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RIVERBED TECHNOLOGY, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this Form 10-Q. The information in this Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Such forward-looking statements include statements related to: our business and strategy, trends affecting our business and financial results, international expansion plans, growth of our revenue, costs and expenses (including sales and marketing expenses), our acquisitions. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical facts may be deemed to be forward-looking statements. For example, words such as "may," "will," "could," "should," "estimates," "predicts," "potential," "continue," "strategy," "believes," "anticipates," "plans," "expects," "intends" and similar expressions are intended to identify forward-looking statements. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those discussed elsewhere in this Form 10-Q in the section titled "Risk Factors" and the risks discussed in our other SEC filings. We disclaim any obligation to publicly release any revisions or updates to the forward-looking statements after the date of this Form 10-Q. Overview We were founded in May 2002 by experienced industry leaders with a vision to improve the performance of wide-area distributed computing. Having significant experience in caching technology, our executive management team understood that existing approaches failed to address adequately all of the root causes of this poor performance. We determined that these performance problems could be best solved by simultaneously addressing inefficiencies in software applications and wide-area networks (WANs) as well as insufficient or unavailable bandwidth. This innovative approach served as the foundation of the development of our 17-------------------------------------------------------------------------------- Table of Contents products. We began commercial shipments of our products in May 2004 and have since sold our products to over 14,000 customers worldwide. We offer several product lines including Steelhead appliances, Central Management Console, Interceptor, Steelhead Mobile, Whitewater and Cascade products. We are headquartered in San Francisco, California. Our personnel are located throughout the U.S. and in approximately thirty countries worldwide. We expect to continue to add personnel in the U.S. and internationally to provide additional geographic sales, research and development, general and administrative and technical support coverage. Company Strategy Our goal is to establish our solutions as the preeminent performance and efficiency standard for organizations relying on wide-area distributed computing. Key elements of our strategy include: Maintain and extend our technological advantages We believe that we offer the broadest ability to enable rapid, reliable access to applications and data for our customers. We intend to enhance our position as a leader and innovator in the WAN optimization market. We also intend to continue to sell new capabilities, such as our new cloud solutions, into our installed base. Continuing investments in research and development are critical to maintaining our technological advantage. Enhance and extend our product lines We plan to introduce enhancements to our product capabilities in order to address our customers' size and application requirements. We also plan to introduce new products to extend our market and utilize our technology platform to extend our capabilities. Riverbed is a leader in the WAN optimization market through our Steelhead product line. Our Steelhead appliances consist of our proprietary software that is delivered as appliances on a purpose-built hardware computing platform, and as software for end users for public and private cloud environments. We sell different Steelhead appliances to address the needs of customers ranging from small office deployments to large headquarters and data center locations. In addition to WAN optimization functionality, Steelhead appliances support the RSP, a virtualized environment within Steelhead appliances upon which third-party applications can be installed. In 2009, we added the Cascade product line through our acquisition of Mazu Networks. The Cascade product line helps organizations manage, secure and optimize the availability and performance of global applications. The acquisition allows us to meet enterprise and service provider customer demands by extending our suite of WAN optimization products to include global application performance, reporting and analytics. In 2010, we introduced our Whitewater product that is engineered for the public cloud. Our Whitewater product is a cloud storage accelerator, designed to accelerate, de-duplicate, and secure data that is to be stored in the public cloud. In July 2011, we announced the acquisitions of Zeus Technology, Ltd. (Zeus) and Aptimize Ltd. (Aptimize) which expanded our products and technology to compete in the virtual application delivery controller (ADC) market. Zeus pioneered the development of software-based highly scalable ADCs that deliver high-performance software-based load balancing and traffic management solutions for virtual and cloud environments. Aptimize is a market leader in web content optimization, an innovative new technology area that allows customers to deliver both internal web applications, like SharePoint, and external web applications, like e-commerce websites, much faster. Increase market awareness To generate increased demand for our products, we will continue promoting our brand and the effectiveness of our comprehensive WAN optimization solution. Scale our sales force and distribution channels Growth in revenue and increase in market share are key goals for us. We intend to expand our direct sales force and leverage our indirect channels to extend our geographic reach and market penetration. We sell our products directly through our sales force and indirectly through channel partners. We derived 95% of our revenue through indirect channels in the first six months of 2011. We expect revenue from channel partners to continue to constitute a substantial majority of our future revenue. Enhance and extend our support and services capabilities On an ongoing basis, we plan to enhance and extend our support and services capabilities to continue to support our growing global customer base. Our support organization goals include providing customers with the highest service levels in the industry for 18 -------------------------------------------------------------------------------- Table of Contents hardware replacement and software support. Our sales organization is focused on maintaining a high rate of service contract renewals on our existing customer base. Our professional services team is focused on developing and distributing training programs directed at our partners, and expanding our professional service offering. Major Trends Affecting Our Financial Results Company outlook We believe that our current value proposition, which enables customers to improve the performance of their applications and access to their data across WANs, while also offering the ability to simplify IT infrastructure and realize significant capital and operating cost savings, should allow us to continue to grow our business. Our product revenue growth rate will depend significantly on continued growth in the WAN optimization market, and our ability to continue to attract new customers in that market and generate additional sales from existing customers. Our growth in support and services revenue is dependent upon increasing the number of products under support contracts, which is dependent on both growing our installed base of customers and renewing existing support contracts. Our future profitability and rate of growth will be directly affected by the continued acceptance of our products in the marketplace, as well as the timing and size of orders, product mix, average selling prices and costs of our products and general economic conditions. Our ability to grow and maintain profitability in the future will also be affected by the extent to which we must incur additional expenses to expand our sales, support, marketing, development, and general and administrative capabilities to grow our business. The largest component of our expenses is personnel costs. Personnel costs consist of salaries, benefits and incentive compensation for our employees, including commissions for sales personnel and stock-based compensation. Revenue Our revenue has grown rapidly since we began shipping products in May 2004, increasing from $2.6 million in 2004 to $551.9 million in 2010. Revenue grew by 40% in the six months ended June 30, 2011 to $333.9 million from $238.7 million in the six months ended June 30, 2010. We believe that our revenue growth in 2009 and 2010, during periods in which the global macroeconomic environment negatively impacted many businesses, is a positive sign that our products have a significant value proposition to our customers and that the WAN optimization market is still expanding. Costs and Expenses Operating expenses consist of sales and marketing, research and development, general and administrative expenses, and acquisition-related costs. Personnel-related costs, including stock-based compensation, are the most significant component of each of these expense categories. As of June 30, 2011, we had 1,389 employees, an increase of 26% from 1,102 employees at June 30, 2010. The increase in employees is the most significant driver behind the increase in costs and operating expenses from the six months ended June 30, 2010 to the six months ended June 30, 2011. The increase in employees was required to support our increased revenue. The timing and number of additional hires has and could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue, in any particular period. Stock-based Compensation Expense Stock-based compensation expense and related payroll taxes were $25.1 million and $18.3 million in the three months ended June 30, 2011 and 2010, respectively, and $49.2 million and $34.2 million in the six months ended June 30, 2011 and 2010, respectively. We expect to continue to incur significant stock-based compensation expense and anticipate further growth in stock-based compensation expense as our employee base grows because we expect stock-based compensation to continue to play an important part in the overall compensation structure for our employees. Stock-based compensation expense and related payroll tax was as follows: Three months ended Six months ended June 30, June 30, (in thousands) 2011 2010 2011 2010 Cost of product $ 286 $ 141 $ 554 $ 266 Cost of support and services 1,892 1,398 3,604 2,682 Sales and marketing 10,135 7,575 19,695 14,321 Research and development 7,384 5,102 14,690 9,333 General and administrative 5,365 4,072 10,619 7,560 Total stock-based compensation expense and related payroll taxes $ 25,062 $ 18,288 $ 49,162 $ 34,162 19 -------------------------------------------------------------------------------- Table of Contents Acquisitions During fiscal 2010, we acquired two companies to expand our product offerings. These acquisitions were not significant, individually or in the aggregate. Combined, the total purchase price for these acquisitions was approximately $26.3 million, which was paid in cash. The purchase price allocation for these acquisitions included $13.8 million of goodwill, $13.5 million of identifiable intangible assets, $3.3 million of in-process research and development intangible assets, $2.2 million of acquired debt, paid down at the acquisition date, and $3.5 million of net tangible liabilities. The results of operations of these companies are included in our condensed consolidated results for the period subsequent to the acquisition date. In the six months ended June 30, 2011, we recognized $6.2 million in revenue, from the sale of these acquired companies' products and services and we recognized $5.1 million of operating expenses, which included $1.9 million of acquisition-related intangible amortization, and $0.5 million of stock-based compensation costs. During the first half of 2011, we recorded $1.4 million of acquisition-related costs, which included transaction and integration costs related to acquisitions completed during the third quarter of 2011. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP). These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our condensed consolidated financial statements could be adversely affected. The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following: revenue recognition, accounting for business combinations, stock-based compensation, accounting for income taxes, inventory valuation and allowances for doubtful accounts. Please refer to Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Annual Report on Form 10-K for our year ended December 31, 2010 for a more complete discussion of our critical accounting policies and estimates including revenue recognition, goodwill, intangible assets and impairment assessments, stock-based compensation, accounting for income taxes, inventory valuation and allowances for doubtful accounts. Our critical accounting policies have been discussed with the Audit Committee of the Board of Directors. We believe there have been no material changes to our critical accounting policies and estimates during the three and six months ended June 30, 2011, compared to those discussed in our Form 10-K for the year ended December 31, 2010. Results of Operations Revenue We derive our revenue from sales of our appliances and software licenses and from support and services. Product revenue primarily consists of revenue from sales of our Steelhead and Cascade products and is typically recognized upon shipment. Support and services revenue includes unspecified software license updates and product support. Support revenue is recognized ratably over the contractual period, which is typically one year. Service revenue includes professional services and training, which to date has not been significant, and is recognized as the services are performed. 20-------------------------------------------------------------------------------- Table of Contents Three months ended Six months ended June 30, June 30, (in thousands) 2011 2010 2011 2010 Total Revenue $ 170,295 $ 126,227 $ 333,858 $ 238,650 Total Revenue by Type: Product $ 116,860 $ 84,505 $ 229,012 $ 159,242 Support and services $ 53,435 $ 41,722 $ 104,846 $ 79,408 % Revenue by Type: Product 69% 67% 69% 67% Support and services 31% 33% 31% 33% Total Revenue by Geography: United States $ 96,516 $ 63,820 $ 186,855 $ 122,131 Europe, Middle East and Africa $ 40,028 $ 36,842 $ 79,077 $ 68,255 Rest of the World $ 33,751 $ 25,565 $ 67,926 $ 48,264 % Revenue by Geography: United States 57% 51% 56% 51% Europe, Middle East and Africa 23% 29% 24% 29% Rest of the World 20% 20% 20% 20% Total Revenue by Sales Channel: Direct $ 9,705 $ 6,982 $ 17,960 $ 16,278 Indirect $ 160,590 $ 119,245 $ 315,898 $ 222,372 % Revenue by Sales Channel: Direct 6% 6% 5% 7% Indirect 94% 94% 95% 93% Quarter Ended June 30, 2011 Compared to the Quarter Ended June 30, 2010: Product revenue increased by 38% in the three months ended June 30, 2011 as compared to the three months ended June 30, 2010, due primarily to an increase in unit volume from increasing sales to existing customers and the addition of new customers. We believe the market for our products has grown due to increased market awareness of WAN optimization and an increase in distributed organizations, which increases dependence on timely access to data and applications. Substantially all of our customers purchase support when they purchase our products. Support and services revenue increased 28% in the three months ended June 30, 2011 as compared to the three months ended June 30, 2010. As our customer base grows, we expect our revenue generated from support and services to increase; however, we expect the renewal rate of support contracts by existing customers to remain level. In the three months ended June 30, 2011 and June 30, 2010, we derived 94% of our revenue from indirect channels. We expect indirect channel revenue to continue to be a substantial majority of our revenue. We generated 43% of our revenue in the three months ended June 30, 2011 from international locations, compared to 49% in the three months ended June 30, 2010. We continue to expand into international locations and introduce our products in new markets and expect international revenue to increase in dollar amount over time. Six Months Ended June 30, 2011 Compared to the Six Months Ended June 30, 2010: Product revenue increased by 44% in the six months ended June 30, 2011 over the same period in the prior year due primarily to an increase in unit volume from sales to new customers and additional purchases by existing customers. Support and services revenue increased by 32% in the six months ended June 30, 2011 over the same period in the prior year due to higher first year support sales from higher product sales and the continued renewal of support contracts by our existing customers. Cost of Revenue and Gross Margin Cost of product revenue consists of the costs of the appliance hardware, manufacturing, shipping and logistics costs, expenses for inventory obsolescence, warranty obligations and amortization of acquisition-related intangibles. We utilize third parties to assist in the design and manufacture of our appliance hardware, embed our proprietary software and perform shipping logistics. Cost of support and service revenue consists of personnel costs of technical support and professional services personnel, spare parts and logistics services. As we expand internationally and into other sectors, we may incur additional costs to conform our products to 21-------------------------------------------------------------------------------- Table of Contents comply with local laws or local product specifications. In addition, as we expand internationally, we will continue to hire additional technical support personnel to support our growing international customer base. Our gross margin has been and will continue to be affected by a variety of factors, including the mix and average selling prices of our products, new product introductions and enhancements, the cost of our appliance hardware, expenses for inventory obsolescence and warranty obligations, cost of support and service personnel, and the mix of distribution channels through which our products are sold. Three months ended Six months ended June 30, June 30, (in thousands) 2011 2010 2011 2010 Revenue: Product $ 116,860 $ 84,505 $ 229,012 $ 159,242 Support and services 53,435 41,722 104,846 79,408 Total revenue 170,295 126,227 333,858 238,650 Cost of revenue: Cost of product 23,683 18,612 47,418 35,244 Cost of support and services 16,415 12,364 31,635 23,598 Total cost of revenue 40,098 30,976 79,053 58,842 Gross profit $ 130,197 $ 95,251 $ 254,805 $ 179,808 Gross margin for product 80% 78% 79% 78% Gross margin for support and services 69% 70% 70% 70% Total gross margin 76% 75% 76% 75% Quarter Ended June 30, 2011 Compared to the Quarter Ended June 30, 2010: The total cost of revenue increased $9.1 million in the three months ended June 30, 2011 compared to the three months ended June 30, 2010. The cost of product sold increased $5.1 million primarily due to an increase in unit volume associated with higher revenue. Cost of support and services revenue increased $4.1 million as we added more technical support headcount domestically and abroad to support our growing customer base. Technical support and services headcount was 183 employees as of June 30, 2011 compared to 151 employees as of June 30, 2010. Gross margins increased to 76% in the three months ended June 30, 2011 from 75% in the three months ended June 30, 2010. Product gross margins increased to 80% in the three months ended June 30, 2011 from 78% in the three months ended June 30, 2010 as a result of volume leverage and favorable product mix. Gross margins for support and services decreased slightly to 69% as we increased personnel costs to support a growing customer base. Six Months Ended June 30, 2011 Compared to the Six Months Ended June 30, 2010: The total cost of revenue increased $20.2 million in the six months ended June 30, 2011 compared to the six months ended June 30, 2010. The increase in cost of product revenue of $12.2 million was due primarily to increased unit volume associated with higher revenue. Cost of support and services revenue increased $8.0 million due to increased personnel related costs as a result of increased headcount. Gross margins increased to 76% in the six months ended June 30, 2011 from 75% in the six months ended June 30, 2010. Product gross margins increased to 79% in the six months ended June 30, 2011 from 78% in the six months ended June 30, 2010 as a result of volume leverage and favorable product mix. Gross margins for support and services remained at 70%. 22-------------------------------------------------------------------------------- Table of Contents Sales and Marketing Expenses Sales and marketing expenses represent the largest component of our operating expenses and include personnel costs, sales commissions, marketing programs and facilities costs. Marketing programs are intended to generate revenue from new and existing customers, and are expensed as incurred. We plan to continue to make investments in sales and marketing with the intent to add new customers and increase penetration within our existing customer base by increasing the number of sales personnel worldwide, expanding our domestic and international sales and marketing activities, increasing channel penetration, building brand awareness and sponsoring additional marketing events. We expect future sales and marketing expenses to continue to increase and continue to be our most significant operating expense. Generally, sales personnel are not immediately productive and sales and marketing expenses do not immediately result in increased revenue. Hiring additional sales personnel reduces short-term operating margins until the sales personnel become productive and generate revenue. Accordingly, the timing of sales personnel hiring and the rate at which they become productive will affect our future performance. Three months ended Six months ended June 30, June 30, (in thousands) 2011 2010 2011 2010 Sales and marketing expenses $ 63,737 $ 51,990 $ 124,821 $ 102,058 Percent of total revenue 37% 41% 37% 43% Quarter Ended June 30, 2011 Compared to the Quarter Ended June 30, 2010: Sales and marketing expenses increased by $11.7 million, or 22.6%, in the three months ended June 30, 2011 compared to the three months ended June 30, 2010 primarily due to increases in personnel costs of $8.0 million. The increase in personnel costs, which include salaries, commissions, bonuses and related benefits and stock-based compensation, was primarily due to headcount increasing to 628 employees as of June 30, 2011 from 512 employees as of June 30, 2010 . Six Months Ended June 30, 2011 Compared to the Six Months Ended June 30, 2010: The increase in sales and marketing expenses for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 of $22.8 million is primarily due to increases in personnel costs of $15.5 million, increases in marketing costs of $2.1 million and increases in travel and entertainment expenses of $1.8 million. Research and Development Expenses Research and development (R&D) expenses primarily include personnel costs and facilities costs. We expense R&D costs as incurred. We are devoting substantial resources to the continued development of additional functionality for existing products and the development of new products. We intend to continue to invest significantly in our R&D efforts because we believe they are essential to maintaining our competitive position. Investments in R&D personnel costs are expected to increase in dollar amount. Three months ended Six months ended June 30, June 30, (in thousands) 2011 2010 2011 2010 Research and development expenses $ 29,942 $ 20,664 $ 58,251 $ 39,549 Percent of total revenue 18% 16% 17% 17% Quarter Ended June 30, 2011 Compared to the Quarter Ended June 30, 2010: R&D expenses increased by $9.3 million, or 44.9%, in the three months ended June 30, 2011 compared to the three months ended June 30, 2010 primarily due to increases in personnel costs of $4.6 million and outside services of $1.3 million. The increase in personnel costs, which include salaries, bonuses and related benefits and stock-based compensation, was primarily due to headcount increasing to 384 employees as of June 30, 2011 from 293 employees as of June 30, 2010. Six Months Ended June 30, 2011 Compared to the Six Months Ended June 30, 2010: The increase in R&D expenses for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 of $18.7 million is primarily due to an increase in personnel costs of $11.4 million, outside services of $2.4 million and facilities and information technology costs of $1.1 million. General and Administrative Expenses General and administrative expenses consist primarily of compensation for personnel and facilities costs related to our executive, finance, human resources, information technology and legal organizations, and fees for professional services. Professional services include legal, audit and information technology consulting costs. 23-------------------------------------------------------------------------------- Table of Contents Three months ended Six months ended June 30, June 30, (in thousands) 2011 2010 2011 2010 General and administrative expenses $ 14,913 $ 11,569 $ 28,596 $ 22,315 Percent of total revenue 9% 9% 9% 9% Quarter Ended June 30, 2011 Compared to the Quarter Ended June 30, 2010: General and administrative expenses increased by $3.3 million, or 28.9%, in the three months ended June 30, 2011 compared to the three months ended June 30, 2010 due to an increase in personnel costs of $1.8 million. The increase in personnel costs, which include salaries, bonuses and related benefits and stock-based compensation, was primarily due to headcount increasing to 166 employees as of June 30, 2011 from 127 employees as of June 30, 2010. Six Months Ended June 30, 2011 Compared to the Six Months Ended June 30, 2010: The increase of $6.3 million in general and administrative expenses for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 is primarily due to an increase in personnel costs of $4.2 million and outside services of $1.3 million. Acquisition-Related Costs Quarter Ended June 30, 2011 Compared to the Quarter Ended June 30, 2010: The acquisition-related costs recorded in the three months ended June 30, 2011 include $1.4 million of transaction and integration costs related to acquisitions completed during the third quarter of 2011. There were no acquisition-related costs recorded in the three months ended June 30, 2010. Six Months Ended June 30, 2011 Compared to the Six Months Ended June 30, 2010: The acquisition-related costs recorded in the first six months of 2011 include $1.4 million of transaction and integration costs related to acquisitions completed during the third quarter of 2011. The acquisition-related costs recorded in the first six months of 2010 include changes in the fair value of the acquisition-related contingent consideration. The final liability for contingent consideration relating to the Mazu acquisition, which was determined pursuant to the achievement of certain bookings targets through March 31, 2010, was paid during the third quarter of 2010. During the six months ended June 30, 2010, we recognized $2.7 million of acquisition-related costs due to the change in fair value of acquisition-related contingent consideration to be distributed directly to the Mazu shareholders. Other Income, Net Other income, net consists primarily of interest income on our cash and investments, interest expense, and foreign currency exchange gains and losses. Cash has historically been invested in highly liquid investments such as time deposits held at major banks, commercial paper, U.S. government agency discount notes, money market mutual funds and other money market securities with average portfolio maturities at the date of purchase less than one year. Three months ended Six months ended June 30, June 30, (in thousands) 2011 2010 2011 2010 Interest income $ 427 $ 223 $ 869 $ 482 Other (86 ) (39 ) (30 ) (183 ) Total other income, net $ 341 $ 184 $ 839 $ 299 Quarter Ended June 30, 2011 Compared to the Quarter Ended June 30, 2010: Other income, net increased in the three months ended June 30, 2011 compared to the three months ended June 30, 2010 primarily due to increased interest income on higher average interest rates on higher investment balances. Weighted average interest rates applicable to our cash and investment balances increased to 0.3% in the three months ended June 30, 2011 compared to 0.2% in the three months ended June 30, 2010. Six Months Ended June 30, 2011 Compared to the Six Months Ended June 30, 2010: Other income, net, increased in the six months ended June 30, 2011 due to increased interest income on cash and investment balances as a result of declining interest rates. Weighted average interest rates applicable to our cash and investment balances increased to 0.3% in the six months ended June 30, 2011 compared to 0.1% in the six months ended June 30, 2010. Other expense primarily represents foreign exchange losses on foreign currency denominated liabilities. Provision for Income Taxes The provision for income taxes for the three months ended June 30, 2011 and 2010 was $9.3 million and $4.7 million, respectively. Our income tax provision consists of federal, foreign, and state income taxes. Our effective tax rate was 45.1% and 41.5% for the three months ended June 30, 2011 and 2010, respectively, and 42.9% and 43.3% for the six months ended June 30, 2011 and 2010, respectively. 24 -------------------------------------------------------------------------------- Table of Contents Our effective tax rate differs from the federal statutory rate due to state taxes and significant permanent differences. Significant permanent differences arise primarily from taxes in foreign jurisdictions with a tax rate different than the U.S. federal statutory rate, stock-based compensation expense, R&D credits, certain acquisition related items, and the amortization of deferred tax charges related to our intercompany sale of intellectual property rights. We recorded a deferred charge during the six months ended June 30, 2011 related to the deferral of income tax expense on intercompany profits that resulted from the sale of our intellectual property rights outside of North and South America to our Singapore subsidiary. The deferred charge is included in the Other Current Assets and the Other Assets lines of the condensed consolidated balance sheets in the amounts of $5.6 million and $19.6 million, respectively. The deferred charge will be amortized as a component of income tax expense over the 5 year economic life of the intellectual property. Our effective tax rate for the three months ended June 30, 2011 is higher when compared to the same period in the prior year primarily due to the income tax expense on intercompany profits that resulted from the sale of our intellectual property rights outside of North and South America to our Singapore subsidiary in the current year and the current year impact of stock-based compensation related to our foreign subsidiaries. Our effective tax rate in 2011 and in future periods may fluctuate on a quarterly basis. The effective tax rate could be affected by the geographic distribution of our worldwide earnings or losses, our stock-based compensation expense, changes in the valuation of our deferred tax assets, changes in actual results versus our estimates, or changes in tax laws, regulations, accounting principles, or interpretations thereof. Additionally, in the future our effective rate will likely decrease as a result of our entering into an intercompany research and development program with our Singapore subsidiary and a tax holiday in Singapore. 25 -------------------------------------------------------------------------------- Table of Contents We record a valuation allowance to reduce our deferred tax assets to the amount we believe is more likely than not to be realized. In assessing the need for a valuation allowance, we have considered our historical levels of income and expectations of future taxable income. In determining future taxable income, we make assumptions to forecast federal, state and international operating income, the reversal of temporary differences, and the implementation of any feasible and prudent tax planning strategies. The assumptions require significant judgment regarding the forecasts of taxable income, and are consistent with our forecasts used to manage our business. We occasionally record valuation allowances for deferred tax assets established in purchase accounting. In the future, we may conclude that it is more likely than not that the deferred tax assets will be realized based on expectations of taxable income and other factors. This would result in a reduction of the valuation allowance and a decrease to income tax expense for the period such determination is made. In the year ended December 31, 2010, management concluded that a valuation allowance was needed on our California income tax credit carryforwards. Due to a change in our forecasted income allocated to California for tax years after 2010, it is more likely than not that the California income tax credit carryforwards will not be utilized in the foreseeable future. Accordingly, we have established a 100% valuation allowance against the California tax credit carryforwards. During the six months ended June 30, 2011, we increased our liability for unrecognized income tax benefits by $9.3 million to $16.2 million for tax positions related to the current year. The unrecognized tax benefits that, if recognized, would impact the effective tax rate were $15.2 million as of June 30, 2011. We are subject to potential income tax audits on open tax years by any taxing jurisdiction in which we operate. The taxing authorities of the most significant jurisdictions are the United States Internal Revenue Service, California Franchise Tax Board and HM Revenue and Customs in the United Kingdom (UK) and the Inland Revenue Authority of Singapore. We do not anticipate any material adjustments to our tax provisions relating to previously filed tax returns. The statute of limitations for federal, state, UK and Singapore tax purposes are generally three, four, one and four year(s) respectively; however, we continue to carryover tax attributes prior to these periods for federal and state purposes, which would still be open for examination by the respective tax authorities. Accordingly, all years since our inception are open to tax examinations for federal and state purposes. Liquidity and Capital Resources As of As of June 30, December 31, (in thousands) 2011 2010 Working capital $ 499,565 $ 374,898 Cash and cash equivalents $ 180,898 $ 165,726 Short and long-term investments $ 430,227 $ 335,414 Six months ended June 30, (in thousands) 2011 2010 Cash provided by operating activities $ 56,720 $ 71,238 Cash used in investing activities $ (104,139 ) $ (34,009 ) Cash provided by financing activities $ 62,157 $ 30,107 Cash and Cash Equivalents Cash and cash equivalents consist of money market mutual funds, government-sponsored enterprise obligations, treasury bills, commercial paper and other money market securities with remaining maturities at date of purchase of 90 days or less. Short and long-term investments consist of government-sponsored enterprise obligations, treasury bills and corporate bonds and notes. The fair value of investments is determined as the exit price in the principal market in which we would transact. The fair value of our investments has not materially fluctuated from historical cost. The accumulated unrealized losses, net of tax, on investments recognized in accumulated other comprehensive income in our stockholders' equity as of June 30, 2011 is $0.1 million. The recent volatility in the credit markets has increased the risk of material fluctuations in the fair value of investments. Cash and cash equivalents, short-term investments and long-term investments increased by $110.0 million in the six months ended June 30, 2011 to $611.1 million. Pursuant to certain lease agreements and as security for our merchant services agreement with our financial institution, we are required to maintain cash reserves, classified as restricted cash. Long-term restricted cash totaled $2.6 million at June 30, 2011 and December 31, 2010. Long-term restricted cash is included in other assets in the condensed consolidated balance sheets and consists primarily of funds held as collateral for letters of credit for the security deposit on the leases of our corporate headquarters and is restricted until the end of the lease terms on July 31, 2014. 26-------------------------------------------------------------------------------- Table of Contents Since the fourth quarter of 2004, we have expanded our operations internationally. Our sales contracts are principally denominated in U.S. dollars and therefore changes in foreign exchange rates have not materially affected our cash flows from operations. As we fund our international operations, our cash and cash equivalents are affected by changes in exchange rates. To date, the foreign currency effect on our cash and cash equivalents has not been material. Cash Flows from Operating Activities Our largest source of operating cash flows is cash collections from our customers. Our primary uses of cash from operating activities are for personnel related expenditures, product costs, outside services, and rent payments. Our cash flows from operating activities will continue to be affected principally by the extent to which we grow our revenue and spend on hiring personnel in order to grow our business. The timing of hiring sales personnel in particular affects cash flows as there is a lag between the hiring of sales personnel and the generation of revenue and related cash flows from their sales efforts. Cash provided by operating activities was $56.7 million in the six months ended June 30, 2011 a decrease of $14.5 million compared to $71.2 million in the six months ended June 30, 2010. The decrease in cash flow from operating activities was primarily due to a decrease in cash flow of $8.4 million from operations after adjusting for non-cash items, primarily related to an increase in cash used for excess tax benefits from employee stock plans, and a $22.9 million decrease from the change in operating assets and liabilities, primarily increases in trade receivables and prepaid taxes. Cash Flows used in Investing Activities Cash flows used in investing activities primarily relate to purchases of investments, net of sales and maturities and capital expenditures. Cash used in investing activities increased by $70.1 million to $104.1 million in the six months ended June 30, 2011 compared to $34.0 million in the six months ended June 30, 2010. The increase in cash used in investing activities is primarily due to increased proceeds from the sales and maturities of securities of $9.1 million offset by increased use of cash from purchases of securities of $76.9 million. Cash provided by Financing Activities Cash provided by financing activities in the six months ended June 30, 2011 totaled $62.2 million and consisted of proceeds from the issuance of common stock of $38.0 million and excess tax benefit from employee stock plans of $34.2 million offset by cash used to net share settle equity awards of $10.1 million. We believe that our net proceeds from operations, together with our cash balance at June 30, 2011, will be sufficient to fund our projected operating requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of expansion into new territories, the timing of introductions of new products and enhancements to existing products, and the continuing market acceptance of our products. In the future, we may enter into other arrangements for potential investments in, or acquisitions of, complementary businesses, services or technologies, which could require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all. Contractual Obligations The following is a summary of our contractual obligations as of June 30, 2011: Remaining six months Total of 2011 2012 2013 2014 2015 Thereafter (in thousands) Contractual Obligations Operating leases $ 61,470 $ 4,573 $ 9,512 $ 10,212 $ 9,037 $ 5,432 $ 22,704 Purchase obligations (1) $ 11,469 11,460 9 0 0 0 0 Total contractual obligations $ 72,939 $ 16,033 $ 9,521 $ 10,212 $ 9,037 $ 5,432 $ 22,704 (1) Represents amounts associated with agreements that are enforceable, legally binding and specify terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of payment. Obligations under contracts that we can cancel without a significant penalty are not included in the table above. 27 -------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements At June 30, 2011 and December 31, 2010, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes, nor did we have any undisclosed material transactions or commitments involving related persons or entities. Other At June 30, 2011 and December 31, 2010, we did not have commercial commitments under lines of credit, standby repurchase obligations or other such debt arrangements. Recent Accounting Pronouncements See Note 1 of "Notes to Condensed Consolidated Financial Statements" for recent accounting pronouncements that could have an effect on us. |