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GIGAMON INC. - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations
[March 13, 2014]

GIGAMON INC. - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations


(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, this discussion contains forward-looking statements that reflect our plans, estimates and beliefs. The words "believe," "may," "will," "estimate," "continue," "anticipate," "intend," "expect," and similar expressions are intended to identify forward-looking statements. Our actual results could differ materially from those contained in or implied by any forward-looking statements. Factors that could cause or contribute to those differences include, but are not limited to, those identified below and those discussed above in the section titled "Risk Factors" and elsewhere in this Annual Report on Form 10-K.



Overview We have developed an innovative solution that delivers pervasive and dynamic intelligent visibility of traffic across networks. Our solution, which we refer to as our Traffic Visibility Fabric, consists of distributed network appliances that enable an advanced level of visibility, modification and control of network traffic. Our Fabric enables IT organizations to forward traffic from network and server infrastructure to management, analysis, compliance and security tools in a manner that is optimized for specific uses or functions.

In 2005, we introduced our patented Flow Mapping technology in combination with the launch of our first product, the GigaVUE-MP. In 2010, we introduced our GigaSMART platform to support advanced packet modification applications, and have since introduced 12 licensable applications including De-Duplication, Tunneling, Advanced Packet Filtering, FlowVUE, GTP Correlation and NetFlow Generation. We have also continued to expand our Fabric Node portfolio including adding the GigaVUE H Series chassis, the first Terabit scale Traffic Visibility Fabric for high-throughput environments, which we launched in 2011. In 2012, we introduced GigaVUE-VM, a software-only version of our platform for virtualized and cloud-based applications, and GigaVUE-FM, our software-only management offering. In 2013, we introduced the GigaVUE-HB1 platform, which incorporates GigaSMART as standard, to extend the reach of the Traffic Visibility Fabric to smaller environments and mid-size enterprises, and several new software applications, including Adaptive Packet Filtering (content-based filtering), FlowVUE and GTP Correlation (subscriber-based sampling).


We generate product revenue primarily from sales of perpetual software licenses installed on physical appliances for our Traffic Visibility Fabric solutions to channel partners, including distributors and resellers, as well as directly to end-user customers. We market and sell our products through a hybrid sales model, which combines a high-touch sales organization and an overlay channel sales team that actively assists our extensive network of channel partners throughout the sales process. We also provide our channel partners with marketing assistance, technical training and support.

We generate services revenue primarily from the sale of maintenance and support services for our products. A one-year contract for our maintenance and support services is bundled with the initial contract to purchase our products.

Following expiration of this one-year contract, our end-user customers typically purchase maintenance and support contracts that generally have one-year terms.

We have experienced significant growth since our inception in 2004. Our revenue increased from $68.1 million in fiscal 2011 to $140.3 million in fiscal 2013, representing a compound annual growth rate, or CAGR, of 44%. Our net loss was $9.5 million in fiscal 2013 and our net income was $7.5 million and $16.9 million in fiscal 2012 and 2011, respectively. Our net loss in fiscal 2013 included a one-time cash charge of $20.4 million relating to performance units payments as a result of our IPO in June 2013. We generated cash from operations of $23.3 million, $27.7 million and $21.6 million in fiscal 2013, 2012 and 2011, respectively. We operate as a single reportable segment.

50-------------------------------------------------------------------------------- Table of Contents Key Performance Indicators of Our Business We monitor a variety of key performance indicators to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. These key performance indicators include the following (dollars in thousands): Fiscal Years Ended December 28, December 31, December 31, 2013 2012 2011 Key Performance Indicators: Revenue $ 140,295 $ 96,715 $ 68,105 Gross margin 78 % 79 % 79 % (Loss) income from operations $ (30,201 ) $ 7,676 $ 17,023 Deferred revenue $ 47,476 $ 30,820 $ 21,962 Revenue. We monitor our revenue to assess the acceptance of our products by our end-user customers and growth in the markets we serve.

Gross margin. We monitor our gross margin to assess the impact on our current and forecasted financial results from any changes to the pricing and mix of products we are selling to our end-user customers.

(Loss) income from operations. We monitor our (loss) income from operations to assess how effectively we are conducting our operations as well as controlling our operating expenses, which are primarily driven by headcount.

Deferred revenue. Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue. The majority of our deferred revenue balance consists of the unamortized portion of services revenue from maintenance and support contracts. We also defer revenue, and the related costs of product revenue, on sales of products to distributors who stock inventory until the distributors report to us that they have sold the products to end-user customers. We monitor our deferred revenue balance because it represents a significant portion of the revenue that we will recognize in future periods.

Initial Public Offering and Follow-On Public Offering On June 17, 2013, we completed our IPO, in which 7,762,500 shares of common stock were sold at a public offering of $19.00 per share. We issued and sold 5,512,500 shares of common stock, inclusive of the 1,012,500 shares of common stock sold in connection with the full exercise of the overallotment option of shares granted to the underwriters, at a public offering price of $19.00 per share. We received proceeds of $93.4 million, net of underwriting discounts and commissions and offering expenses. In addition, our selling stockholders sold 2,250,000 shares of common stock at a public offering price of $19.00 per share.

We did not receive any proceeds from the sales of shares by the selling stockholders.

On October 28, 2013, we completed our follow-on public offering, in which 5,100,000 shares of our common stock were sold at a public offering price of $38.50 per share. We issued and sold 300,000 shares of common stock, for which we received proceeds of $10.2 million, net of underwriting discounts and commissions and offering expenses. In addition, our selling stockholders sold 4,800,000 shares of common stock, which included 293,718 shares of common stock issued upon the exercise of options by certain selling stockholders with an aggregate exercise price of $1.3 million, at a public offering price of $38.50 per share. We did not receive any proceeds from the sale of shares by the selling stockholders.

51 -------------------------------------------------------------------------------- Table of Contents Financial Overview Revenue We generate revenue from the sale of products and related services, including maintenance and support. We present revenue net of discounts, rebates and sales taxes. Our revenue is comprised of the following: Product revenue. We generate product revenue primarily from sales of perpetual software licenses installed on physical appliances for our Traffic Visibility Fabric solutions. We generally recognize product revenue at the time of product delivery, provided that all other revenue recognition criteria have been met. As a percentage of revenue, we expect our product revenue to vary from quarter-to-quarter based on, among other things, the timing of orders and delivery of products and seasonal and cyclical factors.

We have experienced seasonality in the sale of our products. The first quarter of each year is usually our lowest revenue quarter during the year and product revenue typically declines sequentially from the prior fourth quarter. We generally expect an increase in sales in the second half of the year, primarily due to the buying habits of many of our end-user customers as budgets for annual capital purchases are being fully utilized.

We expect our product revenue to increase in absolute dollars as we continue to add new end-user customers, expand the volume of shipments to our current end-user customers and introduce new products.

Services revenue. We generate service revenue from sales of maintenance and support contracts, which are bundled with sales of products, and from subsequent renewals of those contracts. We offer tiered maintenance and support services under our renewable, fee-based maintenance and support contracts, which includes technical support, hardware repair and replacement parts, bug fixes, patches and unspecified upgrades on a when-and-if-available basis. We recognize services revenue ratably over the duration of the contract, which is typically one year and can be up to five years; as a result, the impact on services revenue will lag any shift in product revenue because product revenue is recognized when a product is sold and revenue criteria are satisfied, whereas services revenue is recognized ratably over the contract term. We expect our services revenue to increase in absolute dollars as we increase our installed base by selling more products and adding more end-user customers.

Cost of revenue Our cost of revenue consists of the following: Cost of product revenue. Cost of product revenue primarily consists of the costs associated with manufacturing our products, including third-party hardware manufacturing costs, as well as personnel costs for salary, benefits, bonuses, stock-based compensation expense and other compensation, shipping costs, allocated costs of facilities and information technology, warranty costs and any inventory write-downs. We expect cost of product revenue to increase in absolute dollars in connection with the anticipated increase in product revenue.

Cost of services revenue. Cost of services revenue primarily consists of personnel costs for salary, benefits, bonuses, stock-based compensation expense and other compensation related to our customer support organization, as well as allocated costs of facilities and information technology. We expect cost of services revenue to increase in absolute dollars in connection with the anticipated increase in services revenue.

52-------------------------------------------------------------------------------- Table of Contents Gross profit and gross margin Gross profit has been and will continue to be affected by a variety of factors including shipment volumes, changes in the mix of products and services sold, new product introductions and upgrades to existing products, changes in customer mix, changes in pricing, the extent of customer rebates and incentive programs and changes in our product costs including any excess inventory write-offs. We expect our gross margin to fluctuate over time depending on a variety of factors, including those described above, and it may decrease over the longer-term in the event that we experience additional competitive pricing pressure.

Operating expenses Operating expenses consist of research and development, sales and marketing and general and administrative expenses. Personnel costs comprise a significant component of our operating expenses, and consist of salary, benefits, bonuses, stock-based compensation expense and other compensation. With respect to our sales organization, personnel costs also include sales commissions. Headcount attributable to our operating expenses increased to 326 as of December 28, 2013, compared to 224 as of December 31, 2012 and 136 as of December 31, 2011. We expect to continue to hire new employees to support our anticipated growth, particularly with respect to an anticipated increase in sales and marketing and research and development headcount in fiscal 2014. We expect operating expenses to increase in absolute dollars as we continue to grow, and that our operating margin may decline in the near term as we continue to invest for future growth.

Research and development. Our research and development efforts are focused on new product development and on developing additional functionality for our existing products. Research and development expenses consist primarily of personnel costs, and to a lesser extent, prototype materials, allocated costs of facilities and information technology and product certification. We expense research and development costs as incurred. We expect our research and development expenses to increase in absolute dollars as we continue to develop new products and enhance our existing products.

Sales and marketing. Sales and marketing expenses are the largest component of our operating expenses and consist primarily of personnel costs, as well as travel expenses, trade shows, marketing and promotional activities, and allocated costs of facilities and information technology. We sell our products through our global sales organization, which is divided into three geographic regions: North America, Europe and Asia Pacific. We expect our sales and marketing expenses to increase in absolute dollars as we expand our sales and marketing efforts internationally and domestically to help drive increased revenue.

General and administrative. General and administrative expenses consist of personnel costs and allocated costs of facilities and information technology related to our executive, finance, human resources and legal functions, as well as professional services costs. Professional services costs consist primarily of outside legal and accounting services. We have incurred, and expect to continue to incur, additional expenses as a result of operating as a public company, including costs to maintain compliance with the rules and regulations applicable to companies listed on a national securities exchange and costs related to reporting obligations.

Interest income and other expense, net Interest income consists primarily of income earned on our invested cash, cash equivalents and investments. We expect interest income to increase modestly depending on our average invested balances during the period and market interest rates.

Other expense, net consists primarily of foreign currency exchange losses related to transactions denominated in currencies other than the U.S. dollar, which have not been material to date.

53-------------------------------------------------------------------------------- Table of Contents Provision for income taxes Prior to May 31, 2013, we conducted our operations through Gigamon LLC, a pass through entity that filed its income tax return as a partnership for federal and state income tax purposes. As a result, prior to May 31, 2013, we were not subject to U.S. federal or state income taxes as our taxable income was reported by our individual members.

On May 31, 2013, we converted from a Delaware limited liability company (a pass through entity not subject to U.S. federal and state income taxes) to a Delaware corporation. Accordingly, following such conversion, we elected to be treated as a corporation under Subchapter C of Chapter 1 of the United States Internal Revenue Code, as amended, or the Code, and, therefore, are subject to both federal and state income taxes. As a result of this tax election, we recorded a one-time non-cash income tax benefit of $14.8 million in fiscal 2013, for the deferred tax asset amount recorded upon our change in entity status from a Delaware limited liability company to a Delaware corporation.

We are also subject to state taxes in certain states that may assess capital taxes or taxes based on gross receipts. We also have a subsidiary in a foreign jurisdiction, which is subject to local income taxes.

Stock-based compensation expense and other compensation charges Prior to the formation of our company in 2009, Gigamon Systems LLC, our majority stockholder prior to the LLC Conversion, issued options to purchase its common units to some of its employees. As these employees became our employees upon the contribution of all of the assets and liabilities of Gigamon Systems LLC to us in January 2009, we assumed all of the necessary tax obligations and recorded a relatively small stock-based compensation expense related to these options in our consolidated statement of operations. Between January 1, 2009 and December 31, 2011, instead of granting stock options to our employees, we granted performance units to our employees under our 2009 Performance Unit Plan.

The vested performance units were satisfied by us with a cash payment to the holders of performance units in connection with the completion of our IPO.

Accordingly, the grant of performance units did not result in stock-based compensation expense or compensation charges in any period prior to the completion of our IPO, but, upon the completion of our IPO, we recorded cash-based compensation expense and related payroll taxes of $20.4 million for our performance units based on our IPO price of $19.00 per share, which is reflected in cost of revenue and operating expenses in the second quarter of fiscal 2013.

We began granting stock options in April 2012 and began granting restricted stock units, or RSUs, in August 2012. Prior to the second quarter of fiscal 2013, we did not record any stock-based compensation expense associated with stock options and RSUs that did not begin to vest until the completion of our IPO, or the IPO Awards. Upon the completion of our IPO in fiscal 2013, we recorded stock-based compensation expense of $5.5 million, net of estimated forfeitures, related to these IPO Awards and began offering eligible employees the opportunity to purchase shares under our 2013 Employee Stock Purchase Plan.

Total stock-based compensation expense, net of estimated forfeitures, was $32.5 million, $3.6 million and zero in fiscal 2013, 2012 and 2011, respectively. As of December 28, 2013, unrecognized stock-based compensation expense, net of estimated forfeitures, was $26.3 million.

Change in Reporting Calendar Effective January 1, 2013, we changed our reporting period from a calendar year ending on December 31 of each year to a 52- or 53-week fiscal year that ends on the last Saturday in December. Fiscal 2013 was a 52-week fiscal year, which ended on December 28, 2013, and each quarter was a 13-week quarter.

54-------------------------------------------------------------------------------- Table of Contents Results of Operations The following tables set forth our results of operations for the periods presented in dollars and as a percentage of our revenue (in thousands, except percentages): Fiscal Year Ended December 28, December 31, December 31, 2013 2012 2011 Consolidated Statement of Operations Data: Revenue: Product $ 101,717 $ 69,516 $ 51,308 Services 38,578 27,199 16,797 Total revenue 140,295 96,715 68,105 Cost of revenue: Product 26,103 18,039 12,528 Services 4,727 2,246 1,900 Total cost of revenue 30,830 20,285 14,428 Gross profit 109,465 76,430 53,677 Operating expenses: Research and development 42,067 17,730 12,530 Sales and marketing 72,024 39,359 19,358 General and administrative 25,575 11,665 4,766 Total operating expenses 139,666 68,754 36,654 (Loss) income from operations (30,201 ) 7,676 17,023 Interest income 95 64 4 Other expense, net (94 ) (70 ) (16 ) (Loss) income before income tax benefit (provision) (30,200 ) 7,670 17,011 Income tax benefit (provision) 20,663 (139 ) (80 ) Net (loss) income $ (9,537 ) $ 7,531 $ 16,931 Net (loss) income includes stock-based compensation expense and performance units expenses allocated as follows: Stock-based compensation expense: Cost of revenue $ 3,496 $ 153 $ - Research and development 11,467 542 8 Sales and marketing 11,034 893 2 General and administrative 6,546 2,011 2 Total stock-based compensation expense $ 32,543 $ 3,599 $ 12 Performance units expenses: Cost of revenue $ 353 $ - $ - Research and development 5,188 - - Sales and marketing 7,991 - - General and administrative 6,839 - - Total performance units expenses $ 20,371 $ - $ - 55 -------------------------------------------------------------------------------- Table of Contents Fiscal Year Ended December 28, December 31, December 31, 2013 2012 2011 Percentage of Revenue: Revenue: Product 73 % 72 % 75 % Services 27 % 28 % 25 % Total revenue 100 % 100 % 100 % Cost of revenue 22 % 21 % 21 % Gross margin 78 % 79 % 79 % Operating expenses: Research and development 30 % 18 % 18 % Sales and marketing 51 % 41 % 29 % General and administrative 19 % 12 % 7 % Total operating expenses 100 % 71 % 54 % (Loss) income from operations (22 %) 8 % 25 % Interest income 0 % 0 % 0 % Other expense, net (0 %) (0 %) (0 %) (Loss) income before income tax benefit (provision) (22 %) 8 % 25 % Income tax benefit (provision) 15 % (0 %) (0 %) Net (loss) income (7 %) 8 % 25 % Comparison of Fiscal 2013 and Fiscal 2012 Revenue Fiscal Year Ended December 31, December 28, 2013 2012 Increase % Increase (dollars in thousands) Revenue: Product $ 101,717 $ 69,516 $ 32,201 46 % Services 38,578 27,199 11,379 42 % Total revenue $ 140,295 $ 96,715 $ 43,580 45 % Product revenue increased $32.2 million in fiscal 2013, compared to fiscal 2012, primarily due to an increase in the volume of sales of our H Series products, including our recently introduced HB-1 products, partially offset by lower volume of sales of our G Series products. Revenue from our H Series products, including HB-1 products, increased to $64.2 million in fiscal 2013 from $27.1 million in fiscal 2012, partially offset by a decrease in revenue from our G Series products to $37.5 million in fiscal 2013 from $42.4 million in fiscal 2012, primarily due to a decrease in the volume of units sold.

Services revenue increased $11.4 million in fiscal 2013, compared to fiscal 2012, primarily due to the growth in our installed base at our existing end-user customers and also due to an increase in the total number of end-user customers under maintenance and support contracts with us, which was primarily driven by higher sales of our products.

56-------------------------------------------------------------------------------- Table of Contents Cost of revenue and gross margin Fiscal Year Ended December 28, December 31, 2013 2012 Increase % Increase (dollars in thousands) Cost of revenue: Product $ 26,103 $ 18,039 $ 8,064 45 % Services 4,727 2,246 2,481 110 % Total cost of revenue $ 30,830 $ 20,285 $ 10,545 52 % Gross margin: Product 74 % 74 % Services 88 % 92 % Total gross margin 78 % 79 % Stock-based compensation expense included in cost of revenue $ 3,496 $ 153 $ 3,343 * Performance units expenses included in cost of revenue $ 353 $ - $ 353 * * Not meaningful Total gross margin decreased to 78% in fiscal 2013 from 79% in fiscal 2012 as expenses increased as a percentage of revenue, primarily due to a $3.3 million increase in stock-based compensation expense and a $0.4 million expense related to our performance units, partially offset by the sale of previously written-down inventory, net of an excess and obsolete inventory write-down, in fiscal 2013.

Product gross margin remained consistent at 74% in fiscal 2013 and fiscal 2012, primarily due to an increase in cost of product revenue resulting from an increase in stock-based compensation expense of $2.0 million and expenses related to our performance units of $0.3 million, offset by the sale of previously written-down inventory of $0.8 million, net of an excess and obsolete inventory write-down, in fiscal 2013, compared to inventory write-downs of $1.5 million in fiscal 2012.

Services gross margin decreased to 88% in fiscal 2013 from 92% in fiscal 2012, primarily due to an increase in stock-based compensation expense of $1.4 million in fiscal 2013.

57 -------------------------------------------------------------------------------- Table of Contents Operating expenses Fiscal Year Ended December 28, December 31, 2013 2012 Increase % Increase (dollars in thousands) Operating expenses: Research and development $ 42,067 $ 17,730 $ 24,337 137 % Sales and marketing 72,024 39,359 32,665 83 % General and administrative 25,575 11,665 13,910 119 % Total operating expenses $ 139,666 $ 68,754 $ 70,912 103 % Stock-based compensation expense included in: Research and development $ 11,467 $ 542 $ 10,925 * Sales and marketing 11,034 893 10,141 * General and administrative 6,546 2,011 4,535 226 % Total stock-based compensation expense $ 29,047 $ 3,446 $ 25,601 * Performance units expenses included in: Research and development $ 5,188 $ - $ 5,188 * Sales and marketing 7,991 - 7,991 * General and administrative 6,839 - 6,839 * Total performance units expenses $ 20,018 $ - $ 20,018 * * Not meaningful Research and development expenses increased $24.3 million in fiscal 2013 compared to fiscal 2012, primarily due to a $10.9 million increase in stock-based compensation expense and a $5.2 million expense related to our performance units in fiscal 2013. Net of stock-based compensation expense and expenses related to our performance units, research and development expenses increased $8.2 million, primarily attributable to a $5.7 million increase in personnel costs primarily driven by increased headcount, a $1.0 million increase in development expense, a $0.8 million increase in allocated costs of facilities and information technology and a $0.8 million increase in depreciation expense.

Sales and marketing expenses increased $32.7 million in fiscal 2013 compared to fiscal 2012, primarily due to a $10.1 million increase in stock-based compensation expense and an $8.0 million expense related to our performance units in fiscal 2013. Net of stock-based compensation expense and expenses related to our performance units, sales and marketing expenses increased $14.5 million, primarily attributable to a $10.4 million increase in personnel costs, primarily driven by increased headcount and additional commissions related to higher sales of our products and services, a $2.3 million increase in allocated costs of facilities and information technology and a $1.1 million increase in employee-related programs, travel and professional services.

General and administrative expenses increased $13.9 million in fiscal 2013 compared to fiscal 2012 primarily due to a $6.8 million expense related to our performance units and a $4.5 million 58-------------------------------------------------------------------------------- Table of Contents increase in stock-based compensation expense in fiscal 2013. Net of expenses related to our performance units and stock-based compensation expense, general and administrative expenses increased $2.5 million, primarily attributable to a $1.2 million increase in personnel and other allocated costs of facilities and information technology and a $0.9 million increase in office expense.

Income Tax Benefit (Provision) Fiscal Year Ended December 28, December 31, 2013 2012 Increase % Increase (dollars in thousands)Income tax benefit (provision) $ 20,663 $ (139) $ 20,802 * * Not meaningful.

We recognized an income tax benefit of $20.7 million in fiscal 2013 compared to an income tax provision of $0.1 million in fiscal 2012, primarily due to a one-time tax benefit of $14.8 million for the deferred tax asset recorded upon our change in status from a Delaware limited liability company to a Delaware corporation and also due to operating losses we incurred as a Delaware corporation following the LLC Conversion, partially offset by foreign income taxes. Prior to May 31, 2013, we conducted our U.S. operations through Gigamon LLC, a pass through entity that filed income tax return as a partnership for federal and state income tax purposes, and therefore, we were not subject to U.S. federal or state income taxes as our taxable income was reported by our individual members.

We had no valuation allowance recorded against our deferred tax assets as of December 28, 2013.

Comparison of the Fiscal 2012 and Fiscal 2011 Revenue Fiscal Year Ended December 31, December 31, 2012 2011 Increase % Increase (dollars in thousands) Revenue: Product $ 69,516 $ 51,308 $ 18,208 35 % Services 27,199 16,797 10,402 62 % Total revenue $ 96,715 $ 68,105 $ 28,610 42 % Product revenue increased $18.2 million in fiscal 2012 compared to fiscal 2011 primarily due to the introduction of our H Series family of products and to a lesser extent from the sales of our G Series product portfolio. Revenue from our new H Series products in fiscal 2012 increased to $27.1 million from $5.1 million in fiscal 2011. Additionally, revenue from our G Series products decreased by $3.8 million primarily due to a decrease in the volume of units sold in fiscal 2012 compared to fiscal 2011.

Services revenue increased $10.4 million in fiscal 2012 compared to fiscal 2011, primarily due to an increase in the total number of end-user customers under maintenance and support contracts, which was driven by higher sales of our products.

59 -------------------------------------------------------------------------------- Table of Contents Cost of revenue and gross margin Fiscal Year Ended December 31, December 31, 2012 2011 Increase % Increase (dollars in thousands) Cost of revenue: Product $ 18,039 $ 12,528 $ 5,511 44 % Services 2,246 1,900 346 18 % Total cost of revenue $ 20,285 $ 14,428 $ 5,857 41 % Gross margin: Product 74 % 76 % Services 92 % 89 % Total gross margin 79 % 79 % Stock-based compensation expense included in cost of revenue $ 153 $ - $ 153 * * Not meaningful Total gross margin remained consistent at 79% for fiscal 2012 and fiscal 2011.

Product gross margin decreased to 74% in fiscal 2012 from 76% in fiscal 2011, primarily due to an increase in product sales by our distributors with lower margins, partially offset by lower product costs.

Services gross margin increased to 92% in fiscal 2012 from 89% in 2011, primarily due to the utilization of our existing cost infrastructure to manage a higher number of maintenance and support contracts.

Operating expenses Fiscal Year Ended December 31, December 31, 2012 2011 Increase % Increase (dollars in thousands) Operating expenses: Research and development $ 17,730 $ 12,530 $ 5,200 42 % Sales and marketing 39,359 19,358 20,001 103 % General and administrative 11,665 4,766 6,899 145 % Total operating expenses $ 68,754 $ 36,654 $ 32,100 88 % Stock-based compensation expense included in: Research and development $ 542 $ 8 $ 534 * Sales and marketing 893 2 891 * General and administrative 2,011 2 2,009 * Total stock-based compensation expense $ 3,446 $ 12 $ 3,434 * * Not meaningful 60 -------------------------------------------------------------------------------- Table of Contents Research and development expenses increased $5.2 million in fiscal 2012 compared to fiscal 2011, primarily due to a $2.4 million increase in personnel costs primarily as a result of increased headcount and stock-based compensation expense, a $2.2 million increase in allocated costs primarily associated with the increase in headcount and a $0.3 million increase in depreciation expense.

Sales and marketing expenses increased $20.0 million in fiscal 2012 compared to fiscal 2011, primarily due to a $14.1 million increase in personnel costs primarily as a result of increased headcount, an increase in stock-based compensation expense and additional commissions related to higher sales of our products and services, a $2.4 million increase in trade show, marketing and promotional activities, a $1.6 million increase in travel-related expenses, a $1.0 million increase in employee-related programs and a $0.4 million increase in allocated costs of facilities and information technology.

General and administrative expenses increased $6.9 million in fiscal 2012 compared to fiscal 2011, primarily due to a $5.2 million increase in personnel costs primarily as a result of increased headcount and stock-based compensation expense as well as a $2.6 million increase in professional services costs, partially offset by a $0.9 million decrease in allocated costs of facilities and information technology primarily due to the higher allocation of such costs to our research and development and sales and marketing departments.

Non-GAAP Financial Measures We report all financial information required in accordance with GAAP but we believe that evaluating our ongoing operating results may be difficult to understand if limited to reviewing only GAAP financial measures. Many of our investors have requested that we disclose non-GAAP information because it is useful in understanding our performance as it excludes amounts that many investors feel may obscure our true operating results. Likewise, management uses non-GAAP measures to manage and assess the profitability of our business going forward and does not consider stock-based compensation expense or expenses related to our performance units and related taxes in managing our operations.

Specifically, management does not consider these expenses or benefits when developing and monitoring our budgets and spending. As a result, we use calculations of non-GAAP net income and non-GAAP net income per share, which exclude these expenses when evaluating our ongoing operations and allocating resources within the organization.

61-------------------------------------------------------------------------------- Table of Contents Reconciliations of our GAAP and non-GAAP financial measures were as follows (in thousands, except per share amounts): Fiscal Year Ended December 28, December 31, December 31, 2013 2012 2011 GAAP net (loss) income attributable to common stockholders $ (9,518 ) $ 3,605 $ 10,112 Stock-based compensation expense 32,543 3,599 12 Performance unit expenses 20,371 - - Accretion of preferred stock to redemption value and issuance costs 1,088 2,236 2,078 (Loss) earnings distributable to preferred stockholders (1,107 ) 1,690 4,741 Tax benefit upon conversion of LLC to a C corporation (14,811 ) - - Income tax effect of non-GAAP adjustments (12,673 ) - - Non-GAAP net income $ 15,893 11,130 16,943 Basic and diluted GAAP net (loss) income per share attributable to common stockholders $ (0.39 ) $ 0.21 $ 0.58 Basic Non-GAAP net income per share $ 0.64 $ 0.64 $ 0.98 Diluted Non-GAAP net income per share $ 0.53 $ 0.62 $ 0.98 GAAP and Non-GAAP weighted average number of shares - Basic 24,722 17,300 17,300 GAAP weighted average number of shares - Diluted 24,722 17,303 17,300 Stock-based compensation impact on weighted average number of shares 5,323 570 - Non-GAAP weighted average number of shares - Diluted 30,045 17,873 17,300 Liquidity and Capital Resources As of December 28, 2013, our principal sources of liquidity, which consisted of cash, cash equivalents and investments of $138.2 million, was held in the United States. Our liquidity requirements are primarily to fund our working capital and operating expenses. As of December 28, 2013, we had no material commitments for capital expenditures.

On June 17, 2013, we completed our IPO, in which 7,762,500 shares of our common stock were sold at a public offering price of $19.00 per share. We issued and sold 5,512,500 shares of common stock, inclusive of the 1,012,500 shares of common stock sold in connection with the full exercise of the overallotment option of shares granted to the underwriters, at a public offering price of $19.00 per share. We received proceeds of $93.4 million, net of underwriting discounts, commissions and offering expenses. In addition, our selling stockholders sold 2,250,000 shares of common stock at a public offering price of $19.00 per share. We did not receive any proceeds from the sales of shares by the selling stockholders. We used a portion of the proceeds that we received from our IPO to satisfy our obligations to holders of vested performance units and related payroll taxes of $20.4 million. The compensation expense related to these performance units was recorded and paid in fiscal 2013.

On October 28, 2013, we completed our follow-on public offering, in which 5,100,000 shares of our common stock were sold at a public offering price of $38.50 per share. We sold 300,000 shares of common stock, for which we received proceeds of $10.2 million, net of underwriting discounts, 62-------------------------------------------------------------------------------- Table of Contents commissions and offering expenses. In addition, our selling stockholders sold 4,800,000 shares of common stock, which included 293,718 shares of common stock issued upon the exercise of options by certain selling stockholders with an aggregate exercise price of $1.3 million, at a public offering price of $38.50 per share. We did not receive any proceeds from the sale of shares by the selling stockholders.

We intend to retain any future earnings to finance the operations and expansion of our business, and we do not currently anticipate paying any cash dividends on our common stock.

Our future capital requirements will depend on many factors, including our results of operations and the expansion of our research and development, sales and marketing and general and administrative functions. Based on our current operating plan, we believe our existing cash, cash equivalents and investments, combined with cash generated from operations, will be sufficient to fund our working capital and operating expenses for at least the next 12 months. If we require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future, we may seek to sell additional equity, or raise funds through debt financing or other sources. The sale of additional equity could result in additional dilution to our stockholders. If we raise additional funds by obtaining loans from third parties, the terms of those financing arrangements may include negative covenants or other restrictions on our business that could impair our operating flexibility, and would also require us to incur interest expense. We can provide no assurance that additional financing will be available at all or, if available, that we would be able to obtain financing on terms favorable to us.

Cash flows The following table summarizes our cash flows for the periods indicated (in thousands): Fiscal Year Ended December 28, December 31, December 31, 2013 2012 2011Cash provided by operating activities $ 23,308 $ 27,680 $ 21,617 Cash used in investing activities (61,767 ) (2,006 ) (2,124 ) Cash provided by (used in) financing activities 99,692 (20,101 ) (12,195 ) Cash flows from operating activities Our cash provided by operating activities is generated from sales of our products and services. Our primary uses of cash from operating activities have been for personnel costs, product costs, expenses related to marketing and promotional activities and costs related to our facilities. Our cash flows from operating activities will continue to be affected principally by our working capital requirements and increased spending on personnel, facilities and sales and marketing activities to meet our anticipated business growth.

In fiscal 2013, our operating activities provided cash of $23.3 million. We incurred a net loss of $9.5 million, which included net non-cash expenses of $13.7 million. Non-cash expenses primarily consisted of stock-based compensation expense of $32.5 million and depreciation and amortization expenses of $2.9 million, offset in part by deferred income tax benefit of $20.9 million. Our operating activities provided cash of $23.3 million primarily due to an increase in deferred revenue of $16.7 million driven by an increase in billings for products and services as a result of our larger installed base; a $8.3 million increase in accrued and other liabilities primarily attributable to a $3.9 million increase in employee related accruals and $3.6 million withheld for our ESPP purchases; and a $3.1 million decrease in inventory due to higher inventory turnover in 63 -------------------------------------------------------------------------------- Table of Contents fiscal 2013. These changes were partially offset by a $3.9 million increase in accounts receivable primarily attributable to an increase in the amount of billings and a $3.3 million increase in prepaid expenses, other current assets and other assets. Our days sales outstanding, or DSO, decreased to 52 days as of December 28, 2013 from 60 days as of December 31, 2012.

In fiscal 2012, our operating activities provided cash of $27.7 million primarily as a result of our net income of $7.5 million, which included net non-cash charges of $6.5 million due to stock-based compensation expense of $3.6 million, inventory write-down of $1.5 million, and depreciation and amortization of $1.4 million; a $3.0 million inventory decline driven by higher inventory turnover in fiscal 2012; a $8.9 million increase in deferred revenue due to higher billings for service as we increased the size of our installed base; a $4.0 million increase in accrued and other liabilities primarily due to an increase in employee-related accruals and a $1.7 million decrease in prepaid expenses and other current assets; partially offset by higher accounts receivable of $4.3 million due to an increase in revenue offset by a decrease in our DSO to 60 days as of December 31, 2012 from 69 days as of December 31, 2011.

In fiscal 2011, our operating activities generated cash of $21.6 million primarily as a result of our net income of $16.9 million, which included non-cash charges of $4.0 million due to inventory write-downs and depreciation and amortization; a $10.8 million increase in deferred revenue due to higher service business billings as we added new end-user customers and increased our installed base and a $7.5 million increase in accrued and other liabilities and accounts payable primarily due to an accrual for non-cancelable future commitments related to excess inventories; partially offset by a $9.0 million increase in accounts receivable due to higher sales and an increase in our DSO to 69 days as of December 31, 2011 compared to 49 days as of December 31, 2010, a $3.9 million increase in prepaid expenses and other current assets primarily due to an increase in employee receivables related to equity compensation agreements with certain employees in prior years, and a $4.8 million increase in inventory to support the growth in our product sales.

Cash flows from investing activities In fiscal 2013, cash used in investing activities of $61.8 million consisted of short-term investment purchases of $59.7 million and property and equipment purchases of $4.0 million, offset by $2.0 million in proceeds from the sale of short-term investments. In fiscal 2012 and 2011, cash used in investing activities was $2.0 million and $2.1 million, respectively, and consisted of capital expenditures for property and equipment to support the growth of our business.

Cash flows from financing activities In fiscal 2013, cash provided by financing activities was $99.7 million primarily due to net cash proceeds of $95.3 million and $10.2 million from our sale and issuance of common stock in our IPO and follow-on public offering, respectively. We also generated $1.7 million from stock option exercises in fiscal 2013. In addition, we distributed $7.0 million in fiscal 2013 to Gigamon LLC members pursuant to the Restated Limited Liability Company Agreement by and among Gigamon LLC and certain of its members, dated January 20, 2010, as amended, in effect prior to the LLC Conversion.

In fiscal 2012, cash used in financing activities was $20.1 million as a result of cash distributions of $18.2 million to our Gigamon LLC members and $1.9 million in costs paid in connection with our IPO.

In fiscal 2011, cash used in financing activities was $12.2 million as a result of distributions to Gigamon LLC's members.

64-------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following summarizes our contractual obligations as of December 28, 2013: Payments Due by Period Less More than 1 1 to 3 4 to 5 than 5 year years years years Total (in thousands) Operating lease obligations (1) $ 1,423 $ 6,411 $ 4,312 $ 28 $ 12,174 Purchase commitments (2) 7,451 - - - 7,451 Total $ 8,874 $ 6,411 $ 4,312 $ 28 $ 19,625 (1) Operating lease obligations represent our obligations to make payments under the lease agreements for our facilities and office equipment leases.

(2) Purchase commitments primarily represent our obligations to purchase inventory and related components. We record a liability for firm, non-cancelable and unconditional purchase commitments for quantities in excess of our future demand forecasts consistent with the valuation of our excess and obsolete inventory.

The above table does not include our unrecognized tax benefit, which was $0.2 million as of December 28, 2013, all of which would affect our income tax benefit (provision), if recognized. The ultimate amount and timing of any future settlements cannot be predicted with reasonable certainty.

Off-Balance Sheet Arrangements We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, operating expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. We base our estimates and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows would be affected.

We believe that of our significant accounting policies, which are described in the notes to our consolidated financial statements, the accounting policies discussed below involve the greatest degree of judgment and complexity and have the most significant impact on our consolidated financial statements.

Accordingly, these are the policies we believe are most critical to aid in understanding and evaluating our financial condition and results of operations.

Revenue recognition Revenue is recognized when all of the following criteria have been met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) sales price is fixed or determinable, and 65-------------------------------------------------------------------------------- Table of Contents (4) collectability is reasonably assured. We enter into contracts to sell our products and services, and while some of our sales agreements contain standard terms and conditions, there are agreements that contain multiple elements or non-standard terms and conditions. As a result, significant contract interpretation may be required to determine the appropriate accounting, including whether the deliverables specified in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and, if so, how the price should be allocated among the elements and when to recognize revenue for each element. Changes in the allocation of the sales price between elements may impact the timing of revenue recognition but will not change the total revenue recognized on the contract.

Under our revenue recognition policies, we allocate revenue to each element based on a selling price hierarchy. The selling price for a deliverable is based on our vendor-specific objective evidence, or VSOE, if available, third-party evidence, TPE, if VSOE is not available, or estimated selling price, or ESP, if neither VSOE nor TPE is available. We establish VSOE of selling price using the price charged for a deliverable when sold separately. TPE of selling price is established by evaluating largely interchangeable competitor products or services in stand-alone sales to similarly situated customers. ESP is established considering internal factors such as margin objectives, pricing practices and controls, customer segment pricing strategies and product life cycle. Consideration is also given to market conditions such as industry pricing strategies and technology life cycles. When determining ESP, we apply management judgment to establish margin objectives and pricing strategies and to evaluate market conditions and product life cycles. We do not use TPE as we do not consider our products to be similar to or interchangeable with our competitors' products in standalone sales to similarly situated customers. Revenue from maintenance service contracts is deferred and recognized ratably over the contractual support period, which is generally one to three years. We applied ESP to the majority of our product revenue and VSOE to our service revenue in fiscal 2013, 2012 and 2011.

Our pricing practices may be required to be modified as our business and offerings evolve over time, which could result in changes in selling prices, including both VSOE and ESP, in subsequent periods. There were no material impacts in fiscal 2013, nor do we expect a material impact in the next 12 months on our revenue recognition due to any changes in our VSOE, TPE or ESP.

Inventories Our inventories are stated at the lower of cost or market value on a first-in, first-out basis. We record inventory write-downs for the valuation of inventory at the lower of cost or net realizable value by analyzing market conditions and estimates of future sales as compared to inventory balances. Net realizable value is based upon an estimated average market value reduced by estimated completion and selling costs. We record a liability for firm, non-cancelable and unconditional purchase commitments with our contract manufacturer for quantities in excess of our future demand forecasts consistent with the valuation of our excess and obsolete inventory.

We have established procedures to evaluate inventory balances for excess quantities and obsolescence by analyzing inventory on hand, historical sales levels, estimated future demand and other known factors, and reduce inventory balances to net realizable value for excess and obsolete inventory based on this analysis. Unanticipated changes in technology or customer demand could result in a decrease in demand for our products, which may require a write-down of inventory that could materially affect our results of operations. Write-downs, once established, are not reversed until the related inventory has been subsequently sold or disposed.

Warranty Beginning in February 2011, we have provided a five-year warranty on hardware.

We accrue for potential warranty claims as a component of cost of product revenue based on historical experience 66-------------------------------------------------------------------------------- Table of Contents and other data. Accrued warranty is recorded in accrued liabilities on our consolidated balance sheets and is reviewed periodically for adequacy. If we experience an increase in warranty claims compared with our historical experience, or if the cost of servicing warranty claims is greater than expected, our gross margin and results of operations could be adversely affected. To date, we have not incurred any significant costs associated with our warranty.

Stock-based compensation expense We value our restricted stock units using the market value of our common stock on the date of grant. We recognize expenses, net of estimated forfeitures, related to stock option grants and employee stock purchase plan purchase rights based on the estimated fair value of the awards on the date of grant using the Black-Scholes option-pricing model. The grant date fair value of these awards is recognized on the graded vesting method over the requisite service period, which is generally the vesting period of the respective awards. Stock-based compensation expense is classified in the consolidated statements of operations based on the functional area to which the related recipient belongs.

The Black-Scholes option-pricing model requires the use of highly subjective and complex assumptions which determine the fair value of stock-based awards, including: • Expected term. The expected term represents the period that our stock-based awards are expected to be outstanding. It is based on the "simplified method" for estimating the expected life of a "plain vanilla" stock option. Under this approach, the expected term is presumed to be the midpoint between the average vesting date and the end of the contractual term.

• Risk-free interest rate. The risk-free interest rate for the period covering the expected life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

• Expected volatility. As there was no public market for our common stock prior to our IPO in June 2013, we have limited information on the volatility of our common stock. The expected volatility is determined based on historical volatility of the common stock of a peer group of publicly traded companies. When making the selections of our industry peer companies to be used in the volatility calculation, we considered the size, operational and economic similarities to our principle business operations. The industry peer companies used to determine expected volatility were generally consistent with the peer group used for common stock valuations. However, the peer group we use to determine expected volatility is made up of a smaller number of companies than those considered as part of the peer group for common stock valuation purposes primarily because certain of these companies are significantly larger than we are and therefore had a lower volatility.

• Expected dividend. The expected dividend yield assumption, based on our future expected dividend payouts, assumes no dividend payouts in the foreseeable future.

In addition to the assumptions used in the Black-Scholes option-pricing model for stock option awards, we must also estimate a forfeiture rate to calculate the stock-based compensation expense for our awards. Our forfeiture rate is based on an analysis of our actual and estimated forfeitures. We will continue to evaluate the appropriateness of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover and other factors.

Quarterly changes in the estimated forfeiture rate can have a significant impact on our stock-based compensation expense as the cumulative effect of adjusting the rate is recognized in the period the forfeiture estimate is changed. If a revised forfeiture rate is higher than the previously estimated forfeiture rate, an adjustment is made that will result in a decrease to the stock-based compensation expense recognized in our consolidated financial statements. If a revised forfeiture rate is lower than the previously estimated forfeiture rate, an adjustment is made that will result in an increase to the stock-based compensation expense recognized in our consolidated financial statements.

67-------------------------------------------------------------------------------- Table of Contents We have used and will continue to use judgment in evaluating the expected term, expected volatility and forfeiture rate related to our stock-based compensation expense on a prospective basis. As we continue to accumulate additional data related to our common stock, we may have refinements to the estimates of our expected volatility, expected terms and forfeiture rates, which could materially impact our future stock-based compensation expense.

Income Taxes We are subject to U.S. federal income taxes as well as state taxes. In addition, we are subject to taxes in the foreign jurisdictions where we operate.

Prior to the LLC Conversion in May 2013, we were a Delaware limited liability company that passed through income and losses to our members for U.S. federal and state income tax purposes. As a result, we were not subject to any U.S.

federal or state income taxes as our taxable income was reported by our individual members.

Effective as of the completion of the LLC Conversion on May 31, 2013, we account for income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. In addition, deferred tax assets are recorded for the future benefit of utilizing net operating losses and research and development credit carry forwards. Valuation allowances are provided when necessary to reduce deferred tax assets to the amount expected to be realized.

Accordingly, we assess our needs for a valuation allowance quarterly based on the ASC 740 more-likely-than-not realization threshold criterion. In the assessment, appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, the duration of statutory carryforward periods, our experience with operating losses and tax credit carryforwards expiring, and tax planning alternatives. Significant judgment is required to determine whether a valuation allowance is necessary and the amount of such valuation allowance, if appropriate. The valuation allowance was reviewed and we determined sufficient positive evidence exists to conclude that it is more-likely-than-not that the deferred tax assets will be realized.

Significant judgment is required in the application of the authoritative accounting guidance prescribing a threshold and measurement attribute for the financial recognition and measurement of a tax position taken or expected to be taken in a tax return. We recognize liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step requires us to estimate and measure the tax liability as the largest amount that is more likely than not to be realized upon ultimate settlement. Accounting guidance further requires that a change in judgment related to the expected ultimate resolution of uncertain tax positions to be recognized in earnings in the quarter in which such change occurs. We recognize interest and penalties, if any, related to unrecognized tax benefits in income tax expense.

Recent Accounting Pronouncements In March 2013, the Financial Accounting Standards Board, or the FASB, issued an accounting standard update requiring an entity to release into net income the entire amount of a cumulative translation adjustment related to its investment in a foreign entity when as a parent it either sells a part 68-------------------------------------------------------------------------------- Table of Contents or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group of assets within a foreign entity.

This accounting standard update will be effective prospectively beginning in the first quarter of fiscal 2014. We do not expect the adoption of this accounting standard update to have a material impact on our consolidated financial statements.

In July 2013, the FASB issued a new accounting standard update that requires the presentation of certain unrecognized tax benefits as reductions to deferred tax assets rather than as liabilities in the consolidated balance sheets when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. Early adoption or a retrospective application is permitted. We are required to adopt this new standard on a prospective basis in the first quarter of fiscal 2014. We do not expect the adoption of this accounting standard update to have a material impact on our consolidated financial statements.

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