[May 10, 2013] EMULEX CORP /DE/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) Executive Overview Emulex, a leader in network connectivity, monitoring and management, provides hardware and software solutions for global networks that support enterprise, cloud, government and telecommunications. During the three months ended March 31, 2013, Emulex acquired 99.9% of the outstanding common stock of Endace Limited (Endace), a leading supplier of network visibility infrastructure products. Prior to the acquisition of Endace, Emulex operated within a single business segment. With the acquisition of Endace, Emulex formed the Visibility operating segment, which includes Network Visibility Products. Emulex's products enable end-to-end application visibility, optimization and acceleration. The Company's I/O connectivity offerings, including its line of ultra high-performance Ethernet and Fibre Channel-based connectivity products, have been designed into server and storage solutions from leading original equipment manufacturers (OEMs), including Cisco, Dell, EMC, Fujitsu, Hitachi, HP, Huawei, IBM, NetApp and Oracle, and can be found in the data centers of nearly all of the Fortune 1000. Emulex's monitoring and management solutions, including its portfolio of network visibility and recording products, provide organizations with complete network performance management at speeds up to 100Gb Ethernet (100GbE). We rely almost exclusively on OEMs and sales through distribution channels for our revenue. Our significant OEM customers include the world's leading server and storage providers, including Cisco Systems, Inc. (Cisco), Dell Inc. (Dell), EMC Corporation (EMC), Fujitsu Ltd. (Fujitsu), Hewlett-Packard Company (Hewlett-Packard), Hitachi Data Systems (HDS), Hitachi Limited (Hitachi), Huawei Technologies Company Ltd. (Huawei), Intel Corporation (Intel), International Business Machines Corporation (IBM), NEC Corporation (NEC), Network Appliance, Inc. (NetApp), Oracle Corporation (Oracle), and Xyratex Ltd. (Xyratex). Our significant distributors include ASI Computer Technologies, Inc. (ASI), Avnet, Inc. (Avnet), British Telecom (BT), Digital China Technology Limited, Info X Distribution, LLC (Info X), Ingram Micro Inc. (Ingram Micro), Macnica Networks Corporation (Macnica), Netmarks Inc. (Netmarks), SYNNEX Corporation (SYNNEX), Tech Data Corporation (Tech Data), and Tokyo Electron Device Ltd. (TED). The market for networking infrastructure solutions is concentrated among large OEMs, and as such, a significant portion of our revenues are generated from sales to a limited number of customers. As of March 31, 2013, we had a total of 1,250 employees. Our corporate headquarters are located at 3333 Susan Street, Costa Mesa, California 92626. Our periodic and current reports filed with, or furnished to, the Securities and Exchange Commission pursuant to the requirements of the Securities and Exchange Act of 1934 are available free of charge through our website (www.emulex.com) as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission. References contained herein to "Emulex," the "Company," the "Registrant," "we," "our," and "us" refer to Emulex Corporation and its subsidiaries. Business Operating Segments With our acquisition of Endace, our network connectivity, monitoring and management solutions are now broken into two business operating segments consisting of four product lines. Our Networking Segment consists of our legacy Emulex products and includes Network Connectivity Products (NCP), Storage Connectivity Products (SCP) and Advanced Technology and Other Products (ATP). Our Visibility Segment consists of our Network Visibility Products (NVP) that were acquired through the Endace acquisition. Networking Segment Products: NCP includes industry standard Fibre Channel and Ethernet-based solutions that provide server Input/Output (I/O) and target storage array connectivity to create networks for mission-critical enterprise and cloud data centers. These products enable servers to reliably and efficiently connect to Local Area Networks (LANs), Storage Area Networks (SANs), and Network Attached Storage (NAS) by offloading data communication processing tasks from the server as information is delivered and sent to the network. Our NCP use industry standard protocols including Fibre Channel Protocol (FCP), Internet Protocol (IP), Transmission Control Protocol (TCP)/IP, internet Small Computer System Interface (iSCSI), NAS, and Fibre Channel over Ethernet (FCoE). Emulex Ethernet-based products include our OneConnect® Universal Converged Network Adapters (UCNAs) and Local Area Network on Motherboard (LOM) application specific integrated circuits, and custom form factor solutions for OEM blade servers that enable high performance, scalable networks and convergence. Emulex Fibre Channel-based products include LightPulse® Host Bus Adapters (HBAs), Fibre Channel application specific integrated circuits (ASICs) and custom form factor solutions for OEM blade servers. 21 -------------------------------------------------------------------------------- Table of Contents SCP includes Emulex InSpeed®, switch-on-a-chip (SOC) and backend connectivity, bridge, and router products. SCP is deployed inside storage arrays, tape libraries, and other storage appliances, and connect storage controllers to storage capacity, delivering improved performance, reliability, and connectivity. Emulex SCP uses industry standard protocols including Fibre Channel, Serial Attached Small Computer Interface (SAS), and Serial Advanced Technology Attachment (SATA), and support the broadest range of Hard Disk Drive (HDD) and Solid State Disk (SSD) technologies. ATP primarily consists of Pilot™ Integrated Baseboard Management Controllers (iBMC), OneCommand® Vision I/O performance management software, certain legacy products and other products and services. Visibility Segment Products: NVP consists entirely of the recently acquired Endace® family of network visibility and intelligent network recording products. The EndaceProbe™ captures, indexes and stores network traffic history in order to help organizations troubleshoot problems and respond to network security breaches. EndaceVision™ is a browser-based network traffic search engine that enables engineers to search through large amounts of network history in order to find the network traffic that they need to investigate specific issues. EndaceProbe™ appliances connect to the network via passive network taps or via SPAN ports found on routers and switches. For ultra-fast network segments EndaceAccess™ network visibility headend systems can be used to load balance network traffic across multiple 10GbE ports. Underpinning all of the Endace family of network visibility and recording products are the Data Acquisition and Generation (DAG) network capture cards that are integrated into the EndaceProbe™ appliances and sold as stand-alone components for use in a wide range of monitoring and security systems. For additional information about our operating segments, please see Note 13, "Operating Segment Information," in the accompanying notes to condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q. Business Combination On February 26, 2013, we acquired 89.6% of the outstanding common stock and all of the outstanding stock options of Endace Limited (Endace) for cash consideration of approximately $110.4 million. As of March 31, 2013, we had acquired an additional 10.3% of the outstanding stock of Endace for approximately $12.0 million and had initiated compulsory acquisition proceedings for the remaining outstanding stock. The compulsory acquisition proceedings to acquire the remaining outstanding shares of Endace were concluded on April 25, 2013, at which time we acquired the outstanding noncontrolling interest and obtained ownership of 100% of Endace for approximately $122.4 million. See Note 2, "Business Combination," in the accompanying notes to condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for additional information. Product Redesign Activities and Potential Royalty Obligations Broadcom Corporation (Broadcom) filed a consolidated patent infringement suit against us during fiscal 2010. After a nearly three week trial that ended October 6, 2011, the jury reached a partial verdict involving two out of the six patents. The Court determined that one of the patents (U.S. Patent 7,058,150) [the '150 patent] had been infringed by us, and the jury rendered an advisory verdict on October 12, 2011 to the Court that it is not invalid, and awarded approximately $0.4 million in damages with respect to that patent. The jury reached a unanimous verdict of non-infringement on another patent relating to Emulex Fibre Channel switch products. A mistrial was declared concerning the remaining four patents for which no unanimous verdict was reached. On December 15, 2011, the Court issued judgments as a matter of law (JMOL) that the two patents, on which the jury had rendered advisory verdicts, were not invalid. On December 16, 2011, the Court issued an additional JMOL that one of the patents (U.S. Patent 7,471,691) [the '691 patent] had been infringed by us. On March 16, 2012, the Court issued a decision concerning injunctive relief for the '150 and the '691 patents. The decision provided, in part, for a sunset period of 18 months relating to the '150 patent, starting on October 12, 2011. The decision further provided for a sunset period of 18 months relating to the '691 patent, starting on December 16, 2011. The sunset period allows us to sell the affected products to existing customers for specific customer devices, subject to limitations relating to when the products had been qualified and 22-------------------------------------------------------------------------------- Table of Contents when certain firm orders had been placed. On April 3, 2012, the Court issued a permanent injunction (2012 Permanent Injunction) which, with respect to both the '150 and the '691 patents, further describes the prohibited activities, contains sunset provision terms including royalty rates and computations, limits the territory to allow sales of products that are manufactured outside the U.S. to customers located outside the U.S., permits design around efforts including modifications and design, development, and testing to eliminate infringement, and permits service and technical support for certain products. We expect to incur incremental mitigation, product redesign, appeal related expenses during the remainder of fiscal 2013 and fiscal 2014 in the range of $11 million to $12 million. Through March 31, 2013, we have incurred approximately $8.1 million of such expenses, approximately $3.1 million and $4.5 million of which were recorded in the three months and nine months ended March 31, 2013, respectively. Engineering and development costs will include expenses for activities to redesign, design around, modify, design, develop, test and requalify certain of our affected products during the sunset period, and to implement our end of life processes in the U.S. for certain other affected products. Sales and marketing costs are likely to include expenses for customer support, pre-production samples, education and training, and other miscellaneous costs. General and administrative costs will include expenses for our appeal of the previous verdicts and judgments. In addition, we may be required to participate in certain customer royalty obligations arising under their licensing agreements with Broadcom in the range of $1 million to $8 million during the remainder of fiscal 2013 and fiscal 2014. Such costs would reduce gross margins in the periods accrued. See Note 8, "Commitments and Contingencies," in the accompanying notes to condensed consolidated financial statements under the caption "Litigation" in Part I, Item 1 of this Form 10-Q for additional information. Results of Operations The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements included elsewhere herein. Percentage of Net Revenues Percentage of Net Revenues Three Months Ended Nine Months Ended March 31, April 1, March 31, April 1, 2013 2012 2013 2012 Net revenues 100 % 100 % 100 % 100 % Cost of sales: Cost of goods sold 36 36 36 37 Amortization of core and developed technology intangible assets 5 4 5 5 Patent litigation settlement, damages, sunset period royalties and license fees 1 1 1 - Total cost of sales 42 41 42 42 Gross profit 58 59 58 58 Operating expenses: Engineering and development 37 32 34 33 Selling and marketing 15 13 13 12 General and administrative 8 7 8 8 Amortization of other intangible assets 1 1 1 1 Total operating expenses 61 53 56 54 Operating (loss) income (3 ) 6 2 4 Non-operating (expense) income, net: Interest income - - - - Interest expense - - - - Other (expense) income, net (4 ) - (1 ) - Total non-operating (expense) income, net (4 ) - (1 ) - (Loss) income before income taxes (7 ) 6 1 4 Income tax benefit (provision) 1 1 (1 ) - Net (loss) income (6 )% 7 % - % 4 % 23 -------------------------------------------------------------------------------- Table of Contents Three months ended March 31, 2013, compared to three months ended April 1, 2012 Net Revenues. Net revenues for the three months ended March 31, 2013, decreased by approximately $9.0 million, or 7%, to approximately $116.8 million, compared to approximately $125.7 million for the three months ended April 1, 2012. The decrease in revenues was primarily due to weakness in the server and storage technology markets resulting from continuing concern over the global macroeconomic climate. Net Revenues by Operating Segment and Product LineNet revenues by operating segment and product line were as follows: Net Revenues by Operating Segment and Product Line Three Months Three Months Ended Percentage Ended Percentage March 31, of Net April 1, of Net Increase/ Percentage (in thousands) 2013 Revenues 2012 Revenues (Decrease) Change Networking Segment: Network Connectivity Products $ 85,166 73 % $ 91,127 73 % $ (5,961 ) (7 )% Storage Connectivity Products 20,833 18 % 27,855 22 % (7,022 ) (25 )% Advanced Technology & Other Products 5,914 5 % 6,764 5 % (850 ) (13 )% Total Networking Segment 111,913 96 % 125,746 100 % (13,833 ) (11 )% Visibility Segment: Network Visibility Products 4,873 4 % - - % 4,873 N/A Total net revenues $ 116,786 100 % $ 125,746 100 % $ (8,960 ) (7 )% Networking segment revenues, which includes revenues from NCP, SCP and ATP, decreased by approximately 11% for the three months ended March 31, 2013 compared to the three months ended April 1, 2012, primarily due to decreases in NCP and SCP revenues. NCP primarily consists of standup HBAs, mezzanine cards, I/O ASICs, LOMs, and UCNAs. For the three months ended March 31, 2013, Ethernet based products revenues decreased by approximately $9.6 million, or 37%, from the same period in the prior year, while Fibre Channel based products, which accounted for approximately 67% of total NCP revenues in the three months ended March 31, 2013, decreased by approximately $2.2 million, or 4%. The decrease in Ethernet based products revenue was primarily due to a decrease in units shipped of approximately 55%, arising principally from lower customer demand for 10Gb LOM products as customers consumed residual inventory purchased in prior periods. This was partially offset by an increase in average selling price of approximately 43% due to a change in product mix. The decrease in Fibre-Channel based products revenue was primarily due to a decrease in average selling price of approximately 9%, partially offset by an increase in units shipped of approximately 6%. SCP primarily consists of InSpeed®, SOC and backend connectivity, bridge, and router products. Our SCP revenues decreased by approximately $7.0 million, or 25%, for the three months ended March 31, 2013 compared to the three months ended April 1, 2012, primarily due to a 35% decline in bridging products revenue as a result of a 31% decrease in units shipped due to last-time buys of certain products reaching end of life during fiscal 2012. Our SCP revenue is expected to be lower in the fourth quarter of fiscal 2013 compared to the same period in the prior year. ATP primarily consists of iBMCs, OneCommand® Vision software products, certain legacy products and other products and services. For the three months ended March 31, 2013, iBMC based products accounted for the majority of ATP revenues. The decrease in our ATP revenues for the three months ended March 31, 2013 was primarily due to a decrease in units shipped of approximately 16%. The Visibility segment, which includes the revenues from NVP, had revenues of approximately $4.9 million for the three months ended March 31, 2013 compared to no revenues for the three months ended April 1, 2012 as NVP revenues resulted from the Endace acquisition on February 26, 2013. NVP consists entirely of the recently acquired Endace® family of network visibility and intelligent network recording products. Revenues from systems sales and DAG cards accounted for approximately 69% and 17%, respectively, of total NVP revenues for the three months ended March 31, 2013. Net Revenues by Major Customers In addition to direct sales, some of our larger OEM customers purchase or market products indirectly through distributors, resellers or other third parties. If these indirect sales are purchases of customer-specific models, we are able to track these sales. However, if these indirect sales are purchases of our standard models, we are not able to distinguish them 24-------------------------------------------------------------------------------- Table of Contents by OEM customer. Customers whose direct net revenues, or total direct and indirect net revenues (including customer-specific models purchased or marketed indirectly through distributors, resellers and other third parties), exceeded 10% of our net revenues were as follows: Net Revenues by Major Customers Total Direct and Indirect Revenues Direct Revenues (2) Three Months Three Months Three Months Three Months Ended Ended Ended Ended March 31, April 1, March 31, April 1, 2013 2012 2013 2012 Net revenue percentage (1): OEM: EMC - - 12 % 11 % Hewlett-Packard 18 % 24 % 25 % 28 % Hon Hai Precision Industry Co., Ltd. (Foxconn Technology Group) (3) 13 % - - - IBM 28 % 27 % 32 % 31 % (1) Amounts less than 10% are not presented. (2) Customer-specific models purchased or marketed indirectly through distributors, resellers, and other third parties are included with the OEM's revenues in these columns rather than as revenue for the distributors, resellers or other third parties. (3) Hon Hai Precision Industry Co., Ltd. is a contract manufacturer that performed manufacturing for some of our OEM customers. Direct sales to our top five customers accounted for approximately 68% of total net revenues for the three months ended March 31, 2013, compared to approximately 70% for the three months ended April 1, 2012. Direct and indirect sales to our top five customers accounted for approximately 79% of total net revenues for the three months ended March 31, 2013, compared to approximately 82% for the three months ended April 1, 2012. Our net revenues from customers can be significantly impacted by changes to our customers' business and their business models. Net Revenues by Sales Channel Net revenues by sales channel were as follows: Net Revenues by Sales Channel Three Months Three Months Ended Percentage Ended Percentage March 31, of Net April 1, of Net Increase/ Percentage (in thousands) 2013 Revenues 2012 Revenues (Decrease) Change OEM $ 100,975 86 % $ 115,327 92 % $ (14,352 ) (12 )% Distribution 13,985 12 % 10,282 8 3,703 36 % Other 1,826 2 % 137 - 1,689 1,233 % Total net revenues $ 116,786 100 % $ 125,746 100 % $ (8,960 ) (7 )% The decrease in OEM net revenues for the three months ended March 31, 2013 compared to the three months ended April 1, 2012 reflected decreases of approximately 24% in SCP revenues, 8% in NCP revenues, and 11% in ATP revenues. The increase in distribution net revenues for the three months ended March 31, 2013 compared to the three months ended April 1, 2012 was primarily due to additional NVP net revenues generated through distribution partners. We believe that our net revenues are being generated primarily as a result of product certifications and qualifications with our OEM customers, which take products directly and indirectly through distribution and contract manufacturers. We view product certifications and qualifications as an important indicator of future revenue opportunities and growth for the Company. However, product certifications and qualifications do not necessarily ensure continued market acceptance of our products by our OEM customers. It is also very difficult to determine the future impact, if any, of product certifications and qualifications on our revenues. 25-------------------------------------------------------------------------------- Table of Contents Net Revenues by Geographic Territory Our net revenues by geographic territory based on billed-to location were as follows: Net Revenues by Geographic Territory Three Months Three Months Ended Percentage Ended Percentage March 31, of Net April 1, of Net Increase/ Percentage (in thousands) 2013 Revenues 2012 Revenues (Decrease) Change Asia Pacific $ 65,285 56 % $ 67,461 54 % $ (2,176 ) (3 )% United States 29,713 26 % 40,100 32 % (10,387 ) (26 )% Europe, Middle East, and Africa 19,088 16 % 17,919 14 % 1,169 7 % Rest of the world 2,700 2 % 266 - 2,434 915 % Total net revenues $ 116,786 100 % $ 125,746 100 % $ (8,960 ) (7 )% We believe the increase in Asia Pacific net revenues and decreases in United States (US) and Europe, Middle East, and Africa (EMEA) net revenues, all as a percentage of total net revenues for the three months ended March 31, 2013 compared to the three months ended April 1, 2012, were primarily due to our OEM customers continuing to migrate towards using contract manufacturers that are predominately located in Asia Pacific. However, as we sell to OEMs and distributors who ultimately resell our products to their customers, the geographic mix of our net revenues based on billed-to location may not be reflective of the geographic mix of end-user demand or installations. Gross Profit. Gross profit consists of net revenues less cost of sales. Our gross profit was as follows (in thousands): Gross Profit Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 68,240 58 % $ 74,759 59 % $ (6,519 ) (1 )% Cost of sales includes the cost of producing, supporting, and managing our supply of finished products. Approximately $0.2 million of share-based compensation expense was included in both the three months ended March 31, 2013 and the three months ended April 1, 2012. Approximately $5.5 million and $5.2 million of amortization of technology intangible assets were included in cost of sales for the three months ended March 31, 2013 and April 1, 2012, respectively. The increase in amortization of technology intangible assets was primarily due to acquired finite-lived intangible assets of approximately $41.5 million from the Endace acquisition. See Note 2, "Business Combination," and Note 5, "Goodwill and Intangible Assets, net," in the accompanying notes to condensed consolidated financial statements included in Part I, Item 1 of this Form 10-Q for additional details. Our gross margin percentage for the three months ended March 31, 2013 remained comparable to the three months ended April 1, 2012 due to favorable product mix that was offset by sunset period royalty and patent license fee amortization expenses of approximately $1.4 million related to the Settlement Agreement entered into with Broadcom on July 3, 2012. We will continue to recognize amortization expenses for technology intangible assets over their remaining useful lives, patent license fee related to the Settlement Agreement over the remaining patent license term (which expires on July 1, 2020) and sunset period royalty expenses related to the amended 2012 Permanent Injunction through fiscal 2014. We expect our gross margin percentage to trend downward as the portion of our revenues generated from lower margin products increases in the future. In addition, we will continue to recognize amortization expenses for technology intangible assets over their remaining useful lives, patent license fee related to the Settlement Agreement over the remaining patent license term (which expires on July 1, 2020) and sunset period royalty expenses through fiscal 2014. We may also incur potential costs to reimburse certain customers or directly pay Broadcom certain customer royalty obligations arising in connection from their licensing agreements with Broadcom related to the amended 2012 Permanent Injunction. See "Product Redesign Activities and Potential Royalty Obligations" elsewhere in Part I, Item 2 of this Form 10-Q. Engineering and Development. Engineering and development expenses consist primarily of salaries and related expenses for personnel engaged in the design, development, and support of our products. These expenses also include third-party fees paid to consultants, prototype development expenses, and computer service costs related to supporting computer tools used in the design process. Engineering and development expenses were as follows (in thousands): Engineering and Development Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 43,661 37 % $ 40,361 32 % $ 3,300 5 % 26 -------------------------------------------------------------------------------- Table of Contents Engineering and development expenses increased from approximately $40.4 million during the three months ended April 1, 2012 to approximately $43.7 million for the three months ended March 31, 2013. Approximately $2.6 million and $2.5 million of share-based compensation expense were included in engineering and development costs for the three months ended March 31, 2013 and April 1, 2012, respectively. Engineering and development expenses increased due to an increase in product redesign expenses of approximately $2.4 million related to our mitigation activities for the 2012 Permanent Injunction. Salary and related expenses also increased by approximately $1.7 million due to an increase in headcount from 641 at April 1, 2012 to 781 at March 31, 2013, of which approximately $0.8 million and 83 headcount were associated with our acquisition of Endace. This was partially offset by a decrease of approximately $1.2 million due to lower new product development costs. We plan to continue to invest in engineering and development costs. In addition, due to the 2012 Permanent Injunction, we expect to continue to incur incremental engineering and development expenses to redesign our impacted products through fiscal 2014. See "Product Redesign Activities and Potential Royalty Obligations" and "Business Combination" elsewhere in Part I, Item 2 of this Form 10-Q. Selling and Marketing. Selling and marketing expenses consist primarily of salaries, commissions, and related expenses for personnel engaged in the marketing and sales of our products, as well as samples, trade shows, product literature, promotional support costs, and other advertising related costs. Sales and marketing expenses were as follows (in thousands): Selling and Marketing Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 17,179 15 % $ 15,897 13 % $ 1,282 2 % Selling and marketing expenses for the three months ended March 31, 2013 compared to the three months ended April 1, 2012 increased approximately $1.3 million, or 8%. Approximately $0.9 million of share-based compensation expense were included in selling and marketing costs for each of the three months ended March 31, 2013 and April 1, 2012. Selling and marketing headcount increased to 220 at March 31, 2013 from 150 at April 1, 2012, resulting in an increase in salary and related expenses of approximately $1.8 million, partially offset by a decrease in advertising costs of approximately $0.9 million. Approximately 64 of the increase in headcount and approximately $1.3 million of salary and related expenses were associated with the Endace acquisition. We plan to continue to closely manage and target advertising and market promotion expenses to heighten brand awareness of our new and existing products in an effort to provide overall revenue growth. Due to the 2012 Permanent Injunction, we expect to continue to incur incremental sales and marketing expenses to requalify and recertify our impacted products with customers through fiscal 2014. See "Product Redesign Activities and Potential Royalty Obligations" and "Business Combination" elsewhere in Part I, Item 2 of this Form 10-Q. General and Administrative. Ongoing general and administrative expenses consist primarily of salaries and related expenses for executives, financial accounting support, human resources, administrative services, professional fees, and other corporate expenses. General and administrative expenses were as follows (in thousands): General and Administrative Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 9,526 8 % $ 8,820 7 % $ 706 1 % General and administrative expenses for the three months ended March 31, 2013 compared to the three months ended April 1, 2012 increased approximately $0.7 million, or 8%. Approximately $1.6 million and $2.1 million of share-based compensation expense were included in general and administrative costs for the three months ended March 31, 2013 and April 1, 2012, respectively. Offsetting the decrease in shared-based compensation was an increase of approximately $0.8 million in legal and accounting costs related to the Endace acquisition, an increase of approximately $0.4 million in salary and related expenses, and an increase of approximately $0.4 million in legal costs related to our mitigation activities for the 2012 Permanent Injunction. General and administrative headcount increased to 165 at March 31, 2013 from 139 at April 1, 2012, 27 of which was associated with the Endace acquisition. We expect to continue to incur incremental general and administrative expenses related to our mitigation activities for the 2012 Permanent Injunction and our acquisition of Endace through fiscal 2014. See "Product Redesign Activities and Potential Royalty Obligations" and "Business Combination" elsewhere in Part I, Item 2 of this Form 10-Q. 27 -------------------------------------------------------------------------------- Table of Contents Amortization of Other Intangible Assets. Amortization of other intangible assets consists of amortization of intangible assets such as patents, customer relationships, tradenames with estimable lives, covenants not to compete, and backlog. Amortization expense was as follows (in thousands): Amortization of Other Intangible Assets Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 1,488 1 % $ 1,603 1 % $ (115 ) - % Amortization of other intangible assets for the three months ended March 31, 2013 compared to the three months ended April 1, 2012 decreased by approximately $0.1 million, or 7%. Approximately $0.3 million of the decrease was due to a lower unamortized intangible assets balance at the beginning of the current three month period as a result of certain intangible assets being fully amortized in fiscal 2012. This was partially offset by an increase of approximately $0.1 million in amortization of other intangibles assets associated with assets acquired from Endace. See "Business Combination" elsewhere in Part I, Item 2 of this Form 10-Q. Non-operating (Expense) Income, net. Non-operating (expense) income, net, consists primarily of interest income, interest expense, and other non-operating income and expense items. Our non-operating (expense) income, net, was as follows (in thousands): Non-operating (Expense) Income, net Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ (4,473 ) (4 )% $ (268 ) - % $ (4,205 ) (4 )% Our non-operating (expense) income, net, for the three months ended March 31, 2013 decreased by approximately $4.2 million, compared to the three months ended April 1, 2012, primarily due to a non-recurring foreign exchange transaction loss of approximately $4.7 million related to the cash consideration paid for Endace resulting from changes in the value of the British Pound Sterling (GBP) relative to the U.S. Dollar (USD) between the date the funds were converted to GBP and the dates the funds were disbursed. Income Tax Benefit (Provision). Income tax benefit (provision) was as follows (in thousands): Income Tax Benefit (Provision) Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 1,117 1 % $ 869 1 % $ 248 - % Income tax benefit for the three months ended March 31, 2013 was approximately $1.1 million, compared to approximately $0.9 million during the three months ended April 1, 2012. Our effective tax benefit rate was approximately 14% and 11% for the three months ended March 31, 2013 and April 1, 2012, respectively. The increase in our effective tax benefit rate for the three months ended March 31, 2013 compared to the three months ended April 1, 2012 was primarily due to the continuing impact of our previously recorded U.S. deferred tax asset valuation allowance, changes in the mix of earnings in international versus U.S. tax jurisdictions and the use of an actual year-to-date effective tax rate for the three months ended March 31, 2013 versus an annualized effective tax rate. We continue to generate the majority of our earnings in countries other than the U.S. including India, Ireland, and Isle of Man, where such earnings are generally subject to significantly lower tax rates than the U.S. We expect this trend to continue in the future. We have made no provision for U.S. income taxes or foreign withholding taxes on the earnings of our foreign subsidiaries as these amounts are intended to be indefinitely reinvested in operations outside of the U.S. We expect to recognize an annual effective tax rate for fiscal 2013 that is substantially different from the U.S. Federal statutory rate, primarily due to the continued impact of our previously recorded U.S. deferred tax valuation allowance, including changes in the estimated timing of reversing temporary differences and the resulting amount of deferred tax assets estimated to be recoverable in available carryback periods, and the mix of earnings in international versus U.S. tax jurisdictions. Actual current year originations and reversals of temporary differences that are recoverable in available carryback periods and subject to our U.S. deferred tax valuation allowance could drive significant volatility in our effective tax rate and actual tax expense for fiscal 2013. In addition, changes in the mix of U.S. versus international earnings and changing tax laws could affect our actual tax expense for fiscal 2013. As estimates and judgments are used to project such originations and reversals of temporary differences and the mix of earning in our various tax jurisdictions, the impact to our tax provision could vary significantly if the current planning or assumptions change. We also do not forecast discrete events, such as a settlement of tax audits with governmental authorities or changes in tax laws, due to their inherent uncertainty. Such discrete events could also materially impact our tax expense. As the tax rate is driven by various factors, it is not possible to estimate our future tax rate with a high degree of certainty. 28 -------------------------------------------------------------------------------- Table of Contents Nine months ended March 31, 2013, compared to nine months ended April 1, 2012 Net Revenues. Net revenues for the nine months ended March 31, 2013 decreased by approximately $14.6 million, or 4%, to approximately $358.2 million compared to approximately $372.8 million for the nine months ended April 1, 2012. Net Revenues by Operating Segment and Product LineNet revenues by operating segment and product line were as follows: Net Revenues by Operating Segment and Product Line Nine Months Nine Months Ended Percentage Ended Percentage March 31, of Net April 1, of Net Increase/ Percentage (in thousands) 2013 Revenues 2012 Revenues (Decrease) ChangeNetworking Segment: Network Connectivity Products $ 278,031 78 % $ 274,336 74 % $ 3,695 1 % Storage Connectivity Products 62,272 17 % 79,320 21 % (17,048 ) (21 )% Advanced Technology & Other Products 13,022 4 % 19,158 5 % (6,136 ) (32 )% Total Networking Segment 353,325 99 % 372,814 100 % (19,489 ) (5 )% Visibility Segment: Network Visibility Products 4,873 1 % - - % 4,873 N/A Total net revenues $ 358,198 100 % $ 372,814 100 % $ (14,616 ) (4 )% Networking segment revenues decreased by approximately 5% for the nine months ended March 31, 2013 compared to the nine months ended April 1, 2012. The decrease in revenues was primarily due to weakness in the server and storage technology markets resulting from continuing concern over the global macroeconomic climate. Within NCP, embedded I/O based product revenue increased by 67% primarily due to an increase in units shipped of approximately 69%, partially offset by a decrease in average selling price of approximately 1%. The increase in embedded I/O based product revenue was offset by decreases of 10% and 2% in revenues of Ethernet based products and Fibre Channel based products. Ethernet based products revenue decreased primarily due to a decrease in units shipped of approximately 24%, arising principally from lower customer demand for 10Gb LOM products as customers consumed residual inventory purchased in prior periods. This was partially offset by an increase in average selling price of approximately 18% due to a change in product mix. Fibre Channel based products revenues, which accounted for approximately 68% and 75% of total NCP revenues for the nine months ended March 31, 2013 and the same period in the prior year, respectively, decreased primarily due to a decrease in average selling price of approximately 7%, partially offset by an increase in units shipped of approximately 6%. Our SCP revenues decreased by approximately $17.0 million, or 21%, for the nine months ended March 31, 2013 compared to the nine months ended April 1, 2012. This decrease was primarily due to a decline in backend connectivity product shipments due to last-time buys of certain products reaching end of life during fiscal 2012. For the nine months ended March 31, 2013, iBMC based products accounted for the majority of total ATP revenues. The decrease in ATP revenue for the nine months ended March 31, 2013 was primarily due to a decrease in units shipped of approximately 23% combined with a decrease in average selling price of approximately 11%. The Visibility segment, which includes the revenues from NVP, had revenues of approximately $4.9 million for the nine months ended March 31, 2013 compared to no revenues for the nine months ended April 1, 2012 as NVP revenues resulted from the Endace acquisition on February 26, 2013. NVP consists entirely of the recently acquired Endace® family of network visibility and intelligent network recording products. Revenues from systems sales and DAG cards accounted for approximately 69% and 17% of total NVP revenues for the nine months ended March 31, 2013. 29-------------------------------------------------------------------------------- Table of Contents Net Revenues by Major Customers Customers whose direct net revenues, or total direct and indirect net revenues (including customer-specific models purchased or marketed indirectly through distributors, resellers and other third parties), exceeded 10% of our net revenues were as follows: Net Revenues by Major Customers Direct Revenues Total Direct and Indirect Revenues (2) Nine Months Nine Months Nine Months Nine Months Ended March 31, Ended April 1, Ended March 31, Ended April 1, 2013 2012 2013 2012 Net revenue percentage (1): OEM: Hewlett-Packard 20 % 24 % 24 % 26 % Hon Hai Precision Industry Co., Ltd. (Foxconn Technology Group) (3) 11 % - - - IBM 32 % 31 % 36 % 35 % EMC - - 11 % - (1) Amounts less than 10% are not presented. (2) Customer-specific models purchased or marketed indirectly through distributors, resellers, and other third parties are included with the OEM's revenues in these columns rather than as revenue for the distributors, resellers or other third parties. (3) Hon Hai Precision Industry Co., Ltd. is a contract manufacturer that performed manufacturing for some of our OEM customers. Direct sales to our top five customers accounted for approximately 72% of total net revenues for the nine months ended March 31, 2013 compared to approximately 71% for the nine months ended April 1, 2012. Direct and indirect sales to our top five customers accounted for approximately 82% of total net revenues for the nine months ended March 31, 2013 compared to approximately 81% for the nine months ended April 1, 2012. Our net revenues from customers can be significantly impacted by changes to our customers' business and their business models. Net Revenues by Sales ChannelNet revenues by sales channel were as follows: Net Revenues by Sales Channel Nine Months Nine Months Ended Percentage Ended Percentage March 31, of Net April 1, of Net Increase/ Percentage (in thousands) 2013 Revenues 2012 Revenues (Decrease) Change OEM $ 320,188 89 % $ 337,288 90 % $ (17,100 ) (5 )% Distribution 36,074 10 % 35,331 10 % 743 2 % Other 1,936 1 % 195 - 1,741 893 % Total net revenues $ 358,198 100 % $ 372,814 100 % $ (14,616 ) (4 )% The decrease in OEM net revenues for the nine months ended March 31, 2013 compared to the nine months ended April 1, 2012 reflected a decrease of approximately 21% in SCP revenues and a decrease of approximately 31% in ATP revenues, partially offset by a 2% increase in NCP generated through our OEMs. The increase in distribution net revenues for the nine months ended March 31, 2013 compared to the nine months ended April 1, 2012 was primarily due to NVP net revenues generated through distribution partners, partially offset by a decrease of approximately 5% in NCP net revenues generated through distribution partners. Net Revenues by Geographic Territory Our net revenues by geographic territory based on billed-to location were as follows: NetRevenues by Geographic Territory Nine Months Nine Months Ended Percentage Ended Percentage March 31, of Net April 1, of Net Increase/ Percentage (in thousands) 2013 Revenues 2012 Revenues (Decrease) Change Asia Pacific $ 215,767 60 % $ 214,515 58 % $ 1,252 1 % United States 87,838 25 % 104,142 28 % (16,304 ) (16 )% Europe, Middle East, and Africa 49,920 14 % 53,267 14 % (3,347 ) (6 )% Rest of the world 4,673 1 % 890 - 3,783 425 % Total net revenues $ 358,198 100 % $ 372,814 100 % $ (14,616 ) (4 )% 30 -------------------------------------------------------------------------------- Table of Contents We believe the increase in Asia Pacific net revenues as a percentage of total net revenues and decrease in US net revenues as a percentage of total net revenues for the nine months ended March 31, 2013 compared to the nine months ended April 1, 2012 were primarily due to our OEM customers continuing to migrate towards using contract manufacturers that are predominately located in Asia Pacific. The EMEA net revenues as a percentage of total net revenues essentially remained unchanged. However, as we sell to OEMs and distributors who ultimately resell our products to their customers, the geographic mix of our net revenues based on billed-to location may not be reflective of the geographic mix of end-user demand or installations. Gross Profit. Gross profit consists of net revenues less cost of sales. Our gross profit was as follows (in thousands): Gross Profit Nine Months Ended Percentage of Nine Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 208,782 58 % $ 215,753 58 % $ (6,971 ) - Cost of sales includes the cost of producing, supporting, and managing our supply of quality finished products. Approximately $0.7 million and $1.0 million of share-based compensation expense and approximately $15.8 million and $18.9 million of amortization of technology intangible assets were included in cost of sales for the nine months ended March 31, 2013 and April 1, 2012, respectively. Our gross margin percentage for the nine months ended March 31, 2013 was comparable to same period in the prior year. The decrease in our gross profit was primarily due to a 4% decrease in net revenues. The decrease in amortization of technology intangible assets was offset by the sunset period royalty and patent license fee amortization expenses of approximately $3.4 million related to the Settlement Agreement entered into with Broadcom on July 3, 2012. Engineering and Development. Engineering and development expenses were as follows (in thousands): Engineering and Development Nine Months Ended Percentage of Nine Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 122,244 34 % $ 121,307 33 % $ 937 1 % Engineering and development expenses for the nine months ended March 31, 2013 compared to the nine months ended April 1, 2012 increased by approximately $0.9 million. Approximately $7.5 million and $7.8 million of share-based compensation expense were included in engineering and development costs for the nine months ended March 31, 2013 and April 1, 2012, respectively. Engineering and development expenses increased due to increased product redesign expenses of approximately $2.9 million related to our mitigation activities for the 2012 Permanent Injunction and increased salary and related expenses of approximately $2.2 million related to an increase in headcount from 641 at April 1, 2012 to 781 at March 31, 2013, partially offset by a decrease of approximately $4.1 million in new product development costs. Approximately 83 of the increase in headcount and approximately $0.8 million of salary and related expenses were associated with the Endace Acquisition. 31-------------------------------------------------------------------------------- Table of Contents Selling and Marketing. Sales and marketing expenses were as follows (in thousands): Selling and Marketing Nine Months Ended Percentage of Nine Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 45,685 13 % $ 45,774 12 % $ (89 ) 1 % Selling and marketing expenses for the nine months ended March 31, 2013 remained comparable to the nine months ended April 1, 2012. Approximately $2.6 million and $2.9 million of share-based compensation expense were included in selling and marketing costs for the nine months ended March 31, 2013 and April 1, 2012, respectively. Selling and marketing headcount increased to 220 at March 31, 2013 from 150 at April 1, 2012 primarily due to the Endace acquisition on February 26, 2013. The increase in headcount resulted in a net increase of approximately $2.0 million in salary and related expenses as compared to the same period in fiscal 2012, of which approximately $1.3 million and 64 headcount were associated with our acquisition of Endace. This was partially offset by a decrease in advertising costs of approximately $1.6 million. General and Administrative General and administrative expenses were as follows (in thousands): General and Administrative Nine Months Ended Percentage of Nine Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 29,021 8 % $ 29,808 8 % $ (787 ) - General and administrative expenses for the nine months ended March 31, 2013 compared to the nine months ended April 1, 2012 decreased approximately $0.8 million, or 3%. Approximately $5.4 million and $6.7 million of share-based compensation expense were included in general and administrative costs for the nine months ended March 31, 2013 and April 1, 2012, respectively. General and administrative expenses decreased by approximately $3.7 million in litigation costs related to our on-going patent dispute litigation with Broadcom. The net decrease in general and administrative expenses was partially offset by an increase of approximately $2.8 million in legal and accounting costs related to the Endace acquisition, and an increase of approximately $1.4 million in legal costs related to our mitigation activities for the 2012 Permanent Injunction. Amortization of Other Intangible Assets. Amortization expense was as follows (in thousands): Amortization of Other Intangible Assets Nine Months Ended Percentage of Nine Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ 4,376 1 % $ 4,967 1 % $ (591 ) - Amortization of other intangible assets for the nine months ended March 31, 2013 compared to the nine months ended April 1, 2012 decreased by approximately $0.6 million, or 12%. Approximately $0.7 million of the decrease was due to a lower unamortized intangible assets balance at the beginning of the current three month period as a result of certain intangible assets being fully amortized in fiscal 2012. This was partially offset by an increase of approximately $0.1 million in amortization of other intangibles assets associated with assets acquired from Endace. Non-operating (Expense) Income, net. Non-operating (expense) income, net, was as follows (in thousands): Non-operating Income (Expense), net Nine Months Ended Percentage of Nine Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ (4,832 ) (1 )% $ 325 - $ (5,157 ) (1 )% Our non-operating (expense) income, net, for the nine months ended March 31, 2013 decreased by approximately $5.2 million, compared to the nine months ended April 1, 2012, primarily due to a non-recurring foreign exchange transaction loss of approximately $4.7 million related to the cash consideration paid for Endace resulting from changes in the value of the GBP relative to the USD between the date the funds were converted to GBP and the dates the funds were disbursed. 32 -------------------------------------------------------------------------------- Table of Contents Income Tax Benefit (Provision). Income tax benefit (provision) was as follows (in thousands): Income Tax Benefit (Provision) Nine Months Ended Percentage of Nine Months Ended Percentage of Increase/ Percentage March 31, 2013 Net Revenues April 1, 2012 Net Revenues (Decrease) Points Change $ (3,354 ) (1 )% $ 2,292 - $ (5,646 ) (1 )% Income tax benefit (provision) for the nine months ended March 31, 2013 compared to the nine months ended April 1, 2012 decreased by approximately $5.6 million. Our effective tax (expense) benefit rate was approximately (128)% and 16% for the nine months ended March 31, 2013 and April 1, 2012, respectively. The increase in our effective tax expense rate for the nine months ended March 31, 2013 compared to the nine months ended April 1, 2012 was primarily due to the continuing impact of our previously recorded U.S. deferred tax asset valuation allowance, changes in the mix of earnings in international versus U.S. tax jurisdictions, and the use of an actual year-to-date effective tax rate for the nine months ended March 31, 2013 versus an annualized effective tax rate. We continue to generate the majority of our earnings in countries other than the U.S. including India, Ireland, and Isle of Man, where such earnings are generally subject to significantly lower tax rates than the U.S. We expect this trend to continue in the future. We have made no provision for U.S. income taxes or foreign withholding taxes on the earnings of our foreign subsidiaries as these amounts are intended to be indefinitely reinvested in operations outside the U.S. Critical Accounting Policies The preparation of our consolidated financial statements requires estimation and judgment that affect the reported amounts of net revenues, expenses, assets, and liabilities in accordance with accounting principles generally accepted in the United States. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances and which form the basis for making judgments about the carrying values of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the periods presented. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties. Changes in judgments and uncertainties relating to these estimates could potentially result in materially different results under different assumptions and conditions. If these estimates differ significantly from actual results, the impact to the consolidated financial statements may be material. We believe that the critical accounting policies that are the most significant for purposes of fully understanding and evaluating our reported financial results include the following: Revenue Recognition. We generally recognize revenue at the time of shipment when title and risk of loss have passed, evidence of an arrangement has been obtained, pricing is fixed or determinable, and collectability is reasonably assured. We make certain sales through two tier distribution channels using selected distributors and Master Value Added Resellers (collectively, Distributors). These Distributors are subject to distribution agreements that may be terminated upon written notice by either party and that generally provide privileges to return a portion of inventory and to participate in price protection and cooperative marketing programs that limit our ability to reasonably estimate product returns and the final price of inventory sold to distributors. Accordingly, we recognize revenue on our standard non-OEM specific products sold to our Distributors based on a sell-through model. OEM specific models sold to our Distributors are generally governed under the related OEM agreements rather than under these distribution agreements; accordingly, we generally recognize revenue at the time of shipment for OEM specific products shipped to our Distributors. In the normal course of business, we enter into certain sales transactions, referred to as multiple-element arrangements, which involve making judgments about allocating the consideration to the various elements of the transactions. The most common type of multiple-element arrangements encountered by the Company involves the sale of certain products with post-contract customer support. Consideration in a multiple-element arrangement is allocated at the inception of the arrangement to all deliverables on the basis of the relative selling price of each deliverable. If available, the selling price for each deliverable is determined using vendor-specific objective evidence (VSOE) of the selling price or third-party evidence (TPE) of the selling price, when applying the relative selling price method. If neither VSOE nor TPE of the selling price exists for a deliverable, we use our best estimate of the selling price for that deliverable. In accounting for multiple-element transactions, judgment must be exercised in identifying the separate elements in a bundled transaction as well as determining the values of these elements. These judgments can impact the amount of revenues, expenses and net income recognized over the term of the contract, as well as the period in which they are recognized. We also maintain sales related reserves for our sales incentive programs. Based on the specific program criteria, we classify the costs of these incentive programs as a reduction of revenue, a cost of sale, or an operating expense. Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts based upon historical write-offs as a percentage of net revenues and management's review of outstanding accounts receivable. Amounts due from customers are charged against the allowance for doubtful accounts when management believes that collectibility of the amount is unlikely. Although we have not historically experienced significant losses on accounts receivable, our accounts receivable are concentrated with a small number of customers. Consequently, any write-off associated with one of these customers could have a significant impact on our allowance for doubtful accounts and results of operations. 33 -------------------------------------------------------------------------------- Table of Contents Inventories. Inventories are stated at the lower of cost, on a first-in, first-out basis, or market. We use a standard cost system to determine cost. The standard costs are adjusted periodically to represent actual cost. We regularly compare forecasted demand and the composition of the forecast against inventory on hand and open purchase commitments in an effort to ensure that the carrying value of inventory does not exceed net realizable value. Accordingly, we may have to reduce the carrying value of excess and obsolete inventory if forecasted demand decreases. Intangible Assets and Other Long-Lived Assets. Intangible assets resulting from acquisitions or licensing agreements are carried at cost less accumulated amortization and impairment charges, if any. For assets with determinable useful lives, amortization is computed using the straight-line method over the estimated economic lives of the respective intangible assets, ranging from two to twelve years. Furthermore, we assess whether our intangible assets and other long-lived assets should be tested for recoverability periodically and whenever events or circumstances indicate that their carrying value may not be recoverable. The amount of impairment, if any, is measured based on fair value, which is determined using projected discounted future operating cash flows. Assets to be disposed of are reported at the lower of the carrying amount or fair value less selling costs. Goodwill. Goodwill is not amortized, but instead, is tested at least annually for impairment, or more frequently when events or changes in circumstances indicate that goodwill might be impaired. In assessing goodwill impairment, we have the option to first assess the qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, we determine it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if we conclude otherwise, then we are required to perform the first step of the two-step impairment test by comparing the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered impaired; otherwise, goodwill is considered impaired and the loss is measured by performing step two. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit goodwill with the carrying amount of goodwill. We also have the option to bypass the qualitative assessment and proceed directly to performing the first step of the two-step goodwill impairment test. We may resume performing the qualitative assessment in any subsequent period. The annual impairment test is performed during the fourth fiscal quarter. See Note 5 in the accompanying notes to condensed consolidated financial statements included in Part I, Item 1 of this Form 10-Q for additional information. Although our market capitalization exceeded its book value as of March 31, 2013, our stock price continues to be volatile and thus, it is reasonably possible that our determination that goodwill is not impaired could change in the near term if our market capitalization and estimated control premium decrease below the book value. Income Taxes. We account for income taxes using the asset and liability method, under which we recognize deferred tax assets and liabilities for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for net operating loss and tax credit carryforwards. Tax positions that meet a more-likely-than-not recognition threshold are recognized in the first reporting period that it becomes more-likely-than-not such tax position will be sustained upon examination. A tax position that meets this more-likely-than-not recognition threshold is recorded at the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Previously recognized income tax positions that fail to meet the recognition threshold in a subsequent period are derecognized in that period. Differences between actual results and our assumptions, or changes in our assumptions in future periods, are recorded in the period they become known. We record potential accrued interest and penalties related to unrecognized tax benefits in income tax expense. As a multinational corporation, we are subject to complex tax laws and regulations in various jurisdictions. The application of tax laws and regulations is subject to legal and factual interpretation, judgment, and uncertainty. Tax laws themselves are subject to change as a result of changes in fiscal policy, changes in legislation, evolution of regulations and court rulings. Therefore, the actual liability for U.S. or foreign taxes may be materially different from our estimates, which could result in the need to record additional liabilities or potentially to reverse previously recorded tax liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. A valuation allowance is recorded against any deferred tax assets when, in the judgment of management, it is more likely than not that all of or part of a deferred tax asset will not be realized. In assessing the need for a valuation allowance, we consider all positive and negative 34 -------------------------------------------------------------------------------- Table of Contents evidence, including recent financial performance, scheduled reversals of temporary differences, projected future taxable income, availability of taxable income in carryback periods and tax planning strategies. Based on a review of such information, we believe that insufficient positive evidence exists to support that we will more likely than not be able to realize the majority of our U.S. federal and state deferred tax assets. Therefore, we have recorded a valuation allowance against our deferred tax assets to the extent that they are not expected to be recoverable against taxes previously paid in available carryback periods. Stock-Based Compensation. We account for our stock-based awards to employees and non-employees using the fair value method. Although we grant unvested stock awards, cash-settled stock unit awards and stock options, the majority of the awards granted and stock based compensation recognized consists of unvested stock awards. The fair value of each unvested stock award is determined based on the closing price of our common stock on the grant date. The fair value of each cash-settled unit award is determined based on the closing price of our common stock upon vesting, and therefore, is subject to remeasurement at each reporting period until the award is vested. For stock options, the fair value of each option is based on several criteria including, but not limited to, the valuation model used and associated input factors including principally stock price volatility and, to a lesser extent, expected term, dividend rate, and risk free interest rate. The input factors used in the valuation model are based on subjective future expectations combined with management judgment. Stock-based compensation expense is recognized on a straight-line basis over the requisite service period for each separate vesting tranche of the award. A forfeiture rate assumption is applied in determining the fair value of our stock-based compensation related to both unvested stock awards and stock options based on future expectations and may be revised as significant differences become known. In addition, a probability assessment is applied to unvested performance-based stock awards. These adjustments may materially impact our results of operations in the period such changes are made. Litigation Costs. We record a charge equal to at least the minimum estimated liability for a loss contingency or litigation settlement when both of the following conditions are met: (i) information available prior to issuance of the financial statements indicates that it is probable that a liability had been incurred at the date of the financial statements and (ii) the range of loss can be reasonably estimated. Liabilities related to litigation settlements with multiple elements are recorded based on the fair value of each element. Legal and other litigation related costs are recognized as the services are provided. We record insurance and other indemnity recoveries for litigation costs when both of the following conditions are met: (i) the recovery is probable and (ii) collectability is reasonably assured. The insurance recoveries recorded are only to the extent the litigation costs have been incurred and recognized in the financial statements; however, it is reasonably possible that the actual recovery may be significantly different from our estimates. There are many uncertainties associated with any litigation, and we cannot provide assurance that any actions or other third party claims against us will be resolved without costly litigation or substantial settlement charges. If any of those events were to occur, our business, financial condition and results of operations could be materially and adversely affected. See Note 8 in the accompanying notes to condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q. Recently Adopted and Recently Issued Accounting Standards See Note 1 in the accompanying notes to condensed consolidated financial statements included in Part I, Item I of this Form 10-Q for a description of the recently adopted accounting standards. Liquidity and Capital Resources Our principal sources of liquidity consist of our existing cash balances and investments, as well as funds expected to be generated from operations. At March 31, 2013, we had approximately $158.9 million in working capital and approximately $91.6 million in cash and cash equivalents and current investments as compared to approximately $260.6 million in working capital and approximately $229.9 million in cash and cash equivalents and current investments at July 1, 2012. We maintain an investment portfolio of various security holdings, types, and maturities. We invest in instruments that meet credit quality standards in accordance with our investment guidelines. We limit our exposure to any one issuer or type of investment with the exception of U.S. Government issued or U.S. Government sponsored entity securities. Our investments consisted of marketable certificates of deposit as of March 31, 2013 and we did not hold any auction rate securities or direct investments in mortgage-backed securities. Our cash balances and investments are held in numerous locations throughout the world. As of March 31, 2013, our international subsidiaries held approximately 25% of our total cash, cash equivalents and investment securities, which will be used to repay obligations to U.S. affiliate entities that arise in the normal course of business and would not result in incremental U.S. tax liabilities when paid. Our accounts receivable are primarily with large multinational OEM customers and denominated in U.S. dollars. At March 31, 2013, approximately 16% of our accounts receivable are related to customers with a European billing address. However, we do not believe that the ongoing European Sovereign debt crisis will materially impact the collectability of our accounts receivable or adversely affect our financial position or liquidity. 35-------------------------------------------------------------------------------- Table of Contents Cash Flows The following table summarizes our cash flows: Nine Months Ended March 31, April 1, 2013 2012 (In thousands) Net cash (used in) provided by: Operating activities $ (7,396 ) $ 48,874 Investing activities (89,590 ) (17,301 ) Financing activities (13,151 ) (19,521 ) Effect of foreign currency translation on cash and cash equivalents 160 (274 ) (Decrease) increase in cash and cash equivalents $ (109,977 ) $ 11,778 Operating Activities Cash used in operating activities was approximately $7.4 million during the nine months ended March 31, 2013 compared to cash provided by operating activities of approximately $48.9 million during the nine months ended April 1, 2012. The decrease in cash flows from operating activities was primarily due to a payment of $58.0 million related to the Settlement Agreement entered into with Broadcom on July 3, 2012, of which approximately $36.8 million was accrued during fiscal 2012. See Note 8, "Commitments and Contingencies," in the accompanying notes to condensed consolidated financial statements under the caption, "Litigation" in Part I; Item 1 of this Form 10-Q. The Broadcom payment was partially offset by income tax refunds received of approximately $6.6 million less income taxes paid of approximately $3.3 million. The current period cash used in operating activities resulted from net loss of approximately $0.7 million, changes in operating assets and liabilities including a decrease in accounts payable, accrued liabilities and other liabilities of approximately $44.2 million due primarily to the Broadcom payment, an increase in prepaid expenses, prepaid income taxes and other assets of approximately $12.8 million and an increase in inventories of approximately $3.0 million, offset by an increase in accrued taxes of approximately $3.0 million and non-cash adjustments for amortization of intangible assets of approximately $20.2 million, share-based compensation expense of approximately $16.3 million, and depreciation and amortization of approximately $13.2 million. Investing Activities Cash used in investing activities was approximately $89.6 million during the nine months ended March 31, 2013 compared to approximately $17.3 million during the nine months ended April 1, 2012. The current period usage of cash was primarily related to our acquisition of Endace for approximately $107.7 million and purchases of property and equipment of approximately $10.3 million, offset by a net decrease in investments of approximately $28.4 million. Financing Activities Cash used in financing activities was approximately $13.2 million during the nine months ended March 31, 2013 compared to approximately $19.5 million during the nine months ended April 1, 2012. The current period usage of cash was primarily due to approximately $11.9 million of purchases of noncontrolling interest in Endace, and payroll tax withholdings on behalf of employees for restricted stock of approximately $3.9 million, partially offset by the proceeds from issuance of common stock under stock plans of approximately $2.6 million. Prospective Capital Needs In early August 2008, our Board of Directors authorized a plan to repurchase up to $100.0 million of our outstanding common stock. In April 2009, upon receipt of an unsolicited takeover proposal and related tender offer of Broadcom to acquire us, our Board of Directors elected to temporarily suspend any activity under the share repurchase plan. In light of Broadcom allowing its tender offer to expire on July 14, 2009, Emulex's Board of Directors elected to reactivate the $100.0 million share repurchase plan effective July 15, 2009. From June 29, 2009 through March 31, 2013, the Company repurchased approximately 9.0 million shares of its common stock for an aggregate purchase price of approximately $78.4 million at an average purchase price of $8.67 per share under this plan. Our Board of Directors has not set an expiration date for the plan. Therefore, we may repurchase additional shares under this plan from time to time through open market purchases or privately negotiated transactions. It is expected that any future share repurchases will be financed by available cash and cash from operations. 36 -------------------------------------------------------------------------------- Table of Contents We plan to continue our strategic investment in research and development, sales and marketing, capital equipment, and facilities. We may also consider internal and external investment opportunities in order to achieve our growth and market leadership goals, including licensing and product development alignment agreements with our suppliers, customers, and other third parties. We believe that our existing cash and cash equivalents, current investments, and anticipated cash flows from operating activities will be sufficient to support our working capital needs, capital expenditure requirements and stock repurchasing expenditures for at least the next 12 months although we may also consider external financing sources. We currently do not have any outstanding lines of credit or other borrowings. We have disclosed outstanding legal proceedings in Note 8 in the accompanying notes to condensed consolidated financial statements included in Part I, Item 1 of this Form 10-Q, including the consolidated patent infringement lawsuit filed by Broadcom against us. This lawsuit continues to present risks that could have a material adverse effect on our business, financial condition, or results of operations, including loss of patent rights, monetary damages, and injunction against the sale of accused products. We continue to present a vigorous post-trial defense against this on-going lawsuit, and have appealed the trial verdict. On July 3, 2012, we entered into a Settlement Agreement pursuant to which both parties agreed to settle and release certain claims related to the patent infringement litigation. The Settlement Agreement provided for certain amendments to the April 3, 2012 Permanent Injunction, and dismissals of certain allegations of the lawsuit, including portions of the scheduled re-trial. We also received a worldwide limited license to the '691 patent, the '150 patent, the '194 patent and related families for certain fields of use including Fibre Channel applications. We expect to incur incremental mitigation, product redesign, appeal related expenses during the remainder of fiscal 2013 and fiscal 2014 in the range of $11 million to $12 million. In addition, we may be required to participate in certain customer royalty obligations arising under their licensing agreements with Broadcom in the range of $1 million to $8 million during the remainder of fiscal 2013 and fiscal 2014. Such costs would reduce gross margins in the periods accrued. See "Product Redesign Activities and Potential Royalty Obligations" in Part I, Item 2 of this Form 10-Q. Also see "Third party claims of intellectual property infringement could adversely affect our business" and "We are dependent on sole source and limited source third party suppliers and EMS providers for our products" in Part II, Item 1A - Risk Factors, of this Form 10-Q for a description of certain risks relating to the litigation with Broadcom that could impact our liquidity and prospective capital needs. Off-Balance Sheet Arrangements As part of our ongoing business, we do not participate in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As of April 1, 2012, we did not have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. We issue letters of credit or bank guarantees in the normal course of business as required by certain vendors. As of March 31, 2013, we had approximately $0.7 million in outstanding letters of credit and bank guarantees. Contractual Obligations and Commercial Commitments The following summarizes our contractual obligations as of April 1, 2012, and the effect such obligations are expected to have on our liquidity in future periods. The estimated payments reflected in this table are based on management's estimates and assumptions about these obligations. Because these estimates and assumptions are necessarily subjective, the actual cash outflows in future periods will vary, possibly materially, from those reflected in the table. Payments Due by Period (in thousands) Remaining Total 2013 2014 2015 2016 2017 Thereafter Leases (1) $ 21,303 $ 1,594 $ 5,580 $ 4,935 $ 4,177 $ 2,194 $ 2,823 Purchase commitments (2) 44,694 44,694 - - - - - Other commitments (3) 17,288 3,907 8,731 3,001 942 707 - Total $ 83,285 $ 50,195 $ 14,311 $ 7,936 $ 5,119 $ 2,901 $ 2,823 (1) Lease payments include common area maintenance (CAM) charges. (2) Purchase commitments represent an estimate of all open purchase orders and contractual obligations in the ordinary course of business for which we have not received the goods or services as of March 31, 2013. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule and adjust our requirements based on our business needs prior to the delivery of goods or performance of services. 37 -------------------------------------------------------------------------------- Table of Contents (3) Other commitments consist primarily of commitments for software license fees of approximately $8.9 million and non-recurring engineering services of approximately $6.9 million. (4) Excludes approximately $30.5 million of liabilities for uncertain tax positions for which we cannot make a reasonably reliable estimate of the period of payment. See Note 11 in the accompanying notes to condensed consolidated financial statements included in Part I, Item 1 of this Form 10-Q. (5) The expected timing of payments for the obligations discussed above is estimated based on current information. Timing of payment and actual amounts paid may be different depending on the time of receipt of goods or services or changes to agreed-upon amounts for some obligations. Amounts disclosed as contingent or milestone based obligations depend on the achievement of the milestones or the occurrence of the contingent events and can vary significantly. [ Back To TMCnet.com's Homepage ]