and maintenance expense of $0.7 million; a $0.6 million increase in depreciation expense related to additional computer hardware and software; and increased overhead costs of $0.2 million as we continue to grow.

Research and Development Expenses

 
Three Months Ended
 
 
 
 
 
September 30,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Research and development
$
9,405

 
$
7,564

 
$
1,841

 
24
%
Percentage of revenues
18
%
 
18
%
 
 
 
 

Research and development expenses increased $1.8 million for the three months ended September 30, 2016 compared to the three months ended September 30, 2015, primarily due to an increase in personnel expenses of $1.4 million, driven by the increase in the number of employees, and increased overhead costs of $0.2 million as we continue to grow. We continue to significantly invest in and expand our research and development teams to continuously improve our platform and existing solutions, as well as develop new solutions and capabilities.

Sales and Marketing Expenses

 
Three Months Ended
 
 
 
 
 
September 30,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Sales and marketing
$
14,240

 
$
12,282

 
$
1,958

 
16
%
Percentage of revenues
28
%
 
29
%
 
 
 
 

Sales and marketing expenses increased $2.0 million for the three months ended September 30, 2016 compared to the three months ended September 30, 2015, primarily due to increased personnel expenses of $1.0 million, principally due to an increase in the number of employees; increased marketing expenses of $0.4 million, primarily trade show, lead generation and branding expenses; increased software license and maintenance fees of $0.2 million; and increased consulting services of $0.1 million.



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Table of Contents

General and Administrative Expenses
 
Three Months Ended
 
 
 
 
 
September 30,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
General and administrative
$
8,067

 
$
6,983

 
$
1,084

 
16
%
Percentage of revenues
16
%
 
16
%
 
 
 
 

General and administrative expenses increased $1.1 million for the three months ended September 30, 2016 compared to the three months ended September 30, 2015, primarily driven by increased personnel expenses of $0.9 million, principally due to additional employees, and increased legal, accounting and consulting services of $0.4 million, partially offset by lower bad debt expense and other fees of $0.4 million.
Total Other Income (Expense), Net
 
Three Months Ended
 
 
 
 
 
September 30,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Total other income (expense), net
$
230

 
$
(154
)
 
$
384

 
NM
Percentage of revenues
0
%
 
0
%
 
 
 
 

Total other income (expense), net decreased by $0.4 million for the three months ended September 30, 2016 compared to the three months ended September 30, 2015, primarily due to an increase in investment and interest income and lower foreign exchange losses.
Provision for Income Taxes
 
Three Months Ended
 
 
 
 
 
September 30,