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QLOGIC CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes. In this discussion and elsewhere in this report, we make forward-looking statements. These forward-looking statements are made in reliance upon safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include, without limitation, descriptions of our expectations regarding future trends affecting our business and other statements regarding future events or our objectives, goals, strategies, beliefs and underlying assumptions that are other than statements of historical fact. When used in this report, the words "anticipates," "believes," "can," "continue," "could," "estimates," "expects," "intends," "may," "plans," "potential," "predicts," "should," "will" and similar expressions, or the negative of such expressions, are intended to identify these forward-looking statements. Statements concerning current conditions may also be forward-looking if they imply a continuation of current conditions. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of several factors, including, but not limited to those factors set forth and discussed in Part II, Item 1A "Risk Factors" and elsewhere in this report. In light of the significant uncertainties inherent in the forward-looking information included in this report, the inclusion of this information should not be regarded as a representation by us or any other person that our objectives or plans will be achieved. You are cautioned, therefore, not to place undue reliance on these forward-looking statements, which are made only as of the date of this report. We undertake no obligation to update or revise these forward-looking statements, whether as a result of new information, future events or otherwise. Overview We design and supply high performance server and storage networking connectivity products that provide, enhance and manage computer data communication. These products facilitate the rapid transfer of data and enable efficient resource sharing between servers, networks and storage. Our products are used in enterprise data centers, cloud computing, Web 2.0 and other environments dependent on high performance, reliable data networking. Our products are based primarily on Fibre Channel and Ethernet technologies and are used in connection with storage networks, local area networks, and converged networks. Storage networks are used to provide data across enterprise environments. Fibre Channel is currently the dominant technology for enterprise storage networking. Local area networks (LANs) are used to provide workstation-to-server, server-to-server, and server-to-storage connectivity using Ethernet. Converged networks are designed to address the evolving data center by consolidating and unifying various classes of connectivity and networks, such as storage area networks and LANs, using Ethernet speeds of 10Gb per second and greater. Fibre Channel over Ethernet (FCoE) is a converged networking technology that uses an Ethernet LAN for both storage and local area data transmission, thus combining the benefits of Fibre Channel technology with the pervasiveness of Ethernet-based networks. Similarly, Internet Small Computer System Interface (iSCSI) is an alternative to FCoE and provides storage over Ethernet capabilities. Our converged network products can operate individually as 10Gb Ethernet products, FCoE products, iSCSI products, or in combination as multi-protocol products. We classify our products into two categories - Advanced Connectivity Platforms and Legacy Connectivity Products. Advanced Connectivity Platforms are comprised primarily of adapters and application-specific integrated circuits (ASICs) for server and storage connectivity applications. Legacy Connectivity Products are comprised primarily of Fibre Channel switch products. Our products are sold worldwide, primarily to original equipment manufacturers (OEMs) and distributors. Our customers rely on our various server and storage connectivity products to deliver solutions to information technology professionals in virtually every business sector. Our products are found primarily in server and storage subsystem solutions that are used by enterprises with critical business data requirements. These products are incorporated in solutions from a number of server and storage system OEM customers, including Cisco Systems, Inc., Dell Inc., EMC Corporation, Fujitsu Ltd., Hewlett-Packard Company, Huawei Technologies Co. Ltd., Inspur Group Co., Ltd., International Business Machines Corporation, Lenovo Group Ltd., NetApp, Inc. and Oracle Corporation. 11 -------------------------------------------------------------------------------- Table of Contents Business Acquisition In March 2014, we acquired certain 10/40/100Gb Ethernet controller-related assets from Broadcom Corporation (Broadcom) primarily relating to the NetXtreme® II Ethernet controller family and licensed certain related intellectual property under non-exclusive licenses for total cash consideration of $147.8 million and the assumption of certain liabilities. This business acquisition expands our product portfolio and is expected to accelerate our time to market for next generation products in the server Ethernet connectivity market. Restructuring Plans In March 2014, we commenced a restructuring plan primarily designed to consolidate our Ethernet product roadmap following the acquisition of the Ethernet controller-related assets from Broadcom. This restructuring plan primarily includes a workforce reduction and the consolidation and elimination of certain engineering activities. During the three months ended June 29, 2014, we recorded special charges of $1.7 million in connection with this plan, consisting of $0.7 million of exit costs and $1.0 million of asset impairment charges related to abandoned property and equipment. We substantially completed these restructuring activities during the first quarter of fiscal 2015. In June 2013, we commenced a restructuring plan designed to enhance product focus and streamline business operations. This restructuring plan includes a workforce reduction and the consolidation and elimination of certain engineering activities. In connection with this plan, we ceased development of future ASICs for switch products. During the three months ended June 29, 2014, we recorded special charges of $0.4 million related to this restructuring plan, consisting of exit costs. We expect to incur between $1 million and $2 million of additional severance costs in connection with this plan primarily related to employees required to provide future services. The additional severance costs will be recognized over the requisite service period. First Quarter Financial Highlights A summary of our financial performance during the first quarter of fiscal 2015 is as follows: • Net revenues increased to $119.4 million in the first quarter of fiscal 2015 from $115.7 million in the fourth quarter of fiscal 2014. Revenue from Advanced Connectivity Platforms increased 4% to $104.7 million in the first quarter of fiscal 2015 from $101.1 million in the fourth quarter of fiscal 2014. Revenue from Legacy Connectivity Products was $14.7 million in the first quarter of fiscal 2015 compared to $14.6 million in fourth quarter of fiscal 2014. • Gross profit as a percentage of net revenues was 59.2% in the first quarter of fiscal 2015 compared to 65.9% in the fourth quarter of fiscal 2014. Gross profit for the first quarter of fiscal 2015 included $3.1 million of incremental amortization of purchased intangible assets related to our acquisitions in the fourth quarter of fiscal 2014. • Operating income increased to $5.4 million in the first quarter of fiscal 2015 from an operating loss of $42.6 million in the fourth quarter of fiscal 2014. We recorded special charges of $2.5 million during the first quarter of fiscal 2015 and $56.5 million during the fourth quarter of fiscal 2014. • Net income increased to $6.0 million, or $0.07 per diluted share, in the first quarter of fiscal 2015 from a net loss of $46.8 million, or $0.54 per diluted share, in the fourth quarter of fiscal 2014. • Cash, cash equivalents and marketable securities were $250.4 million as of June 29, 2014 compared to $278.0 million as of March 30, 2014. 12 -------------------------------------------------------------------------------- Table of Contents Results of Operations Net Revenues A summary of our net revenues by product category is as follows: Three Months Ended June 29, June 30, 2014 2013 (Dollars in millions) Net revenues: Advanced Connectivity Platforms $ 104.7 $ 93.2 Legacy Connectivity Products 14.7 19.9 $ 119.4 $ 113.1 Percentage of net revenues: Advanced Connectivity Platforms 88 % 82 % Legacy Connectivity Products 12 18 100 % 100 % Historically, the global marketplace for server and storage connectivity solutions has expanded in response to the information requirements of enterprise data centers, cloud computing, Web 2.0 and other environments dependent on high performance, reliable data networking. The markets we serve have been characterized by rapid advances in technology and related product performance, which has generally resulted in declining average selling prices for existing products over time. The market for our Fibre Channel products is mature and has declined during recent periods. This market decline may be the result of a shift in the information technology (IT) data center deployment model, as more enterprise data centers are using private or public clouds to provide a portion of their requirements. This shift has adversely impacted the enterprise server market. To the extent the Fibre Channel market continues to decline, our quarterly operating results would be negatively impacted. In addition, the United States and other countries around the world have experienced, and are continuing to experience, economic weakness and uncertainty. Political instability in certain regions of the world is significantly contributing to this economic uncertainty. Economic uncertainty is adversely affecting, and in the future may continue to adversely affect, IT spending rates, which may have a negative impact on our revenue and operating results. As a result of these factors, it is extremely difficult for us to forecast future sales levels and historical information may not be indicative of future trends. Net revenues of $119.4 million for the three months ended June 29, 2014 increased 6% from $113.1 million for the three months ended June 30, 2013. The increase in net revenues was the result of an $11.5 million, or 12%, increase in revenue from Advanced Connectivity Platforms, partially offset by a $5.2 million decrease in revenue from Legacy Connectivity Products. The increase in revenue from Advanced Connectivity Platforms was primarily driven by an increase in revenue from Ethernet products associated with an acquisition in the fourth quarter of fiscal 2014. We expect our revenue from Advanced Connectivity Platforms to grow during fiscal 2015, primarily driven by increased shipments of our Ethernet products. The decrease in revenue from Legacy Connectivity Products was primarily due to an 11% decrease in the quantity of switches sold and a 21% decrease in average selling prices of these products. We expect net revenue from our Legacy Connectivity Products to continue to decline over time. As part of the restructuring plan we implemented in June 2013, we ceased development of future ASICs for switch products; however, we will continue to sell and support products based on the current generation switch ASICs. A small number of our customers account for a substantial portion of our net revenues, and we expect that a small number of customers will continue to represent a substantial portion of our net revenues for the foreseeable future. Our top ten customers accounted for 84% and 83% of net revenues during the three months ended June 29, 2014 and June 30, 2013, respectively. We believe our major customers continually evaluate whether or not to purchase products from alternative or additional sources. Accordingly, there can be no assurance that a major customer will not reduce, delay or eliminate its purchases from us. Any such reduction, delay or loss of purchases could have a material adverse effect on our business, financial condition or results of operations. 13 -------------------------------------------------------------------------------- Table of Contents Net revenues by geographic area are as follows: Three Months Ended June 29, June 30, 2014 2013 (In millions) United States $ 47.3 $ 49.1 Asia-Pacific and Japan 50.2 38.7 Europe, Middle East and Africa 17.9 20.6 Rest of world 4.0 4.7 $ 119.4 $ 113.1 Revenues by geographic area are presented based upon the ship-to location of the customer, which is not necessarily indicative of the location of the ultimate end-user of our products. The United States and China are the only countries that represented 10% or more of net revenues for the periods presented. Net revenues from customers in China were $19.1 million and $13.9 million for the three months ended June 29, 2014 and June 30, 2013, respectively. Gross Profit Gross profit represents net revenues less cost of revenues. Cost of revenues consists primarily of the cost of purchased products, assembly and test services; costs associated with product procurement, inventory management, logistics and product quality; and the amortization of purchased intangible assets and other assets. A summary of our gross profit and related percentage of net revenues is as follows: Three Months Ended June 29, June 30, 2014 2013 (Dollars in millions) Gross profit $ 70.7 $ 76.5 Percentage of net revenues 59.2 % 67.6 % Gross profit for the three months ended June 29, 2014 decreased $5.8 million, or 8%, from gross profit for the three months ended June 30, 2013. The gross profit percentage for the three months ended June 29, 2014 decreased to 59.2% from 67.6% for the corresponding quarter in the prior year. The decrease in gross profit and gross profit percentage was primarily due to an unfavorable product mix and incremental acquisition-related costs of $4.2 million for amortization of purchased intangible assets and $0.8 million for acquired inventory valuation step-up amortization. Our ability to maintain our current gross profit percentage may be significantly affected by factors such as the mix of products shipped, manufacturing volumes over which fixed costs are absorbed, sales discounts and customer incentives, component costs, the transition to new products, competitive price pressures, the timeliness of volume shipments of new products, our ability to achieve manufacturing cost reductions, and amortization and impairments of purchased intangible assets and other assets. We anticipate that it will continue to be difficult to reduce manufacturing costs. In addition, our anticipated future growth in revenue is expected to be driven primarily by increased shipments of Ethernet products that have a lower gross profit percentage than our historical corporate average. As a result of these and other factors, our gross profit percentage is expected to decline in future periods. 14-------------------------------------------------------------------------------- Table of Contents Operating Expenses Our operating expenses are summarized in the following table: Three Months Ended June 29, June 30, 2014 2013 (Dollars in millions) Operating expenses: Engineering and development $ 37.8 $ 40.4 Sales and marketing 16.1 19.4 General and administrative 8.9 7.8 Special charges 2.5 12.0 $ 65.3 $ 79.6 Percentage of net revenues: Engineering and development 31.7 % 35.7 % Sales and marketing 13.4 17.2 General and administrative 7.5 6.8 Special charges 2.1 10.6 54.7 % 70.3 % Engineering and Development. Engineering and development expenses consist primarily of compensation and related employee benefit costs, outside service and material costs, occupancy and equipment costs and related computer support costs. During the three months ended June 29, 2014, engineering and development expenses decreased to $37.8 million from $40.4 million for the three months ended June 30, 2013. The decrease was primarily due to a $1.7 million decrease in cash compensation and related employee benefit costs and a $1.4 million decrease in stock-based compensation, both principally due to cost savings achieved as a result of our restructuring plans. We believe continued investments in engineering and development activities are critical to achieving future design wins, expansion of our customer base and revenue growth opportunities. Sales and Marketing. Sales and marketing expenses consist primarily of compensation and related employee benefit costs, sales commissions, promotional activities and travel for sales and marketing personnel. During the three months ended June 29, 2014, sales and marketing expenses decreased to $16.1 million from $19.4 million for the three months ended June 30, 2013. The decrease was primarily due to a $1.4 million decrease in cash compensation and related employee benefit costs and a $0.8 million decrease in stock-based compensation, both principally due to a reduction in headcount resulting from our restructuring plans. The decrease in sales and marketing expenses also included a $0.9 million decrease in promotional expenses. General and Administrative. General and administrative expenses consist primarily of compensation and related employee benefit costs for executive, finance, accounting, human resources, legal and information technology personnel. Non-compensation components of general and administrative expenses include accounting, legal and other professional fees, facilities expenses and other corporate expenses. General and administrative expenses increased to $8.9 million for the three months ended June 29, 2014 from $7.8 million for the three months ended June 30, 2013, primarily due to an increase in consulting and outside services. Special Charges. During the three months ended June 29, 2014, we recorded special charges of $2.5 million, consisting of $1.0 million of exit costs, $1.0 million of asset impairment charges related to abandoned property and equipment and $0.5 million of other charges. During the three months ended June 30, 2013, we recorded special charges of $12.0 million, consisting of $9.6 million of exit costs and $2.4 million of asset impairment charges. The exit costs include severance and related costs associated with involuntarily terminated employees. Certain employees that were notified of their termination are required to provide services for varying periods in excess of statutory notice periods. Severance costs related to these services are recognized ratably over the estimated requisite service period. Exit costs during the three months ended June 30, 2013 also include the estimated costs associated with the portion of a facility under a non-cancelable lease that we ceased using. We expect to incur between $1 million and $2 million of additional exit costs associated with the restructuring plan initiated in June 2013, principally related to severance costs for terminated employees that are required to provide services beyond the statutory notice period. The unpaid exit costs of $7.8 million as of June 29, 2014 are expected to be paid over the terms of the related agreements through fiscal 2018, including $2.5 million during the next twelve months. 15-------------------------------------------------------------------------------- Table of Contents Income Taxes Our provision (benefit) for income taxes was $(0.5) million and $0.7 million for the three months ended June 29, 2014 and June 30, 2013, respectively. The income tax benefit for the three months ended June 29, 2014 was primarily due to adjustments to previously recognized uncertain tax position liabilities and certain other discrete items. Income tax expense was also impacted by the effect of a discrete tax-related item associated with the difference between stock-based compensation expense and the deduction related to stock-based awards on income tax returns. Our federal consolidated income tax returns for fiscal years 2010, 2011 and 2012 are currently under examination by the Internal Revenue Service. We do not believe that the results of this examination will have a material impact on our financial condition or results of operations. Considering the global scope of our operations and the complexity of global tax and transfer pricing rules and regulations, it is difficult to estimate earnings within each tax jurisdiction. If actual earnings within each tax jurisdiction differ materially from our estimates, we may not achieve our expected effective tax rate. Additionally, our effective tax rate may be impacted by other items, including the tax effects of acquisitions and dispositions, changes to tax laws or regulations, examinations by tax authorities, stock-based compensation, uncertain tax positions and changes in our ability to realize deferred tax assets. Liquidity and Capital Resources Our combined balances of cash, cash equivalents and marketable securities decreased to $250.4 million as of June 29, 2014 from $278.0 million as of March 30, 2014. As of June 29, 2014 and March 30, 2014, our international subsidiaries held $204.4 million and $232.8 million, respectively, of our total cash, cash equivalents and marketable securities. These holdings by our international subsidiaries consisted primarily of debt securities due from U.S. issuers, including the U.S. government and related agencies, and U.S. dollar denominated cash and money market funds. Certain foreign regulations could impact our ability to transfer funds to the United States. We currently intend to invest the funds held outside of the United States in our international operations and, as a result, do not intend to repatriate these funds. Should we decide to repatriate funds held outside of the United States, we may incur a significant tax obligation. We believe that existing cash, cash equivalents, marketable securities and expected cash flow from operations will provide sufficient funds to finance our operations for at least the next twelve months. However, it is possible that we may need to supplement our existing sources of liquidity to finance our activities beyond the next twelve months or for the future acquisition of businesses, products or technologies and there can be no assurance that sources of liquidity will be available to us at that time. Revolving Credit Facility We have a credit agreement that provides us with a $125 million unsecured revolving credit facility that matures in March 2018. Borrowings under the credit agreement may be used for general corporate purposes, including permitted share repurchases and acquisitions. Under the credit agreement, we may increase the revolving commitments or obtain incremental term loans in an aggregate amount up to an additional $100 million, subject to certain conditions. There were no borrowings outstanding under the credit agreement as of June 29, 2014. Operating, Investing and Financing Activities Cash used in operating activities was $16.6 million for the three months ended June 29, 2014 compared to cash provided by operating activities of $16.6 million for the three months ended June 30, 2013. Operating cash flow for the three months ended June 29, 2014 consisted of our net income of $6.0 million, net non-cash expenses of $23.4 million and net cash used as a result of changes in operating assets and liabilities of $46.0 million. The changes in operating assets and liabilities included an $18.9 million increase in accounts receivable, a $7.7 million increase in inventories, a $7.2 million decrease in accrued compensation and a $7.3 million decrease in other liabilities. The increase in accounts receivable was primarily due to customer mix and an increase in revenue, as well as the timing of customer shipments and cash collections during the quarter. The increase in inventories was primarily due to advanced purchases of ASICs in support of future customer demand due to long lead times for these products. The decrease in accrued compensation was primarily due to the timing of payment obligations. The decrease in other liabilities was primarily due to the payment of severance and related costs associated with our restructuring plans. 16-------------------------------------------------------------------------------- Table of Contents We expect our business will continue to require additional investments in certain components of working capital. The product fulfillment model associated with our fiscal 2014 acquisitions is expected to require additional investments in inventory during fiscal 2015. Operating cash flow for the three months ended June 30, 2013 consisted of our net loss of $3.1 million, net non-cash expenses of $24.2 million and net cash used as a result of changes in operating assets and liabilities of $4.5 million. The changes in operating assets and liabilities included a $5.4 million decrease in accrued compensation and a $5.4 million decrease in accrued taxes, net, partially offset by a $6.8 million increase in other liabilities. The decrease in accrued compensation was primarily due to the timing of payment obligations. The decrease in accrued taxes was primarily due to estimated tax payments remitted during the fiscal quarter. The increase in other liabilities was primarily due to accrued exit costs associated with our restructuring plan. Cash used in investing activities was $11.8 million for the three months ended June 29, 2014 and consisted of $9.0 million of purchases of property and equipment and $2.8 million of net purchases of available-for-sale securities. During the three months ended June 30, 2013, cash provided by investing activities was $9.2 million and consisted of $19.3 million of net sales and maturities of available-for-sale securities, partially offset by $10.1 million of purchases of property and equipment. We expect capital expenditures to remain significant in the future as we continue to invest in more costly engineering and production tools for new technologies, machinery and equipment, and enhancements to our corporate information technology infrastructure. Cash used in financing activities was $1.9 million for the three months ended June 29, 2014 and consisted primarily of $3.3 million for minimum tax withholdings paid on behalf of employees for restricted stock units that vested during the period, partially offset by $1.4 million of proceeds from the issuance of common stock under stock-based awards. During the three months ended June 30, 2013, cash used in financing activities was $26.8 million and consisted primarily of our purchase of $24.4 million of common stock under our stock repurchase program and $4.3 million for minimum tax withholdings paid on behalf of employees for restricted stock units that vested during the period, partially offset by $2.0 million of proceeds from the issuance of common stock under stock-based awards. Contractual Obligations and Commitments We have certain contractual obligations and commitments to make future payments in the form of non-cancelable purchase orders to our suppliers and commitments under operating lease arrangements. A summary of our contractual obligations as of June 29, 2014, and their impact on our cash flows in future fiscal years, is as follows: 2015 (Remaining nine months) 2016 2017 2018 2019 Total (In millions) Operating leases $ 7.8 $ 7.3 $ 4.1 $ 1.9 $ 0.2 $ 21.3 Non-cancelable purchase obligations 51.8 - - - - 51.8 Total $ 59.6 $ 7.3 $ 4.1 $ 1.9 $ 0.2 $ 73.1 Our liability for unrecognized tax benefits, including related accrued interest and penalties, was $13.9 million as of June 29, 2014. We are not able to provide a reasonable estimate of the timing of future tax payments related to these obligations. Critical Accounting Policies and Estimates The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenues and expenses during the reporting period. We base our estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances, including the current economic environment, in making judgments about the carrying values of assets and liabilities. For a description of the accounting policies that we believe to be our most critical accounting policies and estimates, see Critical Accounting Policies and Estimates included in Part II, Item 7 of our Annual Report on Form 10-K for the year ended March 30, 2014. There have been no material changes in any of our critical accounting policies and estimates during the three months ended June 29, 2014. These accounting policies are significantly affected by judgments, assumptions and estimates used in the preparation of the financial statements and actual results could differ materially from the amounts reported based on these policies. 17 -------------------------------------------------------------------------------- Table of Contents Recently Issued Accounting Standards Not Yet Effective In May 2014, the Financial Accounting Standards Board issued an accounting standard update which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The standard will replace most existing revenue recognition guidance when it becomes effective. The new standard is effective for us in the first quarter of fiscal 2018. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. We are currently evaluating the effect this new guidance will have on our consolidated financial statements and related disclosures, and have not yet selected a transition method. Off-Balance Sheet Arrangements During the periods presented, we did not have any off-balance sheet arrangements other than operating leases. |