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EXTREME NETWORKS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This quarterly report on Form 10-Q, including the following sections, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including in particularly, our expectations regarding market demands, customer requirements and the general economic environment, and future results of operations, and other statements that include words such as "may" "expect" or "believe" . These forward-looking statements involve risks and uncertainties. We caution investors that actual results may differ materially from those projected in the forward-looking statements as a result of certain risk factors identified in the section entitled "Risk Factors" in this Report, our Quarterly Report on Form 10-Q for the third quarter of fiscal 2013, our Annual Report on Form 10-K for the fiscal year ended June 30, 2012, and other filings we have made with the Securities and Exchange Commission. These risk factors, include, but are not limited to: fluctuations in demand for our products and services; a highly competitive business environment for network switching equipment; our effectiveness in controlling expenses; the possibility that we might experience delays in the development or introduction of new technology and products; customer response to our new technology and products; the timing of any recovery in the global economy; risks related to pending or future litigation; and a dependency on third parties for certain components and for the manufacturing of our products. Business Overview We are a leading provider of network infrastructure equipment and services for enterprises, data centers, and service providers. We were incorporated in California in May 1996 and reincorporated in Delaware in March 1999. Our corporate headquarters are located in Santa Clara, California. We develop and sell network infrastructure equipment to our enterprise, data center and telecommunications service provider customers. We conduct our sales and marketing activities on a worldwide basis through a distribution channel utilizing distributors, resellers and our field sales organization. We primarily sell our products through an ecosystem of channel partners who combine our Ethernet products with their offerings to create compelling information technology solutions for end user customers. We utilize our field sales organization to support our channel partners and to sell direct to end-user customers, including some large global accounts. Our customers include businesses, hospitals, schools, hotels, telecommunications companies and government agencies around the world. We outsource the majority of our manufacturing and supply chain management operations as part of our strategy to maintain global manufacturing capabilities and to reduce our costs. We conduct quality assurance, manufacturing engineering, document control and test development in Santa Clara, California and Research Triangle Park, North Carolina. This approach enables us to reduce fixed costs and to flexibly respond to changes in market demand. The market for network infrastructure equipment is highly competitive and dominated by a few large companies. The current economic climate has further driven consolidation of vendors within the Ethernet networking market and with vendors from adjacent markets, including storage, security, wireless and voice applications. We believe that the underpinning technology for all of these adjacent markets is Ethernet. As a result, independent Ethernet switch vendors are being acquired or merged with larger, adjacent market vendors to enable them to deliver complete and broad solutions. As a result, we believe that, as an independent Ethernet switch vendor, we must provide products that, when combined with the products of our large strategic partners, create compelling solutions for end user customers. Our approach is to focus on the intelligence and automation layer that spans our hardware products and that facilitates end-to-end solutions, as opposed to positioning Extreme Networks as a low-cost-vendor with point products. We believe that continued success in our marketplace is dependent upon a variety of factors that includes, but is not limited to, our ability to design, develop and distribute new and enhanced products employing leading-edge technology. Results of Operations During the third quarter of fiscal 2013, we achieved the following results: • Net revenues of $68.2 million compared to net revenues of $73.4 million in the third quarter of fiscal 2012. • Product revenues of $54.1 million compared to product revenues of $58.0 million in the third quarter of fiscal 2012. • Service revenues of $14.1 million compared to service revenues of $15.4 million in the third quarter of fiscal 2012. • Total gross margin of 56% of net revenues compared to total gross margin of 56% of net revenues in the third quarter of fiscal 2012. • Operating loss of $1.9 million (including restructuring charges of $1.1 million and $2.6 million litigation settlement and associated legal fees) compared to operating income of $2.7 million in the third quarter of fiscal 2012. 20-------------------------------------------------------------------------------- Table of Contents • Net loss of $2.2 million compared to net income of $2.4 million in the third quarter of fiscal 2012. • Cash flow provided by operating activities of $7.0 million in the nine months ended March 31, 2013 compared to cash flow provided by operating activities of $6.4 million in the nine months ended April 1, 2012. • Cash and cash equivalents, short-term investments and marketable securities increased by $35.6 million to $189.1 million as of March 31, 2013 from $153.5 million as of June 30, 2012, primarily due to cash provided by operating and investing activities, including the sale of buildings and land offset by cash used for repurchase of common stock. We operate in three regions: Americas, which includes the United States, Canada, Mexico, Central America and South America; EMEA, which includes Europe, Middle East, and Africa; and APAC which includes Asia Pacific, South Asia, Japan, and Australia. The following table presents the total net revenue geographically for the three and nine months ended March 31, 2013 and April 1, 2012, respectively (dollars in thousands): Three Months Ended Nine Months Ended March 31, April 1, $ % March 31, April 1, $ % Net Revenues 2013 2012 Change Change 2013 2012 Change Change Americas: United States $ 21,609 $ 23,452 $ (1,843 ) (7.9 )% $ 69,545 $ 75,841 $ (6,296 ) (8.3 )% Other 6,414 7,464 (1,050 ) (14.1 )% 26,959 26,976 (17 ) (0.1 )% Total Americas 28,023 30,916 (2,893 ) (9.4 )% 96,504 102,817 (6,313 ) (6.1 )% Percentage of net revenue 41.0 % 42.1 % 43.9 % 43.7 % EMEA 28,481 30,349 (1,868 ) (6.2 )% 85,700 91,164 (5,464 ) (6.0 )% Percentage of net revenue 41.8 % 41.4 % 39.0 % 38.8 % APAC 11,699 12,103 (404 ) (3.3 )% 37,677 41,093 (3,416 ) (8.3 )% Percentage of net revenue 17.2 % 16.5 % 17.1 % 17.5 % Total net revenues $ 68,203 $ 73,368 $ (5,165 ) (7.0 )% $ 219,881 $ 235,074 $ (15,193 ) (6.5 )% Net Revenues The following table presents net product and service revenue for the three and nine months ended March 31, 2013 and April 1, 2012, respectively (dollars in thousands): Three Months Ended Nine Months Ended March 31, April 1, $ % March 31, April 1, $ % 2013 2012 Change Change 2013 2012 Change Change Net Revenues: Product $ 54,072 $ 58,009 $ (3,937 ) (6.8 )% $ 175,450 $ 189,316 $ (13,866 ) (7.3 )% Percentage of net revenue 79.3 % 79.1 % 79.8 % 80.5 % Service 14,131 15,359 (1,228 ) (8.0 )% 44,431 45,758 (1,327 ) (2.9 )% Percentage of net revenue 20.7 % 20.9 % 20.2 % 19.5 % Total net revenues $ 68,203 $ 73,368 $ (5,165 ) (7.0 )% $ 219,881 $ 235,074 $ (15,193 ) (6.5 )% Product revenue decreased by $3.9 million or 6.8% in the third quarter of fiscal 2013, and decreased by $13.9 million or 7.3% in the nine months ending March 31, 2013, compared to the corresponding periods of fiscal 2012 primarily due to lower sales volume in the Americas and EMEA regions. In the nine months ending March 31, 2013, we experienced weaker than expected demand from our public sector and enterprise customers in the U.S. and we continued to experience weak demand from our public sector and strategic customers and distributors in the EMEA region attributable to the persistent macroeconomic challenges in Western Europe. Service revenue decreased by $1.2 million, or 8.0% in the third quarter of fiscal 2013, and decreased $1.3 million or 2.9% in the nine months ending March 31, 2013, compared to the corresponding periods of fiscal 2012, reflecting slight decrease in the levels of service contract renewals. 21-------------------------------------------------------------------------------- Table of Contents Cost of Revenue and Gross Profit The following table presents the gross profit on product and service revenue and the gross profit percentage of product and service revenue for the three and nine months ended March 31, 2013 and April 1, 2012 (in thousands): Three Months Ended Nine Months Ended March 31, April 1, $ % March 31, April 1, $ % 2013 2012 Change Change 2013 2012 Change Change Gross profit: Product $ 28,866 $ 31,386 $ (2,520 ) (8.0 )% $ 90,391 $ 102,394 $ (12,003 ) (11.7 )% Percentage of product revenue 53.4 % 54.1 % 51.5 % 54.1 % Service 9,071 9,825 (754 ) (7.7 )% 28,260 28,621 (361 ) (1.3 )% Percentage of service revenue 64.2 % 64.0 % 63.6 % 62.5 % Total gross profit $ 37,937 $ 41,211 $ (3,274 ) (7.9 )% $ 118,651 $ 131,015 $ (12,364 ) (9.4 )% Percentage of net revenue 55.6 % 56.2 % 54.0 % 55.7 % Cost of product revenue includes costs of materials, amounts paid to third-party contract manufacturers, costs related to warranty obligations, charges for excess and obsolete inventory, royalties under technology license agreements, and internal costs associated with manufacturing overhead, including management, manufacturing engineering, quality assurance, development of test plans, and document control. We outsource substantially all of our manufacturing and supply chain management operations, and we conduct quality assurance, manufacturing engineering, document control and distribution in Santa Clara, California, China, and Taiwan. Accordingly, a significant portion of our cost of product revenue consists of payments to our primary contract manufacturer located in Hsinchu, Taiwan. In addition, we OEM our wireless product line from Motorola. Product gross margin decreased to 53.4% from 54.1% in the third quarter of fiscal 2013, and decreased to 51.5% from 54.1% in the nine months ending March 31, 2013, compared to the corresponding periods of fiscal 2012. The decrease in product gross margin for the third quarter of fiscal 2013 was primarily due to lower product revenue offset by economic benefits realized in our manufacturing costs. The decrease in product gross margin for the nine months ending March 31, 2013, compared to the corresponding periods of fiscal 2012 was primarily due to lower product revenue and an increase in charges for excess and obsolete inventory offset by economic benefits realized in our manufacturing costs. Our cost of service revenue consists primarily of labor, overhead, repair and freight costs and the cost of spares used in providing support under customer service contracts. Service gross margin increased to 64.2% from 64.0% in the third quarter of fiscal 2013 and increased to 63.6% from 62.5% in the nine months ending March 31, 2013. The increases in service gross margin were primarily due to lower material costs. Operating Expenses The following table presents operating expenses and operating income (in thousands, except percentages): Three Months Ended Nine Months Ended March 31, April 1, $ % March 31, April 1, $ % 2013 2012 Change Change 2013 2012 Change Change Research and development $ 9,381 $ 10,376 $ (995 ) (9.6 )% $ 30,954 $ 33,866 $ (2,912 ) (8.6 )% Sales and marketing 20,644 20,657 (13 ) (0.1 )% 64,764 65,512 (748 ) (1.1 )% General and administrative 6,288 7,553 (1,265 ) (16.7 )% 18,292 21,777 (3,485 ) (16.0 )% Restructuring charge, net of reversals 1,076 (35 ) 1,111 3,174.3 % 6,242 1,357 4,885 360.0 % Litigation settlement 2,450 - 2,450 100.0 % 2,029 - 2,029 100.0 % Gain on sale of campus - - - - % (11,539 ) - (11,539 ) (100.0 )%Total operating expenses $ 39,839 $ 38,551 $ 1,288 3.3 % $ 110,742 $ 122,512 $ (11,770 ) (9.6 )% Operating income $ (1,902 ) 2,660 $ (4,562 ) (171.5 )% $ 7,909 $ 8,503 $ (594 ) (7.0 )% 22 -------------------------------------------------------------------------------- Table of Contents The following table highlights our operating expenses and operating income as a percentage of net revenues: Three Months Ended Nine Months Ended March 31, April 1, March 31, April 1, 2013 2012 2013 2012 Research and development 13.8 % 14.1 % 14.1 % 14.4 % Sales and marketing 30.3 % 28.2 % 29.5 % 27.9 % General and administrative 9.2 % 10.3 % 8.3 % 9.3 % Restructuring charge, net of reversals 1.6 % (0.1 )% 2.8 % 0.6 % Litigation settlement 3.6 % - % 0.9 % - % Gain on sale of campus - % - % (5.2 )% - % Total operating expenses 58.5 % 52.5 % 50.4 % 52.2 % Operating income (2.8 )% 3.6 % 3.6 % 3.6 % Research and Development Expenses Research and development expenses consist primarily of salaries and related personnel expenses, consultant fees and prototype expenses related to the design, development, and testing of our products. Research and development expenses decreased by $1.0 million, or 9.6% in the third quarter of fiscal 2013 and decreased by $2.9 million, or 8.6% in the nine months ending March 31, 2013, compared to the corresponding periods of fiscal 2012. The decreases in research and development expenses primarily resulted from lower spending on engineering project expenses due to differences in the timing and pattern of planned engineering project spending in the nine months ending March 31, 2013 when compared to the same period last year. Sales and Marketing Expenses Sales and marketing expenses consist of salaries, commissions and related expenses for personnel engaged in marketing and sales functions, as well as trade shows and promotional expenses. Sales and marketing expenses decreased by an immaterial amount, or 0.1% in the third quarter of fiscal 2013 and decreased by $0.7 million, or 1.1% in the nine months ending March 31, 2013, compared to the corresponding periods of fiscal 2012. The decreases in sales and marketing expenses were primarily due to decreases in commissions in the three and nine months ended March 31, 2013. General and Administrative Expenses General and administrative expenses decreased by $1.3 million, or 16.7% in the third quarter of fiscal 2013 and decreased by $3.5 million, or 16.0% in the nine months ending March 31, 2013, compared to the corresponding periods of fiscal 2012. The decreases in general and administrative expenses during the three months ending March 31, 2013, compared to the corresponding period of fiscal 2012, was primarily due to cost reduction initiatives realized as part of our restructuring plan. The decreases in general and administrative expenses during the nine months ending March 31, 2013, compared to the corresponding period of fiscal 2012, was mainly attributable to lower legal costs due to the resolution of certain legal matters. Restructuring Charge, Net of Reversals Restructuring charges increased by $1.1 million in the third quarter of fiscal 2013 and increased by $4.9 million in the nine months ending March 31, 2013, compared to the corresponding periods of fiscal 2012. During the second quarter of fiscal 2013, we further reduced costs through targeted restructuring activities intended to reduce operating costs and realign our organization in the current competitive environment. As part of our restructuring efforts in the second quarter, we initiated a plan to reduce our worldwide headcount by 13%, consolidate specific global administrative functions, and shift certain operating costs to lower cost regions, among other actions. As of March 31, 2013, we had restructuring liabilities of $1.8 million, which we anticipate paying by the end of the first quarter of fiscal 2014. We anticipate incurring additional restructuring charges of approximately $0.6 million through the end of first quarter of fiscal 2014. Litigation Settlement, Net During the third quarter of fiscal 2013, we recognized a litigation charge of $2.5 million related to a settlement agreement with Enterasys Networks Inc. 23-------------------------------------------------------------------------------- Table of Contents Gain on Campus Sale During the first quarter of fiscal 2013, we completed the sale of our corporate campus and accompanying 16 acres of land in Santa Clara, California for net cash proceeds of approximately $44.7 million. We realized a gain of approximately $11.5 million in connection with this transaction. Other Expense, Net Other expense, net increased by $0.1 million in the third quarter of fiscal 2013 and increased by $0.8 million in the nine months ending March 31, 2013, compared to the corresponding periods of fiscal 2012. The change in other expense, net in the third quarter of fiscal 2013, as compared to the same period in fiscal 2012, was insignificant. The increase in other expense, net in the nine months ending March 31, 2013, as compared to the same period of fiscal 2012 was primarily due to gains from the revaluation of certain assets and liabilities denominated in foreign currencies into U.S. dollars. Provision for Income Taxes We recorded an income tax provision of $0.4 million and $0.5 million for the three months ended March 31, 2013 and April 1, 2012, respectively. We recorded an income tax provision of $1.4 million and $1.2 million for the nine months ended March 31, 2013 and April 1, 2012, respectively. The income tax provision for the third quarter of fiscal 2013 consisted primarily of taxes on foreign income and U.S state income taxes. The income tax provision for the third quarter of fiscal 2012 consisted primarily of taxes on foreign income and U.S. state income taxes. The income tax provisions for both quarters were calculated based on the results of operations for the three and nine months ended March 31, 2013 and April 1, 2012, and may not reflect the annual effective rate. We have provided a full valuation allowance for our U.S. net deferred tax assets after assessing both negative and positive evidence when measuring the need for a valuation allowance. For the current quarter, negative evidence, such as the Company's current quarter financial performance, the Company's significant restructuring in the current quarter, and the unfavorable macroeconomic climate were given more weight than our expectations of future profitability, which are inherently uncertain. Accordingly, we believe that there is sufficient negative evidence to maintain a full valuation allowance against our U.S. federal and state net deferred tax assets. This valuation allowance will be evaluated periodically and can be reversed partially or totally if business results have sufficiently improved to support realization of our U.S. deferred tax assets. The sale of our buildings and land in Santa Clara, California during the quarter ended September 30, 2012 resulted in a tax loss that increased the amount of our deferred tax assets with a corresponding increase to the related valuation allowance. Critical Accounting Policies and Estimates Our unaudited condensed consolidated financial statements and the related notes included elsewhere in this report are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. On an ongoing basis, we evaluate our estimates and assumptions. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. As discussed in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report on Form 10-K for the year ended June 30, 2012, we consider the following accounting policies to be the most critical in understanding the judgments that are involved in preparing our consolidated financial statements: • Revenue Recognition • Inventory Valuation • Long Lived Assets • Allowance for Doubtful Accounts • Deferred Tax Valuation Allowance • Accounting for Uncertainty in Income Taxes • Share-Based Compensation 24-------------------------------------------------------------------------------- Table of Contents • Legal Contingencies • Restructuring Costs There have been no changes to our critical accounting policies since the filing of our last Annual Report on Form 10-K. Liquidity and Capital Resources The following summarizes information regarding our cash, investments, and working capital (in thousands): March 31, June 30, 2013 2012 Cash and cash equivalent $ 77,592 $ 54,596 Short-term investments 42,336 23,358 Marketable securities 69,171 75,561 Total cash and investments $ 189,099 $ 153,515 Working capital $ 100,572 $ 72,361 As of March 31, 2013, our principal sources of liquidity consisted of cash, cash equivalents and investments of $189.1 million and net accounts receivable of $43.6 million. Historically, our principal uses of cash have consisted of the purchase of finished goods inventory from our contract manufacturers, payroll and other operating expenses related to the development, marketing of our products and purchases of property and equipment and repurchases of our common stock. We believe that our $189.1 million of cash and cash equivalents and investments at March 31, 2013 will be sufficient to fund our operating requirements, stock repurchase program, and restructuring expenses for at least the next 12 months. Key Components of Cash Flows and Liquidity A summary of the sources and uses of cash and cash equivalents is as follows (in thousands): Nine Months Ended March 31, April 1, 2013 2012 Net cash provided by operating activities $ 7,003 $ 6,407 Net cash provided by (used in) investing activities $ 24,134 $ (3,905 ) Net cash (used in) provided by financing activities $ (8,434 ) $ 1,754 Foreign currency effect on cash $ 293 $ (905 ) Net increase (decrease) in cash and cash equivalents $ 22,996 $ 3,351 Net Cash Provided by Operating Activities Cash flows from operations increased by $0.6 million in the nine months ending March 31, 2013 compared to the corresponding period of fiscal 2012, primarily due to purposeful reduction of inventory spending to bring inventory levels in line with the anticipated near-term demand for our products. Net Cash Provided by Investing Activities Cash flow provided by investing activities in the nine months ending March 31, 2013 was $24.1 million, comprised of proceeds of $42.7 million from the sale of buildings and land in Santa Clara California, proceeds of $26.3 million from the sale and maturities of investments, offset by $40.1 million used to purchase investment securities and $4.8 million used to purchase property and equipment. Net Cash Used in Financing Activities Cash flow used in financing activities in the nine months ending March 31, 2013 was $8.4 million, comprised of $11.0 million used to repurchase shares of our common stock, offset by $2.5 million of proceeds from the exercise of stock options and purchases of shares of our common stock under the ESPP, net of taxes paid on vested and released stock awards. 25-------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following summarizes our contractual obligations at March 31, 2013, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands): Less than 1 More than 5 Total Year 1-3 years 3-5 years years Contractual Obligations: Non-Cancellable Inventory purchase commitments $ 30,324 $ 30,324 $ - $ - $ - Non-cancellable operating lease obligations 35,886 4,711 9,023 7,636 14,516 Total contractual cash obligations $ 66,210 $ 35,035 $ 9,023 $ 7,636 $ 14,516 Non-cancelable inventory purchase commitments represent the purchase of long lead-time component inventory that our contract manufacturers procure in accordance with our forecast. Inventory purchase commitments were $30.3 million as of March 31, 2013, a decrease of $8.5 million from $38.8 million as of June 30, 2012. We expect to honor the inventory purchase commitments within the next 12 months. The amounts in the table above exclude $0.5 million of income tax liabilities related to uncertain tax positions as we are unable to reasonably estimate the timing of settlement. We did not have any material commitments for capital expenditures as of March 31, 2013. Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements as of March 31, 2013. |