[March 15, 2012] DOT HILL SYSTEMS CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement for Forward-Looking Information Certain statements contained in this report, including, statements regarding the development, growth and expansion of our business, our intent, belief or current expectations, primarily with respect to our future operating performance and the products we expect to offer, and other statements regarding matters that are not historical facts, are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and are subject to the "safe harbor" created by these sections. Because such forward-looking statements are subject to risks and uncertainties, many of which are beyond our control, actual results may differ materially from those expressed or implied by such forward-looking statements. Some of the factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements can be found in Item 1A "Risk Factors" and elsewhere in this annual report on Form 10-K. Readers are cautioned not to place undue reliance on forward-looking statements. The forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update such statements to reflect events that occur or circumstances that exist after the date on which they are made. The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and notes thereto included elsewhere in this annual report on Form 10-K. Overview We design, manufacture and market a range of software and hardware storage systems for the entry and mid-range storage markets. Beginning in the second half of 2009, we began placing more emphasis on selling higher gross margin products which includes software, appliance products, and hardware products through indirect sales channels. We have two operating segments, which include storage systems and standalone storage software. Typical customers for our storage systems operating segment, which includes our AssuredSAN line of storage array products, include organizations requiring high reliability, high performance networked storage and data management solutions in an open systems architecture. Our storage solutions consist of integrated hardware, firmware and software products employing a modular system that allows end-users to add various protocol, performance, capacity or data protection schemes as needed. Our broad range of products, from small capacity direct attached to complete multi-hundred terabyte, or TB, storage area networks, or SANs, provide end-users with a cost-effective means of addressing increasing storage demands at compelling price-performance points. Our current product family based on our AssuredSAN architecture provides high performance and large disk array capacities for a broad variety of environments, employing Fibre Channel, Internet Small Computer Systems Interface, or iSCSI or Serial Attached SCSI, or SAS, interconnects to switches and/or hosts. In addition, our Assured family of data protection software products provides additional layers of data protection options to complement our line of storage disk arrays. Our current mainstream 2000 and 3000 series of entry-level storage products and Just a Bunch of Disks, or JBOD, arrays are targeted primarily at mainstream enterprise and small-to-medium business, or SMB, applications. Our AssuredSAN 5000 Series products have been distinguished by certification as Network Equipment Building System, or NEBS, Level 3 (a telecommunications standard for equipment used in central offices) and are MIL-STD-810F (a military standard created by the U.S. government) compliant based on their ruggedness and reliability. In February 2010, we launched the latest AssuredSAN 3000 series of storage arrays that provide high speed interface options including 8 gigabyte, or GB, Fibre Channel, 1GB and 10GB iSCSI over Ethernet and 6GB SAS connectivity. Our standalone storage software operating segment in 2010 and 2011 consisted of our AssuredUVS and AssuredVRA product lines. 43-------------------------------------------------------------------------------- Table of Contents Our AssuredUVS product line, formerly known as the intelligent storage networking system, or iSN TM, is based on the technology we acquired in January 2010 from Cloverleaf Communications, Inc., or Cloverleaf, a privately held software company focused on heterogeneous storage virtualization and unified storage technologies. Such technology was marketed as standalone host based software and also included appliance products consisting of a standard off-the-shelf x86 server combined with the proprietary software that delivers the unified virtual storage feature set. Our storage arrays are also available bundled with this appliance. Sales of AssuredUVS products were not significant in 2011. On February 2, 2012 we decided to re-align our software investments to focus on accelerating the development of software that will be embedded in our AssuredSAN product line to better enable us to launch a set of mid-range storage products in 2012, provide more differentiated entry level products over time and help position us to win new OEM and Channel customers that may be looking for new or alternative suppliers resulting from industry consolidation. Since we do not expect to utilize the Cloverleaf based software in these mid-range product offerings, we have decided to discontinue our investment and development efforts in the Cloverleaf based products. We recently began to market the Cloverleaf asset to prospective acquirers and while there have been indications of interest, there is no assurance we will find a suitable buyer on a timely basis. We have determined that the ongoing cash investment in this operation could outweigh the potential consideration from the sale of this business, and thus, we plan to substantially close down our Israeli software development group by March 31, 2012. Consequently, we do not expect sales of AssuredUVS to represent a significant percentage of our total net revenue in the future. In September 2008, we acquired certain assets, namely RAIDCore from Ciprico Inc., or Ciprico. These products are marketed to OEM accounts as the AssuredVRA product line. This acquisition opened up new markets for us in the enterprise server and workstation markets for data protection internal to the servers and workstations. In particular, the RAIDCore acquisition allows us to broaden our product portfolio in the redundant array of independent disks, or RAID, market while allowing us to sell into the Band 1 market, and to pursue opportunities at current and target OEM customers. We signed our first customer agreement relating to RAIDCore products in May 2009 and began selling to this customer during the third quarter of 2009. Sales of AssuredVRA products were not significant in 2010 and 2011 and we do not expect sales of our AssuredVRA products to increase, in 2012 we do not expect such sales to represent a significant percentage of our future net revenue. We decided to expand our routes to market beyond our focus on original equipment manufacturers, or OEMs, and in October of 2009, we launched a Dot Hill channel program targeted at selling through distributors and resellers. We continued to expand our channel program in 2011 and believe this will provide Dot Hill with additional sales channels for all of our products. The majority of sales to our channel partners were represented by our AssuredSAN line of products in 2011. We expect sales to our channel partners of our AssuredSAN products will increase in 2012. Our agreements with our customers do not contain any minimum purchase commitments and may be terminated at any time upon notice from the applicable customer. Our ability to achieve and maintain profitability will depend on, among other things, the level and mix of orders we actually receive from such customers, the actual amounts we spend on marketing support, the actual amounts we spend for inventory support and incremental internal investment, our ability to reduce product cost, our product lead time, our ability to meet delivery schedules required by our customers and the economic environment. Our products and services are sold worldwide to facilitate server and SAN storage implementations, primarily through OEMs, and supplemented by system integrators, or SIs, distributors and value added resellers, or VARs. Our storage system operating segment OEM partners currently include, among others, Hewlett-Packard, or HP, Sony Ericsson, or Ericsson, Motorola, Inc., or Motorola, General Dynamics Government Systems Corporation, or General Dynamics, Lockheed Martin Corporation, or Lockheed Martin, NEC Corporation, or NEC, Tektronix Inc., or Tektronix, Samsung Electronics, or Samsung, Stratus Technologies, or Stratus, Fujitsu Technology Solutions GmbH, or FTS, and Concurrent Computer Corporation, or Concurrent. Our standalone storage software operating segment OEM partners currently include, among others, Dell Inc., or 44-------------------------------------------------------------------------------- Table of Contents Dell. Although our products and services are sold worldwide, the majority of our net revenue is derived from our U.S. operations. See Note 14 of the Notes to Consolidated Financial Statements for information regarding our operating segments and a breakout of our net revenue by geographical regions. We began shipping products to HP in the fourth quarter of 2007. In January 2008, we amended our agreement with HP to allow for sales of additional products to additional divisions within HP. Our products are primarily sold as HP's MSA 2000/P2000 product family. Sales to HP increased significantly during 2008 and increased again in 2009 primarily as a result of the successful launch and market acceptance of the HP MSA 2000 products. HP launched its third generation product line, now called the P2000 product line, in February 2010. Sales to HP increased again in 2010 as we began selling our next generation host interfaces across the HP P2000 product line. The agreement with HP does not contain any minimum purchase commitments. In October 2011, we extended our supply agreement with HP by 5 years to expire in October 2016 and also extended the expiration of 1.6 million warrants granted to HP in March 2008 to expire concurrently with supply agreement in October 2016. Net revenue from HP approximated 73% of our total net revenue in 2011. We expect sales to HP to continue to represent a substantial percentage of our total net revenue in 2012. We expect to generate additional revenue from our indirect channel sales and from sales of our AssuredUVS and AssuredVRA products as well as new and potential new OEM customers to replace the revenue, and more importantly, the gross profit lost as a result of amending our agreement with NetApp. However, if we are unable to generate sufficient gross profit from these sources to largely replace the gross profit previously associated with NetApp, our financial results could be harmed. Sales to NetApp approximated 25% of our total net revenue in 2009, 26% of our total net revenue in 2010 and 0% of our total net revenue in 2011, all of which was attributable to our storage systems operating segment. In addition, the demand for our products has been affected in the past, and may continue to be affected in the future, by various factors, including, but not limited to, the following: • our ability to maintain and enhance relationships with our customers, in particular our OEM customers, as well as our ability to win new business; • our ability to source critical components such as integrated circuits, hard disk drives, memory and other components on a timely basis; • the amount of field failures resulting in product replacements or recalls; • our ability to launch new products in accordance with OEM schedules and milestones; • general economic and political conditions and specific conditions in the markets we address, including the continuing volatility in the technology sector, current general economic volatility and trends in the data storage markets in various geographic regions; • the timing, rescheduling or cancellation of significant customer orders and our ability, as well as the ability of our customers, to manage inventory; and • the inability of certain of our customers who depend on credit to have access to their traditional sources of credit to finance the purchase of products from us, particularly in the current global economic environment, which may lead them to reduce their level of purchases or to seek credit or other accommodations from us. For these and other reasons, our net revenue and results of operations in 2011 and prior periods may not necessarily be indicative of future net revenue and results of operations. Our manufacturing strategy includes outsourcing substantially all of our manufacturing to third-party manufacturers in order to reduce sales cycle times and manufacturing infrastructure, enhance working capital and 45-------------------------------------------------------------------------------- Table of Contents improve margins by taking advantage of the third parties' manufacturing and procurement economies of scale. In September 2008, we entered into a manufacturing agreement with Foxconn Technology Group, or Foxconn. Under the terms of the agreement, Foxconn supplies us with manufacturing, assembly and test services from its facilities in China and final integration services including final assembly, testing and configure-to-order services through its worldwide facilities. In November 2011 we amended our agreement with Foxconn to extend the manufacturing agreement for a period of three years. In addition, Foxconn agreed to waive the requirement for a letter of credit and improved our payment terms Foxconn began manufacturing products for us in July 2009 and we began shipping products for general availability under the Foxconn agreement during the second half of 2009. The majority of our products sold in 2010 and 2011 were manufactured by Foxconn. We expect Foxconn to manufacture substantially all of our products in 2012. We derive the majority of our net revenue primarily from sales of our Series 2000 and 3000 family of products, which are included in our AssuredSAN product line within the storage systems operating segment. Cost of goods sold includes costs of materials, subcontractor costs, salary and related benefits for the production and service departments, depreciation of equipment used in the production and service departments, production facility rent and allocation of overhead as well as manufacturing variances and freight. Research and development expenses consist primarily of project-related expenses, consulting charges and salaries for employees directly engaged in research and development. Sales and marketing expenses consist primarily of salaries and commissions, marketing related costs, advertising, customer-related evaluation unit expenses, promotional costs and travel expenses. General and administrative expenses consist primarily of compensation to officers and employees performing administrative functions, expenditures for administrative facilities as well as expenditures for legal and accounting services and fluctuations in currency valuations. Other income is comprised primarily of interest income earned on our cash and cash equivalents and other miscellaneous income and expense items. In the second quarter of 2010, our management approved, committed to, and initiated a restructuring and cost reduction plan, or the 2010 Plan, to better align our resources in order to lower our breakeven point. The 2010 Plan included severance and related costs for the reduction of approximately 10% of our workforce, and fees associated with the acceleration of the closure of our Carlsbad, California facility. Substantially all of our 2010 Plan workforce reductions were completed by December 31, 2010 and we completely exited our Carlsbad facility as of June 30, 2010. On February 2, 2012, our Board of Directors approved the implementation of a restructuring and cost reduction plan, or the 2012 Plan, that will include severance and related costs, contractual obligations, administrative costs and long-lived asset impairments associated with the closure of our Israel Technology Development Center totaling $4.7 to $5.9 million. The 2012 Plan is designed to re-align our software investments to focus on accelerating the development of embedded software features, in order to launch a competitive set of mid-range storage array products in 2012, and to provide more differentiated entry-level products for both OEM and channel customers. The majority of the activities comprising the 2012 Plan are expected to be completed by the end of 2012. We expect to record severance costs in the range of $1.2 to $1.4 million, record contractual obligations in the range of $1.2 to $1.5 million, incur legal and other administrative costs in the range of $0.2 to $0.4 million and recognize long-lived asset impairments of approximately $2.1 to $2.6 million in connection with the 2012 Plan. 46-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the financial statements and the reported amounts of net revenue and expenses in the reporting periods. We base our estimates on current facts, historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the accrual of costs and expenses that are not readily apparent from other sources. We evaluate these estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions. To the extent there are material differences between the estimates and the actual results, future results of operations will be affected. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably likely to occur could materially impact the financial statements. We have many accounting policies that require us to make estimates and assumptions; the determination of useful lives of long-lived assets, warranty reserves, accruals for estimated restructuring, tax and legal liabilities and valuation allowance for deferred tax assets. The items listed below are not inclusive of all of our accounting policies but is a listing, identified by management, of those policies which require the most significant judgments and estimates to be made in the preparation of the consolidated financial statements. Revenue Recognition We derive our revenue from sales of our hardware products, software and services. Hardware Hardware product revenue consists of revenue from sales of our AssuredSAN storage systems and our AssuredUVS appliance products that includes our AssuredUVS software which is integrated with industry standard hardware which is essential to the functionality of the integrated system product. We recognize hardware product revenue when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred; (iii) the price is fixed or determinable; and (iv) collectability is reasonably assured. Revenue is recognized for hardware product sales upon transfer of title and risk of loss to the customer and in addition, upon installation for certain of our AssuredUVS appliance products. We record reductions to revenue for estimated product returns and pricing adjustments in the same period that the related revenue is recorded. These estimates are based on historical sales returns, analysis of credit memo data and other factors known at the time. If actual future returns and pricing adjustments differ from past experience and our estimates, additional revenue reserves may be required. Software In accordance with the specific guidance for recognizing software revenue, where applicable, we recognize revenue from perpetual software licenses at the inception of the license term assuming all revenue recognition criteria have been met. We use the relative method to allocate revenue to software licenses at the inception of the license term when vendor-specific objective evidence, or VSOE, of fair value for all unspecified software updates and enhancements related to our products through service contracts. We have established vendor specific objective evidence, or VSOE, for the fair value of our support services as measured by the stated renewal prices paid by our customers when the services are sold separately on a standalone basis. 47-------------------------------------------------------------------------------- Table of Contents Service Our service revenue primarily includes out-of-warranty repairs and product maintenance contracts. Out-of warranty repairs primarily consist of product repair services performed by our contract manufacturers for those customers that allowed their original product warranty to expire without purchasing one of our higher level support service plans. Revenue from these out-of-warranty repairs, and the associated cost of sales, is recognized in the period these services are provided. Service revenue also consists of product maintenance contracts. Revenue from our product maintenance contracts is deferred and recognized ratably over the contract term, generally 12 to 36 months. Net revenue derived from services was less than 10% of total revenue for all periods presented. Revenue Recognition for Arrangements with Multiple Deliverables For multi-element arrangements that include hardware products containing software essential to the hardware product's functionality, undelivered software elements that relate to the hardware product's essential software, and undelivered non-software services, we allocate revenue to all deliverables based on their relative selling prices. In such circumstances, we use a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) VSOE of fair value, (ii) third-party evidence of selling price, or TPE, and (iii) best estimate of the selling price, or ESP. VSOE generally exists only when we sell the deliverable separately and represents the actual price charged by us for that deliverable. ESPs reflect our best estimates of what the selling prices of elements would be if they were sold regularly on a standalone basis. From time to time, we enter into arrangements with customers that include acceptance criteria. In such instances, we defer all revenue on the arrangement until customer acceptance is obtained or the acceptance clause lapses. Revenue Recognition for Sales to Channel Partners On sales to channel partners, we evaluate whether fees are considered fixed or determinable by considering a number of factors, including our ability to estimate returns, payment terms and our relationship and past history with the particular channel partner. If fees are not considered fixed or determinable at the time of sale to a channel partner, revenue recognition is deferred until there is persuasive evidence indicating the product has sold-through to an end-user. Persuasive evidence of sell-through may include reports from channel partners documenting sell-through activity or data indicating an order has shipped to an end-user. Deferred Revenue We also defer revenue on upfront nonrefundable payments from our customers and recognize it ratably over the term of the agreement, unless the payment is in exchange for products delivered that represent the culmination of a separate earnings process. When we provide consideration to a customer we recognize the value of that consideration as a reduction in net revenue. We may be required to maintain inventory with certain of our largest OEM customers, which we refer to as hubbing arrangements. Pursuant to these arrangements we deliver products to a customer or a designated third-party warehouse based upon the customer's projected needs, but do not recognize product revenue unless and until the customer has removed our product from the warehouse to incorporate into its end products. Valuation of Inventories Inventories are comprised of finished goods and purchased parts and assemblies, which include direct labor and overhead, and are valued at the lower of cost (first-in, first-out method) or market value. The valuation of inventory requires us to estimate excess or obsolete inventory. The determination of excess or obsolete inventory 48 -------------------------------------------------------------------------------- Table of Contents requires us to estimate the future demand for our products. Because our markets are volatile, are subject to technological risks, price changes and inventory reduction programs by our customers, and as we are required to make last-time buys of certain components on occasion, there is a risk that we will forecast incorrectly and produce excess inventories of particular products or have commitments to purchase excess inventory components from our suppliers. As a result, actual demand will differ from forecasts, and such a difference has in the past and may in the future have a material adverse effect on our gross margin and our results of operations. Any write downs to inventory due to the existence of excess quantities, physical obsolescence, changes in pricing, damage, or other causes establish a new cost basis for the inventory. When we sell or dispose of reserved inventory the new cost basis is charged to cost of sales. The largest factor affecting the accuracy of our provisions for excess inventories is the accuracy of our production and service forecasts of end-customer demand. The accuracy of our estimates depends in part on the accuracy of the non-binding forecasts we get from our end customers, the accuracy of our own forecast of warranty requirements of our customers, the demand for storage systems in our market segments and the speed at which our products are designed in or out of our customers' products. Share-Based Compensation We account for share-based compensation by measuring and recognizing share-based compensation expense for equity based awards granted, including stock options, restricted stock awards, performance-based restricted stock awards and employee stock purchase plan shares, for which expense will be recognized over the service period of the equity based award based on the fair value of the award, at the date of grant. The estimation of stock option and employee stock purchase plan fair value requires management to make complex estimates and judgments about, among other things, employee exercise behavior, forfeiture rates and the volatility of our common stock. These judgments directly affect the amount of compensation expense that will ultimately be recognized. Compensation expense for restricted stock awards is measured based on the fair-value of the award on the grant date (fair-value is calculated based on the closing price of our common stock on the date of grant) multiplied by the number of shares granted, and is recognized as expense over the respective vesting period. Compensation expense for performance-based restricted stock awards is measured similarly to restricted stock, however, compensation expense is only recorded for awards that ultimately vest, which is contingent upon employees achieving various performance criteria. We currently use the Black-Scholes option pricing model to estimate the fair value of our stock options and employee stock purchase plan shares. The fair values generated by the Black-Scholes model may not be indicative of the actual fair values of our stock options and employee stock purchase plan shares as it does not consider certain factors important to those awards to employees, such as continued employment and periodic vesting requirements as well as limited transferability. The determination of the fair value of share-based payment awards utilizing the Black-Scholes model is affected by our stock price and a number of assumptions, including expected volatility, expected life, risk-free interest rate and expected dividends. We use historical volatility of our stock for the expected life of the grant as the expected volatility assumption required in the Black-Scholes model. Our selection of the historical volatility approach is due to the limited availability of data regarding actively traded options on our stock. The expected life of the stock options is based on historical and other economic data trended into the future. The risk-free interest rate assumption is based on observed interest rates appropriate for the terms of our stock options and employee stock purchase plan shares. The dividend yield assumption is based on our history and expectation of dividend payouts. We evaluate the assumptions used to value stock options on a quarterly basis. If factors change and we employ different assumptions, share-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned share-based compensation expense. 49-------------------------------------------------------------------------------- Table of Contents Valuation of Goodwill We review goodwill for impairment on an annual basis at November 30 and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Our ITC reporting unit, which develops our AssuredUVS software, is a component of the Standalone Storage Software reporting segment identified in the notes to our consolidated financial statements. During September 2011, our primary AssuredUVS customer became delinquent on the settlement of its payables to us and upon our investigation it became evident that its financial resources were limited. It also informed us that they were changing their strategy which would result in a significant decline in our revenue, and we determined it was "more-likely-than-not" that the reporting unit was less than its carrying value. Current accounting standards require that a two-step impairment test be performed on goodwill. In the first step, we compare the fair value of our reporting unit to its carrying value. We determine the fair value of our reporting unit using a combination of the income approach and market capitalization approach. If the fair value of the reporting unit exceeds the carrying value of the net assets, goodwill is not impaired, and we are not required to perform further testing. If the carrying value of the net assets exceeds the fair value of the reporting unit, then we must perform the second step in order to determine the implied fair value of the reporting unit's goodwill and compare it to the carrying value of the reporting unit's goodwill. If the carrying value of the reporting unit's goodwill exceeds its implied fair value, then we must record an impairment charge equal to the difference. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future discounted cash flows. Under the market capitalization approach, valuation multiples are calculated based on operating data from publicly traded companies within our industry. Multiples derived from companies within our industry provide an indication of how much a knowledgeable investor in the marketplace would be willing to pay for a company. These multiples are applied to the operating data for the reporting unit to arrive at an indicated fair value. Significant management judgment is required in the forecasts of future operating results that are used in the estimated future discounted cash flow method of valuation. The estimates we have used are consistent with the plans and estimates that we use to manage our business. We base our fair value estimates on forecasted revenue and operating costs along with business plans. Our forecasts consider the effect of a number of factors including, but not limited to, the current future projected competitiveness and market acceptance of the product, technological risk, the ease of use and ease of implementation of the product, the likely outcome of sales and marketing efforts and projected costs associated with product development, customer support and selling, general and administrative costs. The assumptions and forecasts used were consistent with those used to evaluate certain of our long-lived assets for impairment at September 30, 2011 (see below). It is possible, however, that the plans may change and that actual results may differ significantly from our estimates. The valuation resulted in the recognition of an impairment charge to goodwill of $4.1 million for the quarter ended September 30, 2011. No additional goodwill remains on the balance sheet of the Company as of December 31, 2011. Valuation of Long-Lived Assets Long-lived assets consist primarily of intangible assets with finite lives and property and equipment. We evaluate long-lived assets for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. We assess the recoverability of the assets based on the undiscounted future cash flows the assets are expected to generate and recognize an impairment loss when estimated undiscounted future cash flows expected to result from the use of the assets plus net proceeds expected from disposition of the assets, if any, are less than the carrying value of the assets. If an asset is deemed to be impaired, the amount of the impairment loss represents the excess of the asset's carrying value compared to its estimated fair value. Fair value estimates are based on assumptions concerning the amount and timing of estimated future cash flows and assumed discount rates, reflecting varying degrees of perceived risk. 50 -------------------------------------------------------------------------------- Table of Contents All long-lived assets identified with the Israel Technology Center, or ITC reporting unit are considered one asset group, and are included as a component of the "Standalone Storage Software" reportable segment. Recent events involving our ITC reporting unit resulted in a significant decline in actual and planned earnings. As of September 30, 2011, we identified a change in circumstances that indicated the carrying amount of our long-lived assets may not be recoverable, as our primary AssuredUVS customer informed us that use of the AssuredUVS software would no longer be a component of its business strategy, which would result in a significant decline in revenues for the Company. Our long-lived assets consist of the intangible assets associated with our acquisition of certain identified Cloverleaf assets acquired in January 2010 with a carrying value of $5.0 million and property and equipment of $1.2 million. Since we did not have an immediate replacement for our AssuredUVS customer, management's forecasted undiscounted cash flows indicated that the assets were potentially not recoverable, and proceeded to estimate the fair value of each long-lived asset. Property and equipment comprise mostly machinery and equipment used for testing and development of our AssuredUVS technology. Management determined that carrying value approximated fair value, as property was either acquired in the 2010 acquisition of Cloverleaf, has been purchased subsequently, or could be re-deployed, establishing recent evidence of fair value. It is depreciated over a 3 - 5 year estimated useful life. Intangible assets consist primarily of acquired software of $4.9 million and a trade name of $0.1 million. We determined the fair value of the acquired software by estimating the replacement cost of the software, taking into account both the software as acquired and subsequent development work, as well as the business alternatives we were considering and the corresponding value of the software in these alternative approaches. We estimated the value of the software based on the probabilities of each of the business alternatives. We determined the fair value of the trade name using an income approach and considered the fact that the software's trade name at the time of acquisition was no longer being used. All estimates were based on management using appropriate assumptions and projections. Our impairment analysis at September 30, 2011 identified $2.9 million of impaired long-lived assets, consisting entirely of intangible assets recognized as part of the Cloverleaf acquisition in 2010. Long-lived asset impairment charges are recorded consistent with our treatment of related amortization expense specific to each acquired intangible assets. We recorded $2.8 million of impaired acquired software and $0.1 million of impaired acquired trade name as a component of cost of goods sold for the twelve months ended December 31, 2011. We are evaluating numerous alternatives to monetize the software asset including developing an appliance based on industry standard servers, developing storage bundles with our AssuredSAN products, developing and porting the software to be based on open source code such as Linux, integrating some of the AssuredUVS features into some of our AssuredSAN products and making substantial changes to the AssuredUVS operations. In February 2012, the Board of Directors approved a plan to exit our AssuredUVS business and close down our Israel Technology Development Center. We evaluated the potential impact, if any, on our valuation of our acquired software and other long-lived assets maintained at our Israel Technology Development Center, and based on the facts and circumstances in existence at December 31, 2011, we believe the current valuations are appropriate. However, as a result of our decision in the 2012 fiscal year to shut down our AssuredUVS business, we will assess the recorded long-lived asset valuation for Israel Technology Development Center in the first quarter of 2012. 51-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth certain items from our statements of operations as a percentage of net revenue for the periods indicated (percentages may not add due to rounding): Years Ended December 31, 2009 2010 2011 Net revenue 100.0 % 100 % 100.0 % Cost of goods sold 83.9 83.0 78.9 Gross profit 16.1 17.0 21.1 Operating expenses: Research and development 12.0 12.5 18.0 Sales and marketing 4.7 4.8 7.0 General and administrative 4.3 3.9 4.7 Restructuring charge 1.0 0.9 0.3 Goodwill and long-lived asset impairment charge - - 2.1 Total operating expenses 22.0 22.1 32.1 Operating loss (5.9 ) (5.2 ) (11.0 ) Other income, net 0.1 0.0 0.0 Loss before income taxes (5.8 ) (5.2 ) (11.0 ) Income tax expense (benefit) 0.0 0.1 0.1 Net loss (5.8 )% (5.2 )% (11.1 )% Year Ended December 31, 2010 Compared to Year Ended December 31, 2011 Net Revenue 2010 2011 (Decrease) % Change (in thousands, except percentages) Net revenue $ 252,494 $ 197,461 $ (55,033 ) (21.8 )% The decrease in net revenue for the year ended December 31, 2011 to $197.5 million from $252.5 million for the year ended December 31, 2010, was primarily due to the decision in the fourth quarter of 2010 to exit our low margin business with NetApp. Sales to NetApp totaled $65.6 million for the year ended December 31, 2010 and totaled $0 for the year ended December 31, 2011. A portion of the lost NetApp sales were replaced by sales to OEM partners other than HP which grew to $44.8 million for the year ended December 31, 2011 from $36.7 million for the year ended December 31, 2010. Without NetApp sales in 2010, our net revenue would have increased 6% in 2011 over 2010. Sales to HP remained flat year-over-year totaling $144.9 million for the year ended December 31, 2011 and $144.7 million for the year ended December 31, 2010 due largely to the shortage of hard disk drives in the fourth quarter of 2011 as well as HP inventory optimization initiatives. Sales to HP are due to the successful launch and market acceptance of the HP MSA 2000 products, which includes our Series 2000 products and the launch by HP of its third generation product line, now called the P2000 product line, in February 2010, which includes our Series 3000 products. Although our Series 2000 products are in the decline phase of the product life cycle, demand for these products continues to be significant. We released our next generation Series 3000 products in the first quarter of 2010 and sales of these products have increased significantly during each quarter of 2010 and remained consistent throughout 2011. We expect sales to HP to continue to represent a substantial portion of our net revenue in 2012. 52 -------------------------------------------------------------------------------- Table of Contents Cost of Goods Sold and Gross Profit 2010 % of Net Revenue 2011 % of Net Revenue (Decrease) % Change (in thousands, except percentages) Cost of goods sold $ 209,664 83.0 % $ 155,828 78.9 % $ (53,836 ) (25.7 )% Gross profit $ 42,830 17.0 % $ 41,633 21.1 % $ (1,197 ) (2.8 )% Cost of goods sold decreased for the year ended December 31, 2011 compared to the year ended December 31, 2010 primarily as a result of the decrease in sales. Cost of goods sold as a percentage of revenue decreased from 83.0% for the year-ended December 31, 2010 to 78.9% for the year-ended December 31, 2011. Gross profit margin for the year ended December 31, 2011 was 21.1% compared to 17.0% for the year ended December 31, 2010. The increase in gross profit margin was primarily due to exiting the low-margin NetApp business, the growth in Channel and non-HP OEM sales, internal cost reduction initiatives and decreases in manufacturing support costs and manufacturing variances. These decreases were partially offset by the cost of goods sold associated with the increase in sales to other OEM customers and the recognition of impairment charges relating to certain of our long-lived assets held at our ITC reporting unit. Partially offsetting the increase in gross profit margin were higher warranty related expenses of $5.6 million for the year ended December 31, 2011 compared to the same period in 2010. Warranty related expenses increased primarily as a result of quality issues associated with certain power supply devices provided by one of our component suppliers that required us to make substantial repairs and provide replacement parts. . Our gross profit margin is typically sensitive to product and customer mix changes. For example, our gross profit margin on sales of the products we sell to HP is higher than the gross profit margin on the products we previously sold to NetApp. In addition, sales of our software products and services typically have a much higher gross profit margin than that of our hardware products. Also, sales to our channel customers typically have a higher gross profit margin than sales to our Tier 1 OEM customers. For the year ended December 31, 2011, we generated a higher percentage of our net revenue from our channel customers, non-HP OEM's and from sales of software and services, which had a favorable impact on our gross profit margin. We expect that our cost of sales will decrease and our gross profit margin will increase in 2012 as a result of expected increases in sales from our channel customers and from sales of services. We also expect that the mix of products we sell, in particular, the products we sell to HP, will continue to affect, and likely increase, our cost of goods sold and gross profit margin. Research and Development Expenses 2010 % of Net Revenue 2011 % of Net Revenue Increase % Change (in thousands, except percentages) Research and development expenses $ 31,578 12.5 % $ 35,551 18.0 % $ 3,973 12.6 % Research and development expense increased $4.0 million to $35.6 million for the year ended December 31, 2011 compared to $31.6 million for the year ended December 31, 2010. This increase was primarily due to a net increase in salaries and payroll related expenses of $1.3 million, a net increase in stock compensation expenses of $1.2, an increase in engineering materials of $0.5, a net increase in depreciation expense of $0.5 million, an increase in consulting costs of $0.3 million and an increase in software and maintenance charges of $0.2 million. The increase in salary and payroll related expenses is primarily a result of the additional employees engaged in research and development activities associated with the development of next generation entry level products and a mid-range product line, as well as additional investments in our AssuredUVS business. The increase in 53 -------------------------------------------------------------------------------- Table of Contents stock compensation expenses is due to a large portion of stock awards vesting in early 2011 when the stock price was elevated compared with the prior year. The increase in engineering materials is largely the result of the timing of our engineering material purchases in conjunction with the release of our next generation of products anticipated for 2012. Consulting costs increased largely as a result of certain engineering functions being performed by consultants in India and an increase in the use of domestic engineering consultants to assist with certain strategic development projects. The increase in depreciation expense was primarily the result of the additional equipment acquired in the Cloverleaf acquisition and also due to additional capital expenditures for our Longmont engineering labs. 2010 % of Net Revenue 2011 % of Net Revenue Increase % Change (in thousands, except percentages) Sales and marketing expenses $ 12,164 4.8 % $ 13,876 7.0 % $ 1,712 14.1 % Sales and marketing expense increased $1.7 million to $13.9 million for the year ended December 31, 2011 compared to $12.2 million for the year ended December 31, 2010. This increase was primarily due to an increase in commissions and bonuses of $0.6 million, a net increase in stock compensation expenses of $0.2 million, a net increase in salaries and payroll-related expenses of $0.3 million, an increase in bank fees of $0.3 million, an increase in travel expenses of $0.2 million, and other miscellaneous net increases of $0.4 million. These increases were partially offset by a decrease in customer-related evaluation product expenses of $0.3 million. The increase in commissions and bonuses is due to better performance against sales goals. The net increase in stock compensation expenses is due to a new stock bonus plan in 2011 and an overall increase in awards. The net increase in salary and payroll related expenses is primarily a result of additional employees engaged in sales and marketing activities as a result of an increase in the number of sales territories we support and the continued expansion of our channel program. The increase in travel expenses was primarily the result of an increase in sales team employees and customer visits. The increase in bank fees is for credit card merchant fees assessed for one customer that pays by credit card. The decrease in customer-related evaluation product expenses is due to new product releases in 2010, including those products acquired in the Cloverleaf acquisition which were less significant in 2011. General and Administrative Expenses 2010 % of Net Revenue 2011 % of Net Revenue (Decrease) % Change (in thousands, except percentages) General and administrative expenses $ 9,928 3.9 % $ 9,268 4.7 % $ (660 ) (6.6 )% General and administrative expenses decreased $0.7 million to $9.3 million for the year ended December 31, 2011 compared to $9.9 million for the year ended December 31, 2010. This decrease was primarily attributable to a decrease in salary and payroll related expenses of $0.5 million, a reduction in consulting fees of $0.5 million, a net reduction in car lease and other miscellaneous expenses of $0.4 million and a reduction in accounting, legal and advisory fees of $0.2 million. These decreases were partially offset by an increase in stock compensation related expenses of $0.7 million and an increase in bad debt expenses of $0.2 million. The change in accounting, legal and advisory fees was primarily the result of negotiating lower fees with our service providers. The reduction in salary and payroll related expenses primarily was attributable to a reduction in salaries mandated by executive management that were in effect for part of 2010 and for all of 2011. Consulting fees were elevated in 2010 compared with 2011 as the company made the conscious decision in 2010 to hire temporary labor instead of full-time employees anticipating the move from Carlsbad, California to Longmont, Colorado. 54 -------------------------------------------------------------------------------- Table of Contents Restructuring 2010 % of Net Revenue 2011 % of Net Revenue (Decrease) % Change (in thousands, except percentages) Restructuring $ 2,196 0.9 % $ 668 0.3 % $ (1,528 ) (69.6 )% In December 2008, our management approved, committed to, and initiated a restructuring plan, or the 2008 Plan, to improve efficiencies in our operations, which was largely driven by our plan to consolidate our facility in Carlsbad, California into the Longmont, Colorado facility. In the second quarter of 2010, our management approved, committed to, and initiated a restructuring and cost reduction plan, or the 2010 Plan, to better align our resources in order to lower our breakeven point. The 2010 Plan included severance and related costs for the reduction of approximately 10% of our workforce, and fees associated with the acceleration of the closure of our Carlsbad, California facility. For the year ended December 31, 2010, we incurred severance and related costs of $0.6 million related to both our 2008 Plan and 2010 Plan. We also incurred contract termination costs of $1.5 million for the year ended December 31, 2010 primarily for facility lease and other associated costs that we continued to incur without economic benefit and due to revisions to our assumptions regarding the timing and amount of tenant sublease income under both our 2008 Plan and 2010 Plan. We also incurred additional severance-related restructuring charges of approximately $0.1 million in 2010 related to the termination of a former employee of Cloverleaf. All of the severance-related costs were paid to this employee in 2010. The $0.7 million restructuring expense for the year ended December 31, 2011 is primarily related to management's determination that sublease rental income anticipated on the Carlsbad, California facility would not materialize, and the associated write-off of that expected rental income. See Note 6 of Notes to Consolidated Financial Statements for more details regarding our restructuring activities. Goodwill impairment charge 2010 2011 % of Net % of Net Amount Revenue Amount Revenue Increase % Change (in thousands, except percentages) Goodwill impairment charge $ - - % $ 4,140 2.1 % $ 4,140 100 % A decline in our ITC reporting unit's AssuredUVS customer base resulted in a significant decline in actual and planned earnings and we determined it was "more-likely-than-not" that the ITC reporting unit was worth less than its carrying value. As a result we tested goodwill related to our ITC reporting unit for impairment as of September 30, 2011, and determined that the carrying value of goodwill was impaired. We performed the second step of the goodwill impairment test to measure the amount of the impairment resulting in the recognition of an impairment to goodwill of $4.1 million for the year-ended December 31, 2011. Other Income, net 2010 % of Net Revenue 2011 % of Net Revenue (Decrease) % Change (in thousands, except percentages) Other income/(expense), net $ (2 ) 0.0 % $ (25 ) 0.0 % $ (23 ) 1,150 % 55 -------------------------------------------------------------------------------- Table of Contents The decrease in other income, net for the year ended December 31, 2011 is primarily attributable to an increase in interest expense related to the amortization of financing fees for amending our credit agreement with Silicon Valley Bank in February, 2011. Income Taxes We recorded an income tax provision of $0.1 million for the year ended December 31, 2011 and an income tax provision of $0.2 million for the year ended December 31, 2010. The provision for income taxes in both years primarily represents state, local and foreign taxes. Year Ended December 31, 2009 Compared to Year Ended December 31, 2010 Net Revenue 2009 2010 Increase % Change (in thousands, except percentages) Net Revenue $ 234,383 $ 252,494 $ 18,111 7.7 % The increase in net revenue for the year ended December 31, 2010 was primarily due to an increase in sales to HP. Sales to HP totaled $144.7 million for the year ended December 31, 2010 compared to $120.5 million for the for the year ended December 31, 2009. The increase in HP net revenue is due to the successful launch and market acceptance of the HP MSA 2000 products, which includes our Series 2000 products and the launch by HP of its third generation product line, now called the P2000 product line, in February 2010, which includes our Series 3000 products. Although our Series 2000 products are in the decline phase of the product life cycle, demand for these products continues to be significant. We released our next generation Series 3000 products in the first quarter of 2010 and sales of these products have increased significantly during each quarter of 2010. In addition, sales to NetApp increased during the year ended December 31, 2010 compared to the year ended December 31, 2009 based on the success of NetApp's FAS 2000 product line. Sales to NetApp totaled $65.6 million for the year ended December 31, 2010 compared to $58.0 million for the year ended December 31, 2009. However, under our agreement with NetApp, NetApp had the right to manufacture and sell, on a royalty and royalty-free basis, up to certain specified percentages of the products we previously manufactured and sold to NetApp. In the fourth quarter of 2010, we decided to exit our low margin business with NetApp and amended our agreement with NetApp to allow NetApp to manufacture and sell on a royalty-free basis all of the products we previously manufactured and sold to NetApp beginning on or about December 1, 2010. We expect to generate additional revenue from our indirect channel sales as well as new and potential new OEM customers to replace the revenue, and more importantly, the gross profit lost as a result of amending our agreement with NetApp. However, if we are unable to generate sufficient gross profit from these sources to largely replace the gross profit previously associated with NetApp, our financial results could be harmed. We also experienced an increase in net revenue of approximately $7.4 million for the year ended December 31, 2010 compared to the year ended December 31, 2009 as a result of the launch of our channel program in October of 2009, sales of our AssuredUVS products, which are based on the technology acquired as part of the Cloverleaf acquisition in January 2010 and increased sales of our AssuredVRA products as we renegotiated our contract with a major OEM customer in 2010. These increases were partially offset by a decrease in net revenue from Oracle, FTS, Sepaton and other smaller customers. Oracle sales decreased to $0.5 million for the year ended December 31, 2010 compared to $10.3 million for the year ended December 31, 2009. The decline in Oracle net revenue is due to the products we sell to Oracle reaching the end of their product life cycle. FTS sales decreased to $2.8 million for the year ended December 31, 2010 compared to $11.4 million for the year ended December 31, 2009. The decrease in net 56-------------------------------------------------------------------------------- Table of Contents revenue from FTS is due to FTS's decision to internally source the product we sell to FTS. In addition, we also experienced a decline in sales to Sepaton of approximately $2.4 million as a result of Sepaton buying their storage requirements from another source. We also experienced a net decline in sales to other smaller customers of approximately $0.3 million. Cost of Goods Sold and Gross Profit 2009 % of Net Revenue 2010 % of Net Revenue Increase % Change (in thousands, except percentages) Cost of Goods Sold $ 196,556 83.9 % $ 209,664 83.0 % $ 13,108 6.7 % Gross Profit $ 37,827 16.1 % $ 42,830 17.0 % $ 5,003 13.2 % Cost of goods sold increased for the year ended December 31, 2010 compared to the year ended December 31, 2009 primarily as a result of an increase in sales. Cost of goods sold as a percentage of revenue decreased from 83.9% for the year-ended December 31, 2009 to 83.0% for the year-ended December 31, 2010. Gross profit margin for the year ended December 31, 2010 was 17.0% compared to 16.1% for the year ended December 31, 2009. The increase in gross profit margin was primarily due to the continued success of our product cost reduction and value engineering initiatives over the past few years which has significantly reduced our costs for both our Series 2000 and 3000 products that we sell to HP and other customers. In addition, we incurred lower excess and obsolete inventory and scrap charges as a result of various product end of life issues experienced in 2009 and improved inventory management practices in 2010. We were also able to negotiate early payment and volume discounts in 2010, which resulted in lower costs and a higher gross profit margin. We also incurred fewer inventory holding charges as we were able to more efficiently manage inventories being held by our contract manufacturing partners and experienced a decrease in manufacturing overhead costs primarily as a result of our 2010 restructuring activities. Partially offsetting the increase in gross profit margin were higher amortization expense, warranty related expenses and freight costs for the year ended December 31, 2010 compared to the same period in 2009. Warranty related expenses increased as a result of a higher volume of quality related warranty claims, as we experienced component failure issues with certain of our battery and hard disk drive suppliers, as well as firmware failures within one of our products. Additionally, freight costs increased as a result of the increase in revenue and overall shipment volume as well as from expedite charges. Amortization expense increased due to the inclusion of Ciprico amortization in cost of goods sold as a result of the acquired products now generating revenue, as well as additional amortization resulting from the Cloverleaf acquisition. Prior to 2010, Ciprico amortization was included in research and development expense. Our gross profit margin is typically sensitive to product and customer mix changes. For example, our gross profit margin on sales of the products we sell to HP is higher than the gross profit margin on the products we previously sold to NetApp. Conversely, the gross profit margin on sales of the products we previously sold to Oracle is higher than that of the products we currently sell to HP. In addition, sales of our software products and services typically have a much higher gross profit margin than that of our hardware products. Also, sales to our channel customers and non-HP OEM customers typically have a higher gross profit margin than sales to HP. For the year ended December 31, 2010, we generated a lower percentage of our net revenue from Oracle, which had an unfavorable impact on our gross profit margin. However, we generated a higher percentage of our net revenue from our channel customers and from sales of software and services, which had a favorable impact on our gross profit margin. We expected that our cost of sales will decrease and our gross profit margin will increase in 2011 as a result of exiting our relationship with NetApp and as a result of expected increases in sales from our channel customers and from sales of software and services. We also expected that the mix of products we sell, in particular, the products we sell to HP, will continue to affect our cost of goods sold and gross profit margin. 57-------------------------------------------------------------------------------- Table of Contents Research and Development Expenses 2009 % of Net Revenue 2010 % of Net Revenue Increase % Change (in thousands, except percentages) Research and Development Expenses $ 28,120 12.0 % $ 31,578 12.5 % $ 3,458 12.3 % Research and development expense increased $3.5 million to $31.6 million for the year ended December 31, 2010 compared to $28.1 million for the year ended December 31, 2009. This increase was primarily due to an increase in salaries and payroll related expenses of $2.7 million, an increase in consulting costs of $1.1 million, an increase in depreciation expense of $0.4 million, and increases in various other items such as facilities and common expenses and travel, which approximated $0.1 million. In addition, in 2009 and 2010, we determined it was probable that the amount of contingent consideration due to Ciprico would be lower based on lower actual and projected sales of products eligible for the contingent consideration through the end of the contingent consideration period. Accordingly, we reduced the contingent consideration liability and research and development expense in the statement of operations to reflect the reduction in estimated contingent consideration liability. The reduction to research and development expense approximated $0.1 million for the year ended December 31, 2010 and $0.6 million for the year ended December 31, 2009, or a change of $0.5 million. These increases were partially offset by a decrease in Ciprico intangible asset amortization expense of $1.1 million and a decrease in engineering materials expense of $0.2 million. The increase in salary and payroll related expenses is primarily a result of the additional employees engaged in research and development activities associated with the Cloverleaf acquisition. Consulting costs increased largely as a result of certain engineering functions being performed by consultants in India and an increase in the use of domestic engineering consultants to assist with certain strategic development projects. The increase in depreciation expense was primarily the result of the additional equipment acquired in the Cloverleaf acquisition and also due to additional capital expenditures for our Longmont engineering labs. Ciprico intangible asset amortization expense decreased as the related AssuredVRA product is now generating revenue and therefore the amortization is included in cost of sales. The decrease in engineering materials expense is largely the result of the timing of our engineering material purchases in conjunction with the release of our next generation series 3000 products, which occurred in the first quarter of 2010. Sales and Marketing Expenses 2009 % of Net Revenue 2010 % of Net Revenue Increase % Change (in thousands, except percentages) Sales and Marketing Expenses $ 10,970 4.7 % $ 12,164 4.8 % $ 1,194 10.9 % Sales and marketing expense increased $1.2 million to $12.2 million for the year ended December 31, 2010 compared to $11.0 million for the year ended December 31, 2009. This increase was primarily due to an increase in customer-related evaluation product expenses of $0.5 million, an increase in marketing research, public relations and promotional expenses of $0.5 million, an increase in salaries and payroll related expenses of $0.3 million, and an increase in travel expenses of $0.1 million. These increases were partially offset by decreases in facilities and common costs of $0.2 million as a result of our 2010 restructuring activities. The increase in customer-related evaluation product expenses is due to new product releases in 2010, including those products acquired in the Cloverleaf acquisition. The increase in marketing research, public relations and promotional costs is primarily the result of various marketing and branding activities in 2010 for our new products and the continued expansion of our channel programs. The increase in salary and payroll related expenses is primarily a result of additional employees engaged in sales and marketing activities as a result of an increase in the number of sales territories we support and the continued expansion of our channel program. The increase in travel expenses was primarily the result of an increase in customer visits. 58-------------------------------------------------------------------------------- Table of Contents General and Administrative Expenses 2009 % of Net Revenue 2010 % of Net Revenue (Decrease) % Change (in thousands, except percentages) General and Administrative Expenses $ 10,139 4.3 % $ 9,928 3.9 % $ (211 ) (2.1 )% General and administrative expenses decreased $0.2 million to $9.9 million for the year ended December 31, 2010 compared to $10.1 million for the year ended December 31, 2009. This decrease was primarily attributable to a reduction in legal fees of $0.4 million, changes in foreign currency gains and losses of $0.3 million, a reduction in Sarbanes-Oxley fees of $0.3 million and a reduction in board of director fees of $0.2 million. These decreases were partially offset by an increase in salaries and payroll related expenses of $0.8 million and an increase in travel expenses of $0.2 million. The change in foreign currency gains and losses were primarily the result of changes in the value of the Euro and British pound in relation to the United States dollar. The reduction in legal fees was primarily the result of lower fees associated with litigation matters as certain claims against us were dismissed in the first quarter of 2010. The reduction in Sarbanes-Oxley fees were primarily the result of negotiating lower fees with our service provider. Board of director fees decreased as a result of a reduction in the number of members of our Board of Directors. Salaries and payroll related expenses and travel expenses increased primarily as a result of our transition of certain of our administrative functions to Longmont, Colorado from Carlsbad, California in 2010, including the costs of duplicative personnel. Restructuring Charge 2009 % of Net Revenue 2010 % of Net Revenue (Decrease) % Change (in thousands, except percentages) Restructuring Charge $ 2,430 1.0 % $ 2,196 0.9 % $ (234 ) (9.6 )% In December 2008, our management approved, committed to, and initiated a restructuring plan, or the 2008 Plan, to improve efficiencies in our operations, which was largely driven by our plan to consolidate our facility in Carlsbad, California into the Longmont, Colorado facility. For the year ended December 31, 2009, we incurred severance and related costs of $1.0 million for various California employees whose positions have been relocated to Colorado. As part of the 2008 Plan, we also incurred contract termination costs of $1.4 million for the year ended December 31, 2009 primarily for facility lease and other associated costs that we continued to incur without economic benefit and due to revisions to our assumptions regarding the timing and amount of tenant sublease income. In the second quarter of 2010, our management approved, committed to, and initiated a restructuring and cost reduction plan, or the 2010 Plan, to better align our resources in order to lower our breakeven point. The 2010 Plan included severance and related costs for the reduction of approximately 10% of our workforce, and fees associated with the acceleration of the closure of our Carlsbad, California facility. For the year ended December 31, 2010, we incurred severance and related costs of $0.6 million related to both our 2008 Plan and 2010 Plan. We also incurred contract termination costs of $1.5 million for the year ended December 31, 2010 primarily for facility lease and other associated costs that we continued to incur without economic benefit and due to revisions to our assumptions regarding the timing and amount of tenant sublease income under both our 2008 Plan and 2010 Plan. We also incurred additional severance-related restructuring charges of approximately $0.1 million in 2010 related to the termination of a former employee of Cloverleaf. All of the severance-related costs were paid to this employee in 2010. 59 -------------------------------------------------------------------------------- Table of Contents See Note 6 of Notes to Consolidated Financial Statements for more details regarding our restructuring activities. Other Income 2009 % of Net Revenue 2010 % of Net Revenue (Decrease) % Change (in thousands, except percentages) Other Income, net $ 167 0.1 % $ (2 ) 0.0 % $ (169 ) (101.2 )% The decrease in other income, net for the year ended December 31, 2010 is primarily attributable to a decrease in interest income primarily due to declining interest rates and lower cash balances. Income Taxes We recorded an income tax provision of $0.2 million for the year ended December 31, 2010 compared to an income tax benefit of $0.1 million for the year ended December 31, 2009. The 2010 provision for income taxes primarily represents state, local and foreign taxes. The 2009 benefit from income taxes primarily represents federal tax credits, partially offset by state, local and foreign income taxes. The federal tax credits available to us for the year ended December 31, 2009 were not available in 2010. Liquidity and Capital Resources The primary drivers affecting cash and liquidity are the cash portion of our net losses, working capital requirements and capital expenditures. Historically, the payment terms we have had to offer our customers have been relatively similar to the terms received from our creditors and suppliers. We typically bill customers on an open account basis subject to our standard credit quality and payment terms ranging between net 30 and net 45 days. If our net revenue increases, it is likely that our accounts receivable balance will also increase. Our accounts receivable could further increase if customers, in particular large OEM customers, delay their payments or if we grant them extended payment terms. As of December 31, 2011, we had $46.2 million of cash and cash equivalents and $41.4 million of working capital compared to $45.7 million of cash and cash equivalents and $49.9 million of working capital as of December 31, 2010. Cash equivalents include highly liquid investments purchased with an original maturity of 90 days or less and consist principally of money market funds. In addition, we had $0.1 million in short-term debt at December 31, 2011, consisting of a note payable issued in connection with the acquisition of certain intangible assets from Ciprico. As of December 31, 2011, $5.9 million of the $46.2 million of cash, cash equivalents, and marketable securities was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Operating Activities Net cash provided by operating activities for the year ended December 31, 2011 was $2.2 million compared to $9.1 million of cash used in operating activities for the year ended December 31, 2010. The operating activities that affected cash consisted primarily of a net loss which totaled $22.0 million for the year ended December 31, 2011 compared to $13.3 million for the year ended December 31, 2010. The increase in our net loss was significantly attributable to asset impairment charges totaling $7.1 million taken in 2011. 60-------------------------------------------------------------------------------- Table of Contents The adjustments to reconcile net loss to net cash used in operating activities for the year ended December 31, 2011 that did not affect cash consisted of depreciation and amortization of $4.8 million, stock-based compensation expense of $5.4 million, goodwill and long-lived asset impairment charges of $7.1 million, issuance of warrants of $1.0 million and a bad debt charge of $0.2 million. Cash flows from operations reflects the positive impact of $3.3 million related to a decrease in accounts receivable, which was primarily due to a decrease in net revenue in 2011. However, this was offset somewhat by an increase in our days sales outstanding which increased to 62 days for the three-months ended December 31, 2011 compared with 49 days for the three months ended December 31, 2010 primarily due to the timing of intra-quarter sales. Cash flows from operations also reflects the positive impact of $2.1 million related to an overall decrease in inventories at December 31, 2011, as a larger portion of our inventory in 2011 was purchased directly from vendors by our contract manufacturers as opposed to in 2010 where we more often acted as a middleman in these transactions. An additional source of cash flows from operations is $6.2 million related to an increase in accrued compensation and other expenses which was the result of a $5.5 million increase in contingent liabilities related to the recognition of potential payouts on the issue of the power supply failures, an increase of $0.8 million in accrued management bonuses as a result of management attaining certain bonus criteria, a $0.3 increase in accrued commissions and bonuses as a result of the sales force attaining certain of its goals, and an offsetting $0.4 net decrease in miscellaneous accrued accounts. Cash flows from operations include uses of cash of $4.3 million related to an increase in prepaid expenses and other assets due to $1.2 million of asset recovery, the timing of other receivables from our contract manufacturing partners for component parts we buy and ship to them and also due to the timing of payments for various miscellaneous receivables. In addition, cash flows from operations include uses of cash of $0.6 million of other long-term liabilities primarily related to payments of deferred rent, $0.5 million of deferred revenues and $0.3 million in restructuring payments. Investing Activities Cash used in investing activities for the year ended December 31, 2011 was approximately $2.5 million compared to $2.1 million for the year ended December 31, 2010. Cash used in investing activities for the year ended December 31, 2011 was due primarily to the continuous expansion of our laboratories associated with the development of new products. Financing Activities Cash provided by financing activities for the year ended December 31, 2011 was $0.6 million compared to cash used in financing activities of $0.7 million for the year ended December 31, 2010. Cash provided by financing activities for the year ended December 31, 2011 is attributable to $1.0 million of proceeds from the sale of stock to employees under our employee stock plans, offset by $0.4 million for the ongoing pay-down of our note payable associated with our 2008 acquisition of certain intangible assets from Ciprico. Based on current macro-economic conditions and conditions in the state of the data storage systems markets, our own organizational structure and our current outlook for 2012, we presently expect our cash and cash equivalents will be sufficient to fund our operations, working capital and capital requirements for at least the next 12 months. Our standard warranty provides that if our systems do not function to published specifications, we will repair or replace the defective component or system without charge generally for a period of approximately three years. We generally extend to our customers the warranties provided to us by our suppliers and, accordingly, the majority of our warranty obligations to customers are intended to be covered by corresponding supplier warranties. There can be no assurance that our suppliers will continue to provide such warranties to us in the future or that our warranty obligations to our customers will be covered by corresponding warranties from our suppliers, the absence of which could have a potentially significant adverse effect on our operating results and financial condition. 61 -------------------------------------------------------------------------------- Table of Contents In October 2009, we discovered a quality issue associated with certain power supply devices provided by a long-term component supplier, which resulted in a higher than expected level of power supply failures to us and our customers. While we were able to promptly identify and resolve the cause of the failures, we are required to provide replacement products or make repairs to the affected power supply units that had been sold between March and October 2009. Through June 30, 2011, our component supplier had repaired all of the faulty power supplies at no cost to us, and reimbursed us for our out-of-pocket costs which has constituted a reimbursement to customers for certain out-of-pocket costs they incurred in connection with these power supply failures. The total amount reimbursed to us by our component supplier approximated $1.0 million through June 30, 2011. During the third and fourth quarters of 2011 and into the first quarter of 2012, we entered negotiations for a settlement with a material customer. Based on our current expectation of how any such additional product quality claims will ultimately be settled, we believe that we will probably incur a liability of $5.5 million. Consequently, we recorded an additional liability of $2.7 million on our consolidated balance sheet as of December 31, 2011 to increase this liability to $5.5 million. In addition we have agreed to extend the original three year warranty on the affected power supplies to six years. In addition, we entered into negotiations with our component supplier during the third and fourth quarters of 2011 and into the first quarter of 2012, to attempt to recover any losses not previously reimbursed relating to the failed power supply units. In February 2012, we signed a non-binding letter of intent with our component supplier whereby we expect to receive $0.6 million upon signing of the final settlement agreement and a $0.6 million note receivable to be paid out in four, equal installments commencing three months after signing the final settlement agreement, regardless of future purchases from this supplier. In addition, this supplier will extend the warranty on the impacted power supplies from three years to six years and we will be eligible to receive incremental product discounts which are not reasonably estimable. We have increased the previously recorded current asset of $0.5 million within "Prepaid expenses and other assets" to $1.2 million as of December 31, 2011. Furthermore, we have commenced discussions with our General Liability and Errors and Omissions Insurance and underwriters and will continue to pursue our rights to cover any damages we incur and not reimbursed by our supplier. The insurance company has issued a reservation of rights letter to us and at this time it is not possible to estimate to what extent, if any, will be covered by our carrier. As of December 31, 2011, we have not assumed or recorded any insurance reimbursement. To the extent that we are unsuccessful in negotiating settlement agreements with our customer and our component supplier on mutually beneficial terms, or our component supplier does not continue to reimburse us for the expenses incurred by us or our customers, and we are unsuccessful in recovering such expenses from our insurance provider, we could incur additional expenses which could potentially have a material effect on our financial statements. Recently, the hard disk drive component supply chain has been significantly disrupted as a result of severe flooding in Thailand. In addition, some disk drive manufacturers have substantial manufacturing facilities in Thailand that have been closed down due to flooding. It is estimated that over 30% of the worldwide production of hard disk drives or critical component occurs in Thailand. While over 75% of our revenue typically comes from customers who purchase our AssuredSAN products on a drive-less basis, hard disk drives are a critical component in our AssuredSAN storage array products and can represent 30-70% of the cost of such products. Given the severity of the situation and the potential for extensive hard disk drive shortages for us and our customers, we believe the effects on our business and the data storage industry are likely to be substantial and could extend over multiple quarters. We will make every effort to secure and hold inventory of hard disk drives to incorporate into our products. Any purchase of hard drives beyond our immediate requirements, will likely result in increased inventory and a use of cash, but we expect any increase in hard drive inventory holdings to be consumed through our normal sales to customers over the near term. Given that approximately only one quarter of revenue are 62 -------------------------------------------------------------------------------- Table of Contents dependent on hard disk drive supplies, and given our current cash balances and the availability of additional working capital through Silicon Valley Bank, we do not believe we would be constrained in our ability to secure hard disk drives. The actual amount and timing of working capital and capital expenditures that we may incur in future periods may vary significantly and will depend upon numerous factors, including the timing and extent of net revenue and expenditures from our core business and strategic investments, the ability to maintain payment terms with our suppliers consistent with the credit terms of our customers, the overall level of net profits or losses, our ability to manage our relationships with our contract manufacturers, the potential growth or decline in inventory to support our customers, costs associated with product quality issues and the recovery, if any, of such costs by a supplier, the status of our relationships with key customers, partners and suppliers, the timing and extent of the introduction of new products and services, growth in operations and the economic environment. We maintain a credit facility with Silicon Valley Bank for cash advances and letters of credit of up to an aggregate of $30 million based upon an advance rate of 85% of eligible accounts receivable. In February 2011, we amended our credit agreement with Silicon Valley Bank. The amendment extends the maturity date to July 21, 2013, revises the definition of eligible accounts receivable to be less restrictive and also revises the definition of net worth to add stock-based compensation expense, goodwill and long-lived asset impairment charges, subject to certain limitations. Borrowings under the credit facility bear interest at the prime rate and are secured by substantially all of our accounts receivable, deposit and securities accounts. The agreement provides for a negative pledge on our inventory and intellectual property, subject to certain exceptions, and contains usual and customary covenants for an arrangement of its type, including an obligation that we maintain at all times a net worth, as defined in the agreement, of $50 million (subject to certain increases). The agreement also includes provisions to increase the financing facility by $20 million subject to our meeting certain requirements, including $40 million in borrowing base for the immediately preceding 90 days, and Silicon Valley Bank locating a lender willing to finance the additional facility. In addition, if our cash and cash equivalents net of the total amount outstanding under the credit facility fall below $20 million (measured on a rolling three-month basis), the interest rate will increase to prime plus 1% and additional restrictions will apply. Our credit facility also provides for a cash management services sublimit under the revolving credit line of up to $300,000. As of December 31, 2010 we had an outstanding letter of credit issued to our contract manufacturer in China in the amount of $5.0 million. As of December 31, 2011, we are no longer required to carry this letter of credit. As of December 31, 2011, there were no amounts outstanding under the Silicon Valley Bank line of credit. The following table summarizes our contractual obligations as of December 31, 2011 (in thousands). Contractual Obligations Total 2012 2013 2014 Thereafter Operating lease obligations $ 2,861 $ 2,196 $ 665 $ - $ - Inventory related purchase obligations 18,487 18,487 - - - Other purchase obligations 1,654 1,654 - - - Note payable 71 71 - - - Total $ 23,073 $ 22,408 $ 665 $ - $ - We lease office space, equipment and automobiles under non-cancelable operating leases, which expire at various dates through June 2013. For purposes of the table above, the operating lease obligations exclude common area maintenance, real estate taxes and insurance expenses. Inventory related purchase obligations represent contractual purchase commitments to our suppliers for certain components in order to ensure supply of select key components at the most favorable pricing. Other purchase obligations represent purchase commitments made in the ordinary course of business. 63 -------------------------------------------------------------------------------- Table of Contents In addition to the amounts shown in the table above, $0.2 million of unrecognized tax benefits have been recorded as liabilities in accordance with FASB Interpretation 48, and we are uncertain as to if or when such amounts may be settled. Off-Balance Sheet Arrangements At December 31, 2011, we did not have any relationship with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance variable interest, 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. In addition, we did not engage in trading activities involving non-exchange traded contracts. As a result, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. We do not have relationships and transactions with persons and entities that derive benefits from their non-independent relationship with us or our related parties except as disclosed herein. We enter into indemnification agreements with third parties in the ordinary course of business that generally require us to reimburse losses suffered by the third party due to various events, such as lawsuits arising from patent or copyright infringement. These indemnification obligations are considered off-balance sheet arrangements under accounting guidance. It is not possible to determine the maximum potential amount under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Such indemnification agreements may not be subject to maximum loss clauses. Historically, we have not incurred material costs as a result of obligations under these agreements. Recent Accounting Pronouncements In June 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) No. 2011-05, Comprehensive Income (ASC Topic 220)-Presentation of Comprehensive Income. The ASU requires companies to report comprehensive income, including items of other comprehensive income, for all periods presented in a single continuous financial statement in the Consolidated Statements of Operations or split between the Consolidated Statements of Operations and a separate Consolidated Statements of Other Comprehensive Income. The ASU is effective for our first quarter of fiscal year 2012. Other than requiring additional disclosures, the adoption of this new guidance will not have a material impact on our consolidated financial statements. In addition, in December 2011, the FASB issued Accounting Standards Update 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in ASU 2011-05("ASU 2011-12"). ASU 2011-12 defers the specific requirement within ASU 2011-05 to present on the face of the financial statements items that are reclassified from accumulated other comprehensive income to net income separately with their respective components of net income and other comprehensive income. The effective dates for ASU 2011-12 are consistent with the effective dates for ASU 2011-05 and, similar to our evaluation for the adoption of ASU 2011-05, the adoption of this guidance does not have a material effect on our consolidated financial statements. [ Back To TMCnet.com's Homepage ]