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EMC 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 ("MD&A") of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and notes thereto which appear elsewhere in this Quarterly Report on Form 10-Q. The following discussion contains forward-looking statements and should also be read in conjunction with the risk factors set forth in Item 1A of Part II. The forward-looking statements do not include the potential impact of any mergers, acquisitions, divestitures, securities offerings or business combinations that may be announced or closed after the date hereof. Certain tables may not add or recalculate due to rounding.INTRODUCTION We manage our business as three federated businesses, each of which plays a vital role in the delivery of IT-as-a-service ("ITaaS"): EMC Information Infrastructure, Pivotal and VMware Virtual Infrastructure. This approach allows each of the three businesses to individually build best-of-breed products, go-to-market capabilities and ecosystems that they need to succeed in their respective markets while sharing the same ultimate goal of helping customers manage information which is becoming central to their operations as data centers move to an ITaaS model. In 2014, we will continue investing in the best technology and building the most complete portfolio to transition customers from the second platform of IT to the emerging and rapidly growing third platform of IT. We are a leader in the second platform of IT, which continues to support the vast majority of enterprise workloads and customers contained at these environments, and we believe we will continue to gain share in 2014. At the same time, we believe we have more offerings in the third platform of IT than anyone else and are better equipped to help customers bridge the gap as they transition from the second to third platform of IT. The third platform of IT includes cloud computing, Big Data, mobile, and social networking, which to operate successfully requires Trusted IT to establish security, privacy and trust in IT solutions. By segmenting our strategy and executional focus across these three businesses, we can focus on each of their respective missions and offer customers horizontal solutions and more choices than they get from our competitors to maximize control, efficiency and choice. We believe this strategy provides us with the opportunity to take advantage of the solid growth opportunity of EMC Information Infrastructure and the faster growth opportunities of VMware Virtual Infrastructure and Pivotal. EMC Information Infrastructure Our EMC Information Infrastructure business consists of three segments: Information Storage, Information Intelligence and RSA Information Security. The objective for our EMC Information Infrastructure business is to simultaneously increase our market share through our strong and ever expanding portfolio of offerings while investing in the business. During 2014, we will continue to innovate and invest in expanding our total addressable market through increased internal research and development ("R&D"), with a focus on flash, Big Data storage, software-defined storage and converged infrastructure to facilitate the enablement of cloud infrastructures, both public and private. Our investment in new technologies and solutions is reflected in our roadmap for 2014, with numerous innovations, product refreshes and brand-new products as well as continued focus on business acquisitions. We have developed a product portfolio with customers' current and future needs in mind which will continue to evolve as the largest transformation in IT history is creating enormous opportunities in cloud computing, Big Data and Trusted IT. Our go to market model, where we continue to leverage our direct sales force and services organization, as well as our channel and services partners and service providers, positions us well to help enable customers to transition to cloud computing and benefit from Big Data in the most advantageous manner for their businesses. As IT headcount grows at a fraction of the pace of data and the demands from the data center escalate, customers continue to look for simple and scalable ways to build out their ITaaS function. We offer three alternatives to help our customers transition to cloud architectures, in private, hybrid and public clouds, and leverage Big Data to meet these needs: our best-of-breed infrastructure products, proven infrastructure through VSPEX and converged infrastructure with Vblock from VCE Company LLC, our joint venture with Cisco, and other investors VMware and Intel, which continues to gather momentum in one of the fastest growing areas in IT. Our service provider program continues to be an important part of our strategy to lead our customers to the public cloud. Pivotal In April 2013, we, along with VMware and an investment from General Electric Company ("GE"), formed Pivotal, which is focused on building a platform comprising the next generation of data fabrics, application fabrics and a cloud independent platform-as-a-service ("PaaS") to support cloud computing and Big and Fast Data Applications. The first version of this integrated technology platform, Pivotal One, will continue to be a cornerstone offering in 2014 together with high-value strategic services. The foundation of Pivotal One, Cloud Foundry, continues to gain momentum as an open platform for developing and operating new cloud applications that can be run on multiple leading private and public clouds in addition to our own and not lock a customer into any one cloud in particular. On top of this platform, Pivotal will offer its own suite of big and fast data capabilities, featuring game 33-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) changing innovations that use Hadoop Distributed File System ("HDFS") and scalar processing technologies. Additionally, its development services business, Pivotal Labs, will help existing customers and digital era startups build industrial-strength applications with more agility, more speed, and better quality. With its renewed focus on driving a business model to support exclusively software and strategic services, we believe we are positioning the business for rapid growth in the future. VMware Virtual Infrastructure VMware is the leader in virtualization infrastructure solutions utilized by organizations to help transform the way they build, deliver and consume IT resources. VMware develops and markets its product and service offerings within three main product groups, and it also seeks to leverage synergies across these three product areas: SDDC or Software-Defined Data Center, End-User Computing and Hybrid Cloud Computing. VMware pioneered the development and application of virtualization technologies with x86 server-based computing, separating application software from the underlying hardware. The benefits to VMware's customers include lower IT costs and a more automated and resilient systems infrastructure capable of responding dynamically to variable business demands. VMware expects to grow its business by building long-term relationships with its customers which includes selling its solutions through enterprise license agreements ("ELAs"). VMware has articulated a vision for the software-defined data center ("SDDC"), where increasingly infrastructure is virtualized and delivered as a service, enabling control of the data center to be entirely automated by software. The SDDC is designed to transform the data center into an on-demand service that addresses application requirements by abstracting, pooling and automating the services that are required from the underlying hardware. SDDC promises to dramatically simplify data center operations and lower costs. The VMware vCloud Suite, which is its first integrated solution toward realizing the SDDC vision and is based upon its VMware vSphere virtualization platform, was initially introduced in late 2012. On a consolidated basis, given our position and strength, we are working with a very large installed base of loyal customers with leading-edge technology for every layer of the IT stack, products and services for the infrastructure layer that include best-of-breed storage arrays, software defined storage, converged infrastructure and information security. Solutions for the virtualization layer that enable the software defined data center, hybrid cloud and end-user computing and a cloud agnostic PaaS offering have become the PaaS offerings of choice for enterprises looking to build out next-gen apps to harness the power of Big Data. This combination provides a strong portfolio of offerings and solutions in the second platform which will continue to support the majority of workloads for several years to come as the market transitions to the third platform with leading technologies and product as a services offerings and a powerful capability to bridge the gap between the two. Our vision, strategy, market leading assets within our portfolio which continues to be expanded with our recent and upcoming product releases, as well as our go-to market capabilities positions us to continue to anticipate and capitalize on the mega trends of cloud computing and Big Data, while addressing the mobile and social networking trends, with the necessary Trusted IT needs in 2014 and beyond. As a result, we believe on a consolidated basis we will continue to grow faster than the markets we serve in 2014, as we simultaneously invest in the business and grow earnings per share. RESULTS OF OPERATIONS Revenues The following tables present total revenue by our segments (in millions): For the Three Months Ended June 30, June 30, 2014 2013 $ Change % Change Information Storage $ 3,976 $ 3,954 $ 22 1 % Information Intelligence Group 158 152 6 4 % RSA Information Security 243 228 15 6 % Pivotal 54 42 12 29 % VMware Virtual Infrastructure 1,449 1,238 211 17 % Total revenues $ 5,880 $ 5,614 $ 266 5 % 34-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) For the Six Months Ended June 30, June 30, 2014 2013 $ Change % Change Information Storage $ 7,656 $ 7,752 $ (96 ) (1 )% Information Intelligence Group 312 308 4 1 % RSA Information Security 486 460 26 6 % Pivotal 104 77 27 35 % VMware Virtual Infrastructure 2,801 2,404 397 16 % Total revenues $ 11,359 $ 11,001 $ 358 3 % Consolidated product revenues increased 2% to $3,319 million and decreased 1% to $6,327 million for the three and six months ended June 30, 2014, respectively. The percentage increase for the three months ended June 30, 2104 was primarily driven by the VMware Virtual Infrastructure segment, partially offset by the Information Storage segment. The percentage decrease for the six months ended June 30, 2104 was primarily driven by the Information Storage segment, somewhat offset by the VMware Virtual Infrastructure segment. The Information Storage segment's product revenues decreased 1% and 4% to $2,551 million and $4,853 million for the three and six months ended June 30, 2014, respectively. Revenue from the high-end storage business decreased 14% for the three months ended June 30, 2014 primarily driven by a customer pause in purchasing in anticipation of our upcoming refresh of our high end offerings and higher than typical revenues in the three months ended June 30, 2013, which negatively impacted the growth rate for the period. Additionally, the planned change in our order fulfillment processes and higher than normal revenues in the six months ended June 30, 2013 also negatively impacted our high-end growth rate. Partially offsetting this decrease, revenue from the Emerging Storage business increased 52% and 65% for the three and six months ended June 30, 2014, respectively, primarily due to increased demand for our portfolio of best-of-breed products that are thriving with the shift to the third platform, including flash from XtremIO, software defined storage with ViPR, object-based cloud storage with Atmos and scale-out file storage from Isilon. Additionally, revenue from the Unified and Backup Recovery business increased 6% and 5% during the three and six months ended June 30, 2014, respectively, with growth generated from both our VNX and Data Domain offerings. The Pivotal segment's product revenues decreased 1% and 5% to $15 million and $26 million for the three and six months ended June 30, 2014, respectively. The decrease is primarily attributable to an increase in license orders which have subscription-based, ratable revenue recognition. As a result, Pivotal's product revenue decline for the quarter does not reflect the growth in demand which grew compared to the comparable periods in the prior year. Pivotal continues to have significant customer wins with its newer offerings of Pivotal One and Pivotal CF, which is based on Cloud Foundry. Cloud Foundry, a cloud-independent PaaS, continues gaining momentum to become the standard for PaaS, as Pivotal adds numerous sponsors who will utilize the platform to build out the next-generation applications. The VMware Virtual Infrastructure segment's product revenues increased 16% and 15% to $612 million and $1,168 million for the three and six months ended June 30, 2014, respectively. VMware's license revenues increased during the three and six months ended June 30, 2014 primarily due to an increase in revenue from its integrated product suites, including VMware vCloud Suite. Its integrated product suites include various product offerings and are sold at a greater price than our products that are sold on an individual basis. ELAs comprised 37% of their overall sales during both the three months ended June 30, 2014 and 2013 and 32% and 33% of their overall sales during the six months ended June 30, 2014 and 2013, respectively, with the balance represented by non-ELA, or transactional business. The RSA Information Security segment's product revenues increased 7% and 6% to $104 million and $208 million for the three and six months ended June 30, 2014, respectively. The increase in product revenue was driven by growth in both our Identity and Data Protection and Security Management and Compliance businesses. Security continues to become increasingly more important in IT decisions and RSA continues to benefit from this trend with its advanced, data driven security offerings. The Information Intelligence Group segment's product revenues decreased 6% and 13% to $37 million and $72 million for the three and six months ended June 30, 2014, respectively. The year-over-year decrease in product revenues was primarily due to the timing of revenue recognition resulting from growth in the subscription business. This business continues to make progress as it continues to innovate to meet customers' demand for technologies that work seamlessly in mobile cloud environments, like xCP and Syncplicity. 35-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Consolidated services revenues increased 9% to $2,561 million and $5,032 million for both the three and six months ended June 30, 2014, respectively. The consolidated services revenues increase was primarily driven by the Information Storage and VMware Virtual Infrastructure segments' services revenues resulting from increased revenue associated with maintenance services and increased demand for professional services as we continue to provide expertise to customers on effective ways to enable cloud computing and to leverage their Big Data assets. The Information Storage segment's services revenues increased 3% and 4% to $1,425 million and $2,803 million for the three and six months ended June 30, 2014, respectively. The increase in services revenues was primarily attributable to higher revenue associated with maintenance services due to a larger installed base as well as increased professional services. We have experienced a growing demand for professional services as we assist with customers' transitions to cloud architectures, transforming IT infrastructures and virtualizing mission-critical applications. The Pivotal segment's services revenues increased 46% and 57% to $39 million and $78 million for the three and six months ended June 30, 2014, respectively. The increase in services revenues was primarily attributable to higher professional services in the three and six months ended June 30, 2014 as Pivotal transitions to enterprise customers, with their renewed focus on agile development and services surrounding their Pivotal One and Pivotal CF platforms. The VMware Virtual Infrastructure segment's services revenues increased 18% and 17% to $837 million and $1,633 million for the three and six months ended June 30, 2014, respectively. The increase in services revenues was primarily attributable to growth in VMware's software maintenance revenues which benefited from strong renewals, multi-year software maintenance contracts sold in previous periods and additional maintenance contracts sold in conjunction with new software license sales. Additionally, VMware experienced increased demand in their professional services, driven by the growth in their license sales and installed base. The RSA Information Security segment's services revenues increased 6% to $139 million and $278 million for both the three and six months ended June 30, 2014, respectively. Services revenues increased due to an increase primarily in professional services, as well as an increase in maintenance revenues, resulting from continued demand for support from our installed base. The Information Intelligence Group segment's services revenues increased 7% and 6% to $121 million and $240 million for the three and six months ended June 30, 2014, respectively. The increase in services revenues was due to increased customer demand for services related to new product offerings and strategic professional services. Consolidated revenues by geography were as follows (in millions): For the Three Months Ended June 30, June 30, 2014 2013 % Change United States $ 3,056 $ 2,963 3 % Europe, Middle East and Africa 1,669 1,486 12 % Asia Pacific and Japan 802 835 (4 )% Latin America, Mexico and Canada 353 330 7 % Total revenues $ 5,880 $ 5,614 5 % For the Six Months Ended June 30, June 30, 2014 2013 % Change United States $ 5,890 $ 5,795 2 % Europe, Middle East and Africa 3,261 2,963 10 % Asia Pacific and Japan 1,525 1,573 (3 )% Latin America, Mexico and Canada 683 670 2 % Total revenues $ 11,359 $ 11,001 3 % Revenues increased for the three and six months ended June 30, 2014 compared to the same periods in 2013 in the United States, Europe, Middle East and Africa and Latin America, Mexico and Canada. Revenues decreased in the three and six months ended June 30, 2014 in the Asia Pacific and Japan regions when compared to the same periods in 2013. 36-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Changes in exchange rates positively impacted revenue growth by 0.5% for the three months ended June 30, 2014 and had no impact to revenue growth for the six months ended June 30, 2014. The positive impact of the change in rates was most significant in Euro region and the United Kingdom, somewhat offset by negative impacts from the Asia Pacific markets, primarily Australia and Japan. Costs and Expenses The following tables present our costs and expenses, operating income and net income attributable to EMC Corporation (in millions): For the Three Months Ended June 30, June 30, 2014 2013 $ Change % Change Cost of revenue: Information Storage $ 1,784 $ 1,718 $ 66 4 % Information Intelligence Group 58 56 2 4 % RSA Information Security 81 80 1 1 % Pivotal 28 22 6 31 % VMware Virtual Infrastructure 177 129 48 37 % Corporate reconciling items 98 100 (2 ) (2 )% Total cost of revenue 2,226 2,105 121 6 % Gross margins: Information Storage 2,192 2,236 (44 ) (2 )% Information Intelligence Group 100 96 4 4 % RSA Information Security 162 148 14 9 % Pivotal 26 20 6 27 % VMware Virtual Infrastructure 1,272 1,109 163 15 % Corporate reconciling items (98 ) (100 ) 2 (2 )% Total gross margin 3,654 3,509 145 4 % Operating expenses: Research and development(1) 740 695 45 7 % Selling, general and administrative(2) 2,010 1,785 225 13 % Restructuring and acquisition and other related charges 30 7 23 328 % Total operating expenses 2,780 2,487 293 12 % Operating income 874 1,022 (148 ) (14 )% Investment income, interest expense and other expenses, net (65 ) (56 ) (9 ) 16 % Income before income taxes 809 966 (157 ) (16 )% Income tax provision 187 216 (29 ) (14 )% Net income 622 750 (128 ) (17 )% Less: Net income attributable to the non-controlling interest in VMware, Inc. (33 ) (49 ) 16 (31 )% Net income attributable to EMC Corporation $ 589 $ 701 $ (112 ) (16 )% 37-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) For the Six Months Ended June 30, June 30, 2014 2013 $ Change % Change Cost of revenue: Information Storage $ 3,488 $ 3,428 $ 60 2 % Information Intelligence Group 113 113 - - % RSA Information Security 163 159 4 2 % Pivotal 59 40 19 49 % VMware Virtual Infrastructure 344 254 90 36 % Corporate reconciling items 191 200 (9 ) (5 )% Total cost of revenue 4,358 4,194 164 4 % Gross margins: Information Storage 4,168 4,324 (156 ) (4 )% Information Intelligence Group 199 195 4 2 % RSA Information Security 323 301 22 8 % Pivotal 45 37 8 20 % VMware Virtual Infrastructure 2,457 2,150 307 14 % Corporate reconciling items (191 ) (200 ) 9 (5 )% Total gross margin 7,001 6,807 194 3 % Operating expenses: Research and development(3) 1,472 1,370 102 7 % Selling, general and administrative(4) 3,861 3,499 362 10 % Restructuring and acquisition and other related charges 149 155 (6 ) (4 )% Total operating expenses 5,482 5,024 458 9 % Operating income 1,519 1,783 (264 ) (15 )% Investment income, interest expense and other expenses, net (139 ) (126 ) (13 ) 11 % Income before income taxes 1,380 1,657 (277 ) (17 )% Income tax provision 326 292 34 11 % Net income 1,054 1,365 (311 ) (23 )% Less: Net income attributable to the non-controlling interest in VMware, Inc. (74 ) (84 ) 10 (11 )% Net income attributable to EMC Corporation $ 980 $ 1,281 $ (301 ) (23 )% ___________(1) Amount includes corporate reconciling items of $103 million and $85 million for the three months ended June 30, 2014 and 2013, respectively. (2) Amount includes corporate reconciling items of $222 million and $142 million for the three months ended June 30, 2014 and 2013, respectively. (3) Amount includes corporate reconciling items of $196 million and $178 million for the six months ended June 30, 2014 and 2013, respectively. (4) Amount includes corporate reconciling items of $394 million and $292 million for the six months ended June 30, 2014 and 2013, respectively. Gross Margins Overall our gross margin percentages were 62.1% and 62.5% for the three months ended June 30, 2014 and 2013, respectively. The decrease in the gross margin percentage in the second quarter of 2014 compared to 2013 was attributable to the Information Storage segment, which decreased overall gross margins by 100 basis points, and the Pivotal segment, which decreased overall gross margins by 4 basis points. These decreases were partially offset by the VMware Virtual Infrastructure segment, which increased overall gross margins by 56 basis points and the RSA Information Security segment, which increased overall gross margins by 8 basis points during the three months ended June 30, 2014. In addition, the decrease in corporate reconciling items, consisting of stock-based compensation, acquisition and other related intangible asset amortization and the amortization of VMware's capitalized software from prior periods increased the consolidated gross margin percentage by 3 basis points. 38-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Overall our gross margin percentages were 61.6% and 61.9% for the six months ended June 30, 2014 and 2013, respectively. The decrease in the gross margin percentage in the second quarter of 2014 compared to 2013 was attributable to the Information Storage segment, which decreased overall gross margins by 87 basis points, and the Pivotal segment, which decreased overall gross margins by 8 basis points. These decreases were partially offset by the VMware Virtual Infrastructure segment, which increased overall gross margins by 55 basis points, the RSA Information Security segment, which increased overall gross margins by 7 basis points, and the Information Intelligence Group segment, which increased overall gross margins by 2 basis points. In addition, the decrease in corporate reconciling items, consisting of stock-based compensation, acquisition and other related intangible asset amortization and the amortization of VMware's capitalized software from prior periods increased the consolidated gross margin percentage by 8 basis points. For segment reporting purposes, stock-based compensation, acquisition and other related intangible asset amortization and the amortization of VMware's capitalized software from prior periods are recognized as corporate expenses and are not allocated among our various operating segments. The decrease of $2 million in the corporate reconciling items within cost of goods sold for the three months ended June 30, 2014 compared to the same period in 2013 was attributable to a $12 million decrease in amortization of VMware's capitalized software from prior periods, partially offset by a $7 million increase in stock-based compensation expense and a $3 million increase in intangible asset amortization. The decrease of $9 million in the corporate reconciling items within cost of goods sold for the six months ended June 30, 2014 compared to the same period in 2013 was attributable to a $25 million decrease in amortization of VMware's capitalized software from prior periods, partially offset by a $12 million increase in stock-based compensation expense and a $4 million increase in intangible asset amortization. The gross margin percentages for the Information Storage segment were 55.1% and 56.5% for the three months ended June 30, 2014 and 2013, respectively, and 54.4% and 55.8% for the six months ended June 30, 2014 and 2013, respectively. The decrease in gross margin percentage for the three and six months ended June 30, 2014 compared to the same periods in 2013 was due to a decrease in product margins and product and service margins, respectively. The decrease in product margins in both the three and six months ended June 30, 2014 was primarily due to lower sales volume without a corresponding decrease in fixed costs and pricing pressures on our high-end storage products in anticipation of the new VMAX refresh. The decrease in service margins was due to higher costs to support increased field service activity in the three and six months ended June 30, 2014, which was consistent with the field service costs in the second half of 2013, but higher than the field service costs experienced in the first half of 2013. The gross margin percentages for the Pivotal segment were 47.2% and 48.1% for the three months ended June 30, 2014 and 2013, respectively, and 42.9% and 48.1% for the six months ended June 30, 2014 and 2013, respectively. The decrease in gross margin percentage for the three and six months ended June 30, 2014 compared to the same periods in 2013 was primarily due to a higher mix of services revenues as a result of the increased demand for subscription-based licenses and for Pivotal services as Pivotal works with customers to determine how best to leverage newer technologies such as Pivotal CF and Pivotal One. The gross margin percentages for the VMware Virtual Infrastructure segment were 87.8% and 89.6% for the three months ended June 30, 2014 and 2013, respectively, and 87.7% and 89.4% for the six months ended June 30, 2014 and 2013, respectively. The decrease in gross margin percentage for the three and six months ended June 30, 2014 compared to the same periods in 2013 was primarily attributable to the decrease in services margin due to an increase in employee-related expenses driven by incremental growth in headcount, both organic and through the AirWatch acquisition. In addition, increases in costs incurred to provide technical support as well as increases in equipment and depreciation costs contributed to the decreased margins. The gross margin percentages for the RSA Information Security segment were 66.7% and 65.1% for the three months ended June 30, 2014 and 2013, respectively, and 66.4% and 65.2% for the six months ended June 30, 2014 and 2013, respectively. The increase in gross margin percentage for the three and six months ended June 30, 2014 compared to the same periods in 2013 was primarily due to an increase in product margins resulting from sales of higher margin products. The gross margin percentages for the Information Intelligence Group segment were 63.2% and 63.1% for three months ended June 30, 2014 and 2013, respectively, and 63.9% and 63.4% for the six months ended June 30, 2014 and 2013, respectively. The increase in gross margin percentage for the three and six months ended June 30, 2014 compared to the same periods in 2013 was driven by a higher mix of services revenue as a result of lower licenses revenue as demand for subscription-based licenses increases. Research and Development As a percentage of revenues, R&D expenses were 13% and 12% for the three months ended June 30, 2014 and 2013, respectively, and were 13% for both the six months ended June 30, 2014 and 2013. R&D expenses increased $45 million and $102 million for the three and six months ended June 30, 2014, respectively, compared to the same periods in 2013 primarily due to an increase in personnel-related costs, which are expenses driven by incremental headcount from strategic hiring and business 39-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) acquisitions, depreciation expense, infrastructure costs, material costs and business development costs. Personnel-related costs increased by $43 million and $87 million, depreciation expense increased by $10 million and $17 million, infrastructure costs increased by $4 million and $8 million and material costs increased by $6 million and $9 million for the three and six months ended June 30, 2014, respectively. Partially offsetting these increased costs was an increase in capitalized software development costs of $13 million and $24 million for the three and six months ended June 30, 2014, respectively. Corporate reconciling items within R&D, which consist of stock-based compensation and intangible asset amortization, increased $18 million for both the three and six months ended June 30, 2014 when compared to the same periods in 2013. This increase was attributable to stock-based compensation expense for the three and six months ended June 30, 2014. R&D expenses within EMC's Information Infrastructure business, as a percentage of EMC's Information Infrastructure business revenues, were 8% and 9% for the three months ended June 30, 2014 and 2013, respectively, and were 9% for both the six months ended June 30, 2014 and 2013. R&D expenses decreased $19 million and $7 million for the three and six months ended June 30, 2014, respectively, primarily due to changes in personnel-related costs, which are expenses driven by incremental headcount from strategic hiring, infrastructure costs, depreciation expense, material costs, and business development costs. Personnel-related costs decreased by $6 million and increased $1 million, infrastructure costs increased by $2 million and $8 million, depreciation expense increased by $5 million and $10 million, and material costs increased $5 million and $9 million for the three and six months ended June 30, 2014, respectively. Business development costs decreased by $8 million and $4 million for the for the three and six months ended June 30, 2014, respectively. Partially offsetting these costs was an increase in capitalized software development costs of $17 million and $32 million for the three and six months ended June 30, 2014, respectively. R&D expenses within the Pivotal business, as a percentage of Pivotal's revenues, were 62% and for both the three months ended June 30, 2014 and 2013 and were 63% and 68% for the six months ended June 30, 2014 and 2013, respectively. R&D expenses increased $7 million and $14 million for the three and six months ended June 30, 2014, respectively, primarily due to increases in personnel-related costs as the business continues to transition to its new strategic focus and a decrease in capitalized software development costs due to the timing of products reaching technological feasibility. R&D expenses within the VMware Virtual Infrastructure business, as a percentage of VMware's revenues, remained flat at 17% for the three and six months ended June 30, 2014 and 2013. R&D expenses increased $39 million and $77 million for the three and six months ended June 30, 2014, respectively, when compared to the same periods in 2013 largely due to increases in personnel-related costs of $32 million and $66 million, driven by incremental headcount from strategic hiring, depreciation costs of $4 million and $7 million and business development costs of $3 million for each of the three and six months ended June 30, 2014, respectively. Selling, General and Administrative As a percentage of revenues, selling, general and administrative ("SG&A") expenses were 34% and 32% for the three and six months ended June 30, 2014 and 2013, respectively. SG&A expenses increased by $225 million and $362 million for the three and six months ended June 30, 2014, respectively, when compared to the same periods in 2013 primarily due to increases in personnel-related costs, which are expenses driven by incremental headcount from strategic hiring and business acquisitions, increases in business development expense and increases in depreciation expense. Personnel-related costs increased by $178 million and $289 million, business development expense increased by $11 million and $22 million, and depreciation expense increased $20 million for each of the three and six months ended June 30, 2014, respectively. In addition, travel costs increased during the three months ended June 30, 2014 and infrastructure costs increased $17 million for the six months ended June 30, 2014. Corporate reconciling items within SG&A, which consist of stock-based compensation, intangible asset amortization, litigation and acquisition and other related costs, increased $80 million and $102 million for the three and six months ended June 30, 2014, respectively, when compared to the same periods in 2013. Acquisition and other related costs relating to the specified future employment conditions of DSSD employees and AirWatch employees at VMware increased $50 million and $69 million for the three and six months ended June 30, 2014, respectively. Stock-based compensation expense increased $20 million and $24 million for the three and six months ended June 30, 2014, respectively. In addition, during the three and six months ended June 30, 2014, there was a VMware litigation accrual of $11 million. SG&A expenses within EMC's Information Infrastructure business, as a percentage of EMC's Information Infrastructure business revenues, were 26% for both the three months ended June 30, 2014 and 2013 and were 27% and 26% for the six months ended June 30, 2014 and 2013, respectively. SG&A expenses increased $22 million and $46 million for the three and six months ended June 30, 2014, respectively, when compared to the same periods in 2013 primarily due to increases in personnel-related 40-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) costs, which are expenses driven by incremental headcount from strategic hiring and business acquisitions and increases in infrastructure costs, slightly offset by decreases in travel costs. Personnel-related costs increased by $10 million and $29 million, depreciation expense increased by $4 million and $6 million, and infrastructure costs increased by $3 million and $14 million for the three and six months ended June 30, 2014, respectively. Additionally, business development costs increased $3 million for the three months ended June 30, 2014 and travel costs decreased by $3 million for the six months ended June 30, 2014. SG&A expenses within the Pivotal business, as a percentage of Pivotal's revenues, were 85% and 86% for the three months ended June 30, 2014 and 2013, respectively, and were 84% and 95% for the six months ended June 30, 2014 and 2013, respectively. SG&A expenses increased $10 million and $14 million for the three and six months ended June 30, 2014, respectively, when compared to the same periods in 2013 primarily due to increases in personnel-related costs related to strategic hiring by $8 million and $11 million for the three and six months ended June 30, 2014, respectively. SG&A expenses within the VMware Virtual Infrastructure business, as a percentage of VMware's revenues, were 41% and 39% for both the three and six months ended June 30, 2014 and 2013, respectively. SG&A expenses increased $113 million and $200 million for the three and six months ended June 30, 2014, respectively, when compared to the same periods in 2013 primarily due to increases in personnel-related costs, which are expenses driven by incremental headcount from strategic hiring and business acquisitions, depreciation expenses and business development costs. Personnel-related costs increased $82 million and $146 million, depreciation expense increased by $16 million and $17 million and business development costs increased by $8 million and $20 million in the three and six months ended June 30, 2014, respectively. Additionally, travel related costs increased $11 million for both the three and six months ended June 30, 2014. Restructuring and Acquisition-Related Charges For the three and six months ended June 30, 2014, we incurred restructuring and acquisition-related charges of $30 million and $149 million, respectively. For the three and six months ended June 30, 2013, we incurred restructuring and acquisition-related charges of $7 million and $155 million, respectively. For the three and six months ended June 30, 2014, EMC incurred $29 million and $144 million, respectively, of restructuring charges, primarily related to our current year restructuring programs, and during both the three and six months ended June 30, 2014, EMC incurred $2 million of charges in connection with acquisitions for financial, advisory, legal and accounting services. For each of the three and six months ended June 30, 2014, VMware recognized a recovery of $1 million related to its restructuring program. For the six months ended June 30, 2014, VMware incurred $4 million of charges in connection with acquisitions for financial, advisory, legal and accounting services. For the three and six months ended June 30, 2013, EMC incurred $4 million and $85 million, respectively, of restructuring charges, primarily related to our 2013 restructuring programs. For the three and six months ended June 30, 2013, VMware incurred $2 million and $56 million, respectively, of restructuring charges, primarily related to the 2013 restructuring program. For the six months ended June 30, 2013, EMC incurred $3 million and VMware incurred $1 million of costs for financial, advisory, legal and accounting services in connection with acquisitions. Additionally, during the three and six months ended June 30, 2013, VMware incurred $1 million and $10 million, respectively, of impairment charges related to its business realignment. In the first and second quarters of 2014, EMC implemented restructuring programs to create further operational efficiencies which will result in workforce reductions of approximately 1,326 and 210 positions, respectively. The actions will impact positions around the globe covering our Information Storage, RSA Information Security, Information Intelligence Group and Pivotal segments. All of these actions are expected to be completed within a year of the start of the program. During 2013, EMC implemented a restructuring program to create further operational efficiencies which resulted in a workforce reduction of 1,917 positions, of which 1,004 positions were identified in the first and second quarters of 2013. The actions impacted positions around the globe covering our Information Storage, RSA Information Security and Information Intelligence Group segments. All of these actions were completed within a year of the start of the program. During 2013, VMware approved and initiated a business realignment plan to streamline its operations. The plan included the elimination of approximately 710 positions across all major functional groups and geographies. All of these actions were completed within a year of the start of the program. For the three and six months ended June 30, 2014, we recognized $4 million and $8 million, respectively, of lease termination costs for facilities vacated in the period in accordance with our plan as part of all of our restructuring programs and for costs associated with terminating other contractual obligations. For the three and six months ended June 30, 2013, we recognized $5 million and $12 million, respectively, of lease termination costs for facilities vacated in the period in accordance with our plan as part of all of our restructuring programs. These costs are expected to be utilized by the end of 2015. 41-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Investment Income Investment income was $35 million and $34 million for the three months ended June 30, 2014 and 2013, respectively, and $71 million and $67 million for the six months ended June 30, 2014 and 2013, respectively. Investment income increased for both the three and six months ended June 30, 2014 when compared to the same periods in 2013 primarily due to an increase in net realized gains. For the three months ended June 30, 2014, interest income was $25 million and net realized gains were $9 million. For the six months ended June 30, 2014, interest income was $52 million and net realized gains were $17 million. For the three and six months ended June 30, 2013, interest income was $26 million and $52 million and net realized gains were $7 million and $12 million, respectively. Interest Expense Interest expense was $34 million and $31 million for the three months ended June 30, 2014 and 2013, respectively, and was $68 million and $51 million for the six months ended June 30, 2014 and 2013, respectively. Interest expense during the three and six months ended June 30, 2014 consists primarily of interest on the Notes. Interest expense during the three and six months ended June 30, 2013 consists primarily of interest on the 2013 Notes which includes non-cash interest charges related to amortization of the debt discount attributable to the conversion feature of $16 million and $31 million for the three and six months ended June 30, 2013, respectively, as we accreted the 2013 Notes to their stated values over their terms. The increase in interest expense for the three and six months ended June 30, 2014 when compared to the same periods in 2013 is due to interest related to the Notes which were issued during June 2013 and which have a much higher principal amount than the 2013 Notes. See Note 4 to the consolidated financial statements. Other Expense, Net Other expense, net was $66 million and $59 million for the three months ended June 30, 2014 and 2013, respectively, and was $142 million for both the six months ended June 30, 2014 and 2013. Other expense, net primarily consists of our consolidated share of the losses from our converged infrastructure joint venture, VCE Company LLC, net gains and losses on strategic investments and foreign exchange losses. The VCE joint venture is accounted for under the equity method and our consolidated share of VCE's losses is based upon our portion of the overall funding, which was approximately 63% at June 30, 2014, and represents our share of the net losses of the joint venture, net of equity accounting adjustments. The losses recognized from the joint venture exclude our consolidated revenues and gross margins from sales of products and services to VCE, and any additional related selling expenses. See Note 9 to the consolidated financial statements. During the three months ended June 30, 2014 and 2013, we incurred losses related to VCE of $85 million and $71 million, respectively, and for the six months ended June 30, 2014 and 2013, we incurred $160 million and $140 million, respectively. During the three months ended June 30, 2014 and 2013, we recognized net gains from strategic investments of $25 million and net losses from strategic investments of $7 million, respectively, and for the six months ended June 30, 2014 and 2013, we recognized net gains from strategic investments of $27 million and net losses from strategic investments of $21 million, respectively. Included in the net gains on strategic investments during the three months ended June 30, 2014 was a gain on previously held interests in strategic investments of $45 million and an impairment of a strategic investment of $33 million. Additionally, during the three months ended June 30, 2013, we recorded net gains on the divestiture of businesses of $19 million. Provision for Income Taxes Our effective income tax rates were 23.1% and 23.6% for the three and six months ended June 30, 2014, respectively. Our effective income tax rates were 22.4% and 17.7% for the three and six months ended June 30, 2013, respectively. Our effective income tax rate is based upon estimated income before provision for income taxes for the year, composition of the income in different countries, and adjustments, if any, in the applicable quarterly periods for potential tax consequences, benefits and/or resolutions of tax audits or other tax contingencies. For the three and six months ended June 30, 2014, the effective income tax rate varied from the statutory income tax rate principally as a result of the mix of income attributable to foreign versus domestic jurisdictions and state taxes. Our aggregate income tax rate in foreign jurisdictions is lower than our income tax rate in the United States; substantially all of our income before provision for income taxes from foreign operations has been earned by our Irish subsidiaries. We do not believe that any recent or currently expected developments in non-U.S. tax jurisdictions are reasonably likely to have a material impact on our effective income rate. For the three and six months ended June 30, 2013, the effective income tax rate varied from the statutory income tax rate principally as a result of the mix of income attributable to foreign versus domestic jurisdictions, state taxes and the U.S. federal tax credit for increasing research activities. On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law. Some of the provisions were retroactive to January 1, 2012 including an extension of the U.S. federal tax credit for increasing research activities through December 31, 2013. Because the extension was enacted 42-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) after December 31, 2012, our income tax provision for the six months ended June 30, 2013 included the estimated federal tax credit for increasing research activities for the full year 2012 as well as the six months ended June 30, 2013, which reduced our effective tax rate for the six month period. Our effective income tax rate increased in the three and six months ended June 30, 2014 from the three and six months ended June 30, 2013 due primarily to the retroactive renewal of the U.S. federal tax credit for increasing research activities on January 2, 2013 as discussed above. The U.S. federal tax credit for increasing research activities reduced our effective income tax rate by approximately 1.0% and 5.1% for the three and six months ended June 30, 2013, respectively. Our effective income tax rates for the three and six months ended June 30, 2014 does not reflect any U.S. federal tax credit for increasing research activities because the credit expired on December 31, 2013. There were also differences in the mix of income attributable to foreign versus domestic jurisdictions, change in tax contingency reserves and discrete items, the net impact of which is immaterial. We are routinely under audit by the Internal Revenue Service (the "IRS"). We have concluded all U.S. federal income tax matters for years through 2008. The IRS commenced a federal income tax audit for the tax years 2009 and 2010 in the third quarter of 2012. The current federal income tax audit is ongoing and it is not expected to be completed until 2015. We also have income tax audits in process in numerous state, local and international jurisdictions. In our international jurisdictions that comprise a significant portion of our operations, the years that may be examined vary, with the earliest year being 2004. Based on the timing and outcome of examinations of EMC, the result of the expiration of statutes of limitations for specific jurisdictions or the timing and result of ruling requests from taxing authorities, it is reasonably possible that the related unrecognized tax benefits could change from those recorded in our statement of financial position. We anticipate that several of these audits may be finalized within the next twelve months. While we expect the amount of unrecognized tax benefits to change in the next twelve months, we do not expect the change to have a significant impact on our results of operations or financial position. Our effective income tax rate for the remainder of 2014 may be affected by such factors as changes in tax laws, regulations or income tax rates, changing interpretation of existing laws or regulations, the impact of accounting for stock-based compensation, the impact of accounting for business combinations, changes in our international organization, and changes in overall levels of income before provision for income taxes. Our effective income tax rate may also be adversely affected by earnings being lower than anticipated in countries where we have lower statutory income tax rates and higher than anticipated in countries where we have higher statutory income tax rates. Non-controlling Interest in VMware, Inc. The net income attributable to the non-controlling interest in VMware was $33 million and $49 million for the three months ended June 30, 2014 and 2013, respectively, and was $74 million and $84 million for the six months ended June 30, 2014 and 2013, respectively. The decrease in the three and six months ended June 30, 2014 compared to the same periods in 2013 was due to decreases in VMware's net income. VMware's reported net income was $167 million and $245 million for the three months ended June 30, 2014 and 2013, respectively, and was $366 million and $418 million for the six months ended June 30, 2014 and 2013, respectively. The weighted average non-controlling interest in VMware was approximately 20% for both the three and six months ended June 30, 2014 and 2013. EMC did not purchase any shares of VMware common stock during the three and six months ended June 30, 2014. Financial Condition Cash provided by operating activities was $2,592 million and $2,941 million for the six months ended June 30, 2014 and 2013, respectively. Cash received from customers was $12,644 million and $12,007 million for the six months ended June 30, 2014 and 2013, respectively. The increase in cash received from customers was attributable to an increase in sales volume. Cash paid to suppliers and employees was $9,320 million and $8,485 million for the six months ended June 30, 2014 and 2013, respectively. The increase was primarily due to a general growth in the business to support the increased revenue base as well as the timing of cash payments. For the six months ended June 30, 2014 and 2013, we paid $829 million and $642 million, respectively, in income taxes. These payments are comprised of estimated taxes for the current year, extension payments for the prior year and refunds or payments associated with income tax filings and tax audits. The higher payments in the six months ended June 30, 2014 compared to the six months ended June 30, 2013 were primarily driven by lower stock-based compensation deductions in 2013 compared to 2012. Cash used in investing activities was $1,698 million and $4,534 million for the six months ended June 30, 2014 and 2013, respectively. Cash used for business acquisitions, net of cash acquired, was $1,694 million and $207 million for the six months ended June 30, 2014 and 2013, respectively. This increase in cash used for business acquisitions was due to VMware's acquisition of AirWatch and EMC's acquisitions of DSSD and Symplified during the six months ended June 30, 2014. Acquisition activity 43-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) varies from period to period based upon the number and size of acquisitions in a given period. During the six months ended June 30, 2014, VMware increased its restricted cash by $76 million for amounts to be paid to certain AirWatch employees subject to the achievement of defined employment conditions. Net cash spent on the purchase of strategic and other related investments was $73 million and $46 million during the six months ended June 30, 2014 and 2013, respectively. We provided $63 million and $158 million of funding to our joint venture, VCE Company LLC, during the six months ended June 30, 2014 and 2013, respectively. Also during the six months ended June 30, 2013, VMware received $31 million from dispositions of certain lines of business. Capital additions were $472 million and $437 million for the six months ended June 30, 2014 and 2013, respectively. The increase in capital additions was primarily due to the purchase of a building and other infrastructure investments during the six months ended June 30, 2014. Capitalized software development costs were $245 million and $219 million for the six months ended June 30, 2014 and 2013, respectively. The increase in capitalized software costs was primarily attributable to EMC Information Infrastructure's software development activities. Net sales of investments were $925 million and net purchases of investments were $3,498 million for the six months ended June 30, 2014 and 2013, respectively. This activity varies from period to period based upon our cash collections, cash requirements and maturity dates of our investments as well as cash available after the issuance and payment of debt. Cash used in financing activities was $3,095 million and cash provided by financing activities $4,447 million for the six months ended June 30, 2014 and 2013, respectively. We spent $1,665 million and $21 million for repayment of our long- and short-term obligations including convertible debt in the six months ended June 30, 2014 and 2013, respectively. We received $5,463 million through the issuance of long-term notes in the six months ended June 30, 2013. We spent $994 million and $991 million to repurchase 39 million and 42 million shares of our common stock for the six months ended June 30, 2014 and 2013, respectively. In the six months ended June 30, 2013, we also spent $160 million to purchase 2 million shares of VMware's common stock. In the six months ended June 30, 2014 and 2013, VMware spent $407 million and $302 million, respectively, to repurchase 4 million shares of its common stock in each of the quarters. We generated $333 million and $290 million during the six months ended June 30, 2014 and 2013, respectively, from the issuance of common stock. We generated $45 million and $63 million during the six months ended June 30, 2014 and 2013, respectively, of excess tax benefits from stock-based compensation. Pivotal received a $105 million capital contribution from GE during the six months ended June 30, 2013. Additionally, EMC paid dividends of $407 million to shareholders during the six months ended June 30, 2014. On April 17, 2014, our Board of Directors approved an increase in the quarterly cash dividend paid to EMC shareholders to $0.115 per share of common stock. On July 23, 2014, EMC paid a cash dividend at this new rate of $233 million to shareholders of record as of the close of business on July 1, 2014. Our Board of Directors also declared a cash dividend which will be paid on October 23, 2014 to shareholders of record as of the close of business on October 1, 2014. We plan to spend up to $6.0 billion in the repurchase of shares during the two years ending December 31, 2014. This includes $3.0 billion spent during the year ended December 31, 2013 and $3.0 billion to be spent during the year ending December 31, 2014. We expect to continue to generate positive cash flows from operations and to use cash generated by operations as our primary source of liquidity. We believe that existing cash and cash equivalents, together with any cash generated from operations, will be sufficient to meet normal operating requirements for the next twelve months. In June 2013, we issued $5.5 billion aggregate principal amount of senior notes (collectively, the "Notes") which pay a fixed rate of interest semi-annually in arrears. The first interest payment occurred on December 2, 2013. The proceeds from the Notes have been used to satisfy the cash payment obligation of the converted 2013 Notes as well as for general corporate purposes including stock repurchases, dividend payments, working capital needs and other business opportunities. The Notes of each series are senior, unsecured obligations of EMC and are not convertible or exchangeable. Unless previously purchased and canceled, we will repay the Notes of each series at 100% of the principal amount, together with accrued and unpaid interest thereon, at maturity. However, EMC has the right to redeem any or all of the Notes at specified redemption prices. As of June 30, 2014, we were in compliance with all debt covenants which are customary in nature. The 2011 Notes matured and were settled in 2012. The 2013 Notes matured and a majority of the noteholders exercised their right to convert the outstanding 2013 Notes at the end of 2013. Pursuant to the settlement terms, the majority of the converted 2013 Notes were not settled until January 7, 2014. At that time, we paid the noteholders $1.7 billion in cash for the outstanding principal and 35 million shares for the $858 million in excess of the conversion value over the principal amount, as prescribed by the terms of the 2013 Notes. 44-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) In connection with the issuance of the 2011 Notes and 2013 Notes, we entered into separate convertible note hedge transactions with respect to our common stock (the "Purchased Options"). The Purchased Options allowed us to receive shares of our common stock and/or cash related to the excess conversion value that we would pay to the holders of the 2011 Notes and 2013 Notes upon conversion. The Purchased Options covered, subject to customary anti-dilution adjustments, approximately 215 million shares of our common stock. We paid an aggregate amount of $669 million of the proceeds from the sale of the 2011 Notes and 2013 Notes for the Purchased Options that was recorded as additional paid-in-capital in shareholders' equity. In 2011, we exercised approximately half of the Purchased Options in connection with the planned settlements of the 2011 Notes. In the fourth quarter of 2013, we exercised the remaining 108 million of the Purchased Options in conjunction with the planned settlements of the 2013 Notes, and we received 35 million shares of net settlement on January 7, 2014, representing the excess conversion value of the options. We also entered into separate transactions in which we sold warrants to acquire, subject to customary anti-dilution adjustments, approximately 215 million shares of our common stock at an exercise price of approximately $19.55 per share of our common stock. We received aggregate proceeds of $391 million from the sale of the associated warrants. Upon exercise, the value of the warrants was required to be settled in shares. Approximately half of the associated warrants were exercised in 2012 and the remaining 109 million associated warrants were exercised between February 18, 2014 and March 17, 2014 and were settled with 29 million shares of our common stock. At June 30, 2014, our total cash, cash equivalents, and short-term and long-term investments were $14,634 million. This balance includes approximately $6,637 million held by VMware, of which $4,695 million is held overseas and $1,942 million is held in the U.S. and $7,997 million held by EMC, of which $4,298 million is held overseas and $3,699 million is held in the U.S. If these overseas funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Use of Non-GAAP Financial Measures and Reconciliations to GAAP Results The financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). EMC uses certain non-GAAP financial measures, which exclude stock-based compensation, intangible asset amortization, restructuring charges, acquisition and other related charges, the amortization of VMware's capitalized software from prior periods, infrequently occurring gains, losses, benefits and charges, and special tax items to measure its gross margin, operating margin, net income and diluted earnings per share for purposes of managing our business. EMC also assesses its financial performance by measuring its free cash flow which is also a non-GAAP financial measure. Free cash flow is defined as net cash provided by operating activities, less additions to property, plant and equipment and capitalized software development costs. These non-GAAP financial measures should be considered in addition to, not as a substitute for, measures of EMC's financial performance or liquidity prepared in accordance with GAAP. EMC's non-GAAP financial measures may be defined differently from time to time and may be defined differently than similar terms used by other companies, and accordingly, care should be exercised in understanding how EMC defines its non-GAAP financial measures. EMC's management uses the non-GAAP financial measures to gain an understanding of EMC's comparative operating performance (when comparing such results with previous periods or forecasts) and future prospects and excludes these items from its internal financial statements for purposes of its internal budgets and each reporting segment's financial goals. These non-GAAP financial measures are used by EMC's management in their financial and operating decision-making because management believes they reflect EMC's ongoing business in a manner that allows meaningful period-to-period comparisons. EMC's management believes that these non-GAAP financial measures provide useful information to investors and others (a) in understanding and evaluating EMC's current operating performance and future prospects in the same manner as management does, if they so choose, and (b) in comparing in a consistent manner EMC's current financial results with EMC's past financial results. 45-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued)Our non-GAAP operating results for the three months ended June 30, 2014 and 2013 were as follows (in millions): For the Three Months Ended June 30, June 30, 2014 2013 Gross margin $ 3,752 $ 3,609 Gross margin percentage 63.8 % 64.3 % Operating income 1,327 1,356 Operating margin percentage 22.6 % 24.2 % Income tax provision 300 308 Net income attributable to EMC 882 907 Diluted earnings per share attributable to EMC $ 0.43 $ 0.42 The improvement in the non-GAAP gross margin was attributable to higher sales volume. The decrease in gross margin percentage for the three months ended June 30, 2014 was attributable to a decrease in Information Storage product margins. The product margins for the three months ended June 30, 2014 decreased due to lower sales volume without a corresponding decrease in fixed costs and pricing pressure on our high-end storage products in anticipation of the new VMAX refresh in the second half of 2014. The decrease in the non-GAAP operating income for the three months ended June 30, 2014 was attributable to higher operating expenses. Non-GAAP operating margin percentage for the three months ended June 30, 2014 decreased primarily due to a decrease in gross margin percentage and increases in operating expenses. The decrease in gross margin percentage was primarily attributable to lower storage product gross margins. The increase in operating expenses is driven by the investments we are making at Pivotal and VMware, including continuing development of our offerings in software-defined data center, Big Data analytics, PaaS, hybrid cloud and mobile. 46-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) The reconciliation of the above financial measures from GAAP to non-GAAP is as follows (in millions): For the Three Months Ended June 30, 2014 Diluted Earnings per share Operating Income tax provision Net income attributable Gross margin income (benefit) attributable to EMC to EMC GAAP $ 3,654 $ 874 $ 187 $ 589 $ 0.29 Stock-based compensation 37 262 59 180 0.09 Intangible asset amortization 61 100 30 65 0.03 Restructuring charges - 28 6 22 0.01 Acquisition and other related charges - 52 18 29 0.01 R&D tax credit - - (13 ) 12 0.01 Gain on previously held interests in strategic investments - - - (45 ) (0.02 ) Impairment of strategic investments - - 9 24 0.01 VMware litigation charge - 11 4 6 - Non-GAAP $ 3,752 $ 1,327 $ 300 $ 882 $ 0.43 For the Three Months Ended June 30, 2013 Diluted Earnings per share Operating Income tax provision Net income attributable to Gross margin income (benefit) attributable to EMC EMC GAAP $ 3,509 $ 1,022 $ 216 $ 701 $ 0.32 Stock-based compensation 30 218 62 140 0.07 Intangible asset amortization 58 97 28 65 0.03 Restructuring charges - 5 2 3 - Acquisition and other related charges - 2 - 2 - Amortization of VMware's capitalized software from prior periods 12 12 4 7 - Net gain on disposition of certain lines of business and other - - (5 ) (11 ) - Non-GAAP $ 3,609 $ 1,356 $ 308 $ 907 $ 0.42 We also monitor our ability to generate free cash flow in relationship to our non-GAAP net income attributable to EMC over comparable periods. For the six months ended June 30, 2014, our free cash flow was $1,875 million, a decrease of 18% compared to the free cash flow generated for the six months ended June 30, 2013. The free cash flow for the six months ended June 30, 2014 exceeded our same period non-GAAP net income attributable to EMC by $266 million. EMC uses free cash flow, among other measures, to evaluate the ability of its operations to generate cash that is available for purposes other than capital expenditures and capitalized software development costs. Management believes that information regarding free cash flow provides investors with an important perspective on the cash available to make strategic acquisitions and investments, fund joint ventures, repurchase shares, service debt, pay dividends and fund ongoing operations. As free cash flow is not a measure of liquidity calculated in accordance with GAAP, free cash flow should be considered in addition to, but not as a substitute for, the analysis provided in the statements of cash flows. 47-------------------------------------------------------------------------------- Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued)The reconciliation of the above free cash flow from GAAP to non-GAAP is as follows (in millions): For the Three Months Ended For the Six Months Ended June 30, June 30, June 30, June 30, 2014 2013 2014 2013 Cash Flow from Operations $ 1,253 $ 1,228 $ 2,592 $ 2,941 Capital Expenditures (196 ) (272 ) (472 ) (437 ) Capitalized Software Development Costs (127 ) (113 ) (245 ) (219 ) Free Cash Flow $ 930 $ 843 $ 1,875 $ 2,285 Free cash flow represents a non-GAAP measure related to operating cash flows. In contrast, our GAAP measure of cash flow consists of three components. These are cash flows provided by operating activities of $2,592 million and $2,941 million for the six months ended June 30, 2014 and 2013, respectively, cash used in investing activities of $1,698 million and $4,534 million for the six months ended June 30, 2014 and 2013, respectively, and net cash used in financing activities of $3,095 million and provided by the financing activities of $4,447 million for the six months ended June 30, 2014 and 2013, respectively. All of the foregoing non-GAAP financial measures have limitations. Specifically, the non-GAAP financial measures that exclude the items noted above do not include all items of income and expense that affect EMC's operations or cash flows. Further, these non-GAAP financial measures are not prepared in accordance with GAAP, may not be comparable to non-GAAP financial measures used by other companies and do not reflect any benefit that such items may confer on EMC. Management compensates for these limitations by also considering EMC's financial results as determined in accordance with GAAP. 48-------------------------------------------------------------------------------- Table of Contents |