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WORKDAY, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion of our financial condition and results of operations in conjunction with the condensed consolidated financial statements and notes thereto included elsewhere in this report. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, as well as in the section entitled "Risk Factors." Overview Workday provides enterprise cloud applications for human capital management (HCM), payroll, financial management and analytics. We offer innovative and adaptable technology focused on the consumer Internet experience and cloud delivery model. Our applications are designed for global enterprises to manage complex and dynamic operating environments. We provide our customers highly adaptable, accessible and reliable applications to manage critical business functions that enable them to optimize their financial and human capital resources. We were founded in 2005 to deliver cloud applications to global enterprises. Our applications are designed around the way people work today - in an environment that is global, collaborative, fast-paced and mobile. Our cycle of frequent updates has facilitated rapid innovation and the introduction of new applications throughout our history. We began offering our Human Capital Management (HCM) application in 2006. Since then we have continued to invest in innovation and have consistently introduced new services to our customers, including our Financial Management application in 2007, our Procurement and Employee Expense Management applications in 2008, our Payroll and mobile applications in 2009, our Talent Management application in 2010, our native iPad application and Workday integration platform in 2011, Time Tracking and Grants Management applications in 2012, Big Data Analytics in 2013 and Recruiting in 2014. We offer Workday applications to our customers on an enterprise-wide subscription basis, typically with three-year terms and with subscription fees largely based on the size of the customer's workforce. We generally recognize revenues from subscription fees ratably over the term of the contract. We currently derive a substantial majority of our subscription services revenues from subscriptions to our HCM application. We market our applications primarily through our direct sales force. We have achieved significant growth in a relatively short period of time. Our diverse customer base includes large, global companies and our direct sales force targets organizations with more than 1,000 workers. A substantial majority of our growth comes from new customers. Our current financial focus is on growing our revenues and expanding our customer base. While we are incurring losses today, we strive to invest in a disciplined manner across all of our functional areas to sustain continued near-term revenue growth and support our long-term initiatives. Our operating expenses have increased significantly in absolute dollars in recent periods, primarily due to our significant growth in employees. We had approximately 3,150 and approximately 2,100 employees as of July 31, 2014 and 2013, respectively. We intend to continue investing for long-term growth. We have invested, and expect to continue to invest, heavily in our application development efforts to deliver additional compelling applications and to address customers' evolving needs. In addition, we plan to continue to expand our sales and marketing organizations to sell our applications globally. We expect to make significant investments in our data center infrastructure in fiscal 2015 as we update our technology and plan for future customer growth. We are also investing in personnel to service our growing customer base. These investments will increase our costs on an absolute basis in the near-term. Many of these investments will occur in advance of experiencing any direct benefit from them and will make it difficult to determine if we are allocating our resources efficiently. As a result of these investments, we do not expect to be profitable in the near future. We expect our product development, sales and marketing, and general and administrative expenses as a percentage of revenues to decrease over time as we grow our revenues, and we anticipate that we will gain economies of scale by increasing our customer base without direct incremental development costs and by utilizing more of the capacity of our data centers. Since inception, we have invested heavily in our professional services organization to help ensure that customers successfully deploy and adopt our applications. Additionally, we continue to expand our professional services partner ecosystem to further support our customers. We believe our investment in professional services, as well as partners building consulting practices around Workday, will drive additional customer subscriptions and continued growth in revenues. In addition, over time we expect professional services revenues and the cost of professional services as a percentage of total revenues to decline as we increasingly rely on our partners to deploy Workday applications and as the number of our existing customers continues to grow. 20-------------------------------------------------------------------------------- Table of Contents Components of Results of Operations Revenues We primarily derive our revenues from subscription services fees and professional services fees. Subscription services revenues primarily consist of fees that give our customers access to our cloud applications, which include routine customer support at no additional cost. Professional services fees include deployment services, optimization services, and training. Subscription services revenues accounted for 77% of our revenues during the three months ended July 31, 2014 and represented over 94% of our total unearned revenue as of July 31, 2014. Subscription services revenues are driven primarily by the number of customers, the number of workers at each customer, the number of applications subscribed to by each customer, the price of our applications, and to a lesser extent, renewal rates. The mix of the applications to which a customer subscribes can affect our financial performance due to price differentials in our applications. Compared to our other offerings, our HCM application has been available for a longer period of time, is more established in the marketplace and has benefited from continued enhancements of the functionality over a longer period of time, all of which help us to improve our pricing for that application. However, new products or services offerings by competitors in the future could impact the mix and pricing of our offerings. Subscription services fees are recognized ratably as revenues over the contract term beginning on the date the application is made available to the customer, which is generally within one week of contract signing. Our subscription contracts typically have a term of three years and are non-cancelable. We generally invoice our customers in advance, in annual installments. Amounts that have been invoiced are initially recorded as unearned revenue. Amounts that have not been invoiced represent backlog and are not reflected in our condensed consolidated financial statements. Our consulting engagements are typically billed on a time and materials basis, and revenues are typically recognized as the services are performed. We offer a number of training options intended to support our customers in configuring, using and administering our services. In some cases, we supplement our consulting teams by subcontracting resources from our service partners and deploying them on customer engagements. As Workday's professional services organization and the Workday-related consulting practices of our partner firms continue to develop, we expect the partners to increasingly contract directly with our subscription customers. As a result of this trend, and the increase of our subscription services revenues, we expect professional services revenues as a percentage of total revenues to decline over time. Costs and Expenses Costs of subscription services revenues. Costs of subscription services revenues consist primarily of employee-related expenses related to hosting and supporting our applications, the costs of data center capacity, and depreciation of owned and leased computer equipment and software. Costs of professional services revenues. Costs of professional services revenues consist primarily of employee-related expenses associated with these services, the cost of subcontractors and travel costs. The percentage of total revenues derived from professional services was 23% for the three months ended July 31, 2014. The cost of providing professional services is significantly higher as a percentage of the related revenues than for our subscriptions. Product development. Product development expenses consist primarily of employee-related expenses. We continue to focus our product development efforts on adding new features and applications, increasing the functionality and enhancing the ease of use of our cloud applications. Sales and marketing. Sales and marketing expenses consist primarily of employee-related expenses, sales commissions, marketing programs and travel related expenses. Marketing programs consist of advertising, events, corporate communications, brand building and product marketing activities. Commissions earned by our sales force that can be associated specifically with a non-cancelable subscription contract are deferred and amortized over the same period that revenues are recognized for the related non-cancelable contract. General and administrative. General and administrative expenses consist of employee-related expenses for finance and accounting, legal, human resources and management information systems personnel, legal costs, professional fees and other corporate expenses. 21 -------------------------------------------------------------------------------- Table of Contents Results of Operations Revenues Our total revenues for the three and six months ended July 31, 2014 and 2013 were as follows: Three Months Ended Six Months Ended July 31, July 31, 2014 2013 % Change 2014 2013 % Change (in thousands, except percentages) Revenues: Subscription services $ 143,652 $ 81,111 77 % $ 267,059 $ 149,529 79 % Professional services 43,128 26,444 63 79,458 49,671 60 Total revenues $ 186,780 $ 107,555 74 $ 346,517 $ 199,200 74 Total revenues were $186.8 million for the three months ended July 31, 2014, compared to $107.6 million during the prior year period, an increase of $79.2 million, or 74%. Subscription services revenues were $143.7 million for the three months ended July 31, 2014, compared to $81.1 million for the prior year period, an increase of $62.6 million, or 77%. The increase in subscription revenues was due primarily to the recognition of revenue for an increased number of customer contracts as compared to the prior year period. Professional services revenues were $43.1 million for the three months ended July 31, 2014, compared to $26.4 million for the prior year period, an increase of $16.7 million, or 63%. The increase in professional services revenues was due primarily to the addition of new customers and a greater number of customers requesting deployment and integration services. Total revenues were $346.5 million for the six months ended July 31, 2014, compared to $199.2 million during the prior year period, an increase of $147.3 million, or 74%. Subscription services revenues were $267.1 million for the six months ended July 31, 2014, compared to $149.5 million for the prior year period, an increase of $117.6 million, or 79%. The increase in subscription revenues was due primarily to an increased number of customer contracts as compared to the prior year period. Professional services revenues were $79.5 million for the six months ended July 31, 2014, compared to $49.7 million for the prior year period, an increase of $29.8 million, or 60%. The increase in professional services revenues was due primarily to a greater number of customers requesting deployment and integration services. Core Operating Expenses Management uses the non-GAAP financial measure of core operating expenses to understand and compare operating results across accounting periods, for internal budgeting and forecasting purposes, for short- and long-term operating plans, and to evaluate our financial performance and the ability of operations to generate cash. Management believes that core operating expenses reflects our ongoing business in a manner that allows for meaningful period-to-period comparisons and analysis of trends in our business, as it excludes expenses that are not reflective of ongoing operating results. Management also believes that core operating expenses provides useful information to investors and others in understanding and evaluating our operating results and future prospects in the same manner as management and in comparing financial results across accounting periods and to those of peer companies. The following discussion of our core operating expenses and the components comprising our core operating expenses highlights the factors that our management focuses upon in evaluating our operating margin and operating expenses. The increases or decreases in operating expenses discussed in this section do not include changes relating to share-based compensation, and certain other expenses, which consist of employer payroll taxes on employee stock transactions and amortization of acquisition-related intangible assets. 22-------------------------------------------------------------------------------- Table of Contents Reconciliation of our core operating expenses to the nearest GAAP measure, total operating expenses, is as follows: Three Months Ended July 31, 2014 Core Share-Based Other Total Operating Compensation Operating Operating Expenses(1) Expenses Expenses Expenses (in thousands)Costs of subscription services $ 22,723 $ 1,608 $ 42 $ 24,373 Costs of professional services 37,702 3,519 46 41,267 Product development 59,939 16,737 788 77,464 Sales and marketing 70,908 7,377 238 78,523 General and administrative 14,614 11,541 767 26,922 Total costs and expenses $ 205,886 $ 40,782 $ 1,881 $ 248,549 Operating loss $ (19,106 ) $ (40,782 ) $ (1,881 ) $ (61,769 ) Operating margin (10 )% (22 )% (1 )% (33 )% Three Months Ended July 31, 2013 Core Share-Based Other Total Operating Compensation Operating Operating Expenses(1) Expenses Expenses Expenses (in thousands) Costs of subscription services $ 15,926 $ 401 $ - $ 16,327 Costs of professional services 23,572 801 54 24,427 Product development 37,385 3,465 318 41,168 Sales and marketing 42,053 1,805 292 44,150 General and administrative 10,283 3,311 172 13,766 Total costs and expenses $ 129,219 $ 9,783 $ 836 $ 139,838 Operating loss $ (21,664 ) $ (9,783 ) $ (836 ) $ (32,283 ) Operating margin (20 )% (9 )% (1 )% (30 )% Six Months Ended July 31, 2014 Core Share-Based Other Total Operating Compensation Operating Operating Expenses(1) Expenses Expenses Expenses (in thousands)Costs of subscription services $ 43,081 $ 2,663 $ 88 $ 45,832 Costs of professional services 71,375 5,717 135 77,227 Product development 113,560 27,605 1,470 142,635 Sales and marketing 132,050 14,129 511 146,690 General and administrative 28,085 19,542 358 47,985 Total costs and expenses $ 388,151 $ 69,656 $ 2,562 $ 460,369 Operating loss $ (41,634 ) $ (69,656 ) $ (2,562 ) $ (113,852 ) Operating margin (12 )% (20 )% (1 )% (33 )% 23 -------------------------------------------------------------------------------- Table of Contents Six Months Ended July 31, 2013 Core Share-Based Other Total Operating Compensation Operating Operating Expenses(1) Expenses Expenses Expenses (in thousands)Costs of subscription services $ 30,586 $ 663 $ 8 $ 31,257 Costs of professional services 44,573 1,276 347 46,196 Product development 71,528 5,372 550 77,450 Sales and marketing 79,283 2,848 383 82,514 General and administrative 19,425 7,040 225 26,690 Total costs and expenses $ 245,395 $ 17,199 $ 1,513 $ 264,107 Operating loss $ (46,195 ) $ (17,199 ) $ (1,513 ) $ (64,907 ) Operating margin (23 )% (9 )% (1 )% (33 )% (1) Core operating expenses is a non-GAAP financial measure that excludes share-based compensation and certain other operating expenses from our total operating expenses calculated in accordance with GAAP. The other operating expenses excluded are employer payroll taxes on employee stock transactions and amortization of acquisition-related intangible assets. See "Non-GAAP Financial Measures" below for further information. Core operating margins Core operating margins, calculated using GAAP revenues and core operating expenses, improved from (20)% for the three months ended July 31, 2013 to (10)% for the three months ended July 31, 2014 and improved from (23)% for the six months ended July 31, 2013 to (12)% for the six months ended July 31, 2014. The improvements in our core operating margins in the three and six months ended July 31, 2014 were primarily due to higher subscription services revenues. In evaluating our results, we generally focus on core operating expenses. We believe that our core operating expenses reflect our ongoing business in a manner that allows meaningful period-to-period comparisons. Our core operating expenses are reconciled to the most comparable U.S. generally accepted accounting principles (GAAP) measure, "total operating expenses," in the table above. Core operating expenses increased by $76.7 million, or 59% and $142.8 million, or 58%, respectively, for the three and six months ended July 31, 2014 compared to the prior year periods. The increases were primarily due to higher employee-related costs driven by higher headcount. Costs of subscription services Core operating expenses in costs of subscription services were $22.7 million for the three months ended July 31, 2014, compared to $15.9 million for the prior year period, an increase of $6.8 million, or 43%. The increase was primarily due to an increase of $2.5 million in employee-related costs driven by higher headcount, an increase of $2.2 million in depreciation expense related to our data centers and an increase of $0.9 million in service contracts expense to expand data center capacity. Core operating expenses in costs of subscription services were $43.1 million for the six months ended July 31, 2014, compared to $30.6 million for the prior year period, an increase of $12.5 million, or 41%. The increase was primarily due to an increase of $5.0 million in depreciation expense related to our data centers, an increase of $4.6 million in employee-related costs driven by higher headcount and an increase of $2.4 million in service contracts expense to expand data center capacity. We expect that in the future, core operating expenses in costs of subscription services will continue to increase in absolute dollars as we improve and expand our data center capacity and operations. Costs of professional services Core operating expenses in costs of professional services were $37.7 million for the three months ended July 31, 2014, compared to $23.6 million for the prior year period, a $14.1 million increase, or 60%. This increase was primarily due to increases of $11.5 million to staff our deployment and integration engagements. Due to the large increase in demand for our professional services versus the prior year, we have increased both our internal professional service staff as well as third-party supplemental staff. 24-------------------------------------------------------------------------------- Table of Contents Core operating expenses in costs of professional services were $71.4 million for the six months ended July 31, 2014, compared to $44.6 million for the prior year period, a $26.8 million increase, or 60%. This increase was primarily due to increases of $21.1 million to staff our deployment and integration engagements and $1.7 million in facility and IT-related expenses. Due to the large increase in demand for our professional services versus the prior year, we have increased both our internal professional service staff as well as third-party supplemental staff. For the current fiscal year, we anticipate professional services margins to be lower than fiscal 2014 as we invest in deploying new customers in financial management applications, medium-size enterprise, and education and government categories, where the third party partner ecosystem is still maturing. Product development Core operating expenses in product development were $59.9 million for the three months ended July 31, 2014, compared to $37.4 million for the prior year period, an increase of $22.5 million, or 60%. The increase was primarily due to increases of $16.9 million in employee compensation costs due to higher headcount, $1.6 million in depreciation expense for our development cloud data center, $1.4 million in contracted costs and $1.3 million in facility and IT-related expenses. Core operating expenses in product development were $113.6 million for the six months ended July 31, 2014, compared to $71.5 million for the prior year period, an increase of $42.1 million, or 59%. The increase was primarily due to increases of $30.2 million in employee compensation costs due to higher headcount, $3.2 million in facility and IT-related expenses, $3.2 million in contracted costs and $2.9 million in depreciation expense for our development cloud data center. We expect that in the future, product development expenses will continue to increase in absolute dollars as we improve and extend our applications and develop new technologies. Sales and marketing Core operating expenses in sales and marketing were $70.9 million for the three months ended July 31, 2014, compared to $42.1 million for the prior year period, an increase of $28.8 million, or 68%. The increase was primarily due to increases of $19.3 million in employee compensation costs due to higher headcount and higher commissionable sales volume, $6.5 million in advertising, marketing and event costs, $1.6 million in travel expenses and $1.1 million in facility and IT-related expenses. Core operating expenses in sales and marketing were $132.1 million for the six months ended July 31, 2014, compared to $79.3 million for the prior year period, an increase of $52.8 million, or 67%. The increase was primarily due to increases of $36.7 million in employee compensation costs due to higher headcount and higher commissionable sales volume, $10.0 million in advertising, marketing and event costs, $3.0 million in travel expenses and $2.8 million in facility and IT-related expenses. We expect that sales and marketing expenses will continue to increase in absolute dollars in the future as we continue to invest in sales and marketing by expanding our domestic and international selling and marketing activities, building brand awareness and attracting new customers. General and administrative Core operating expenses in general and administrative were $14.6 million for the three months ended July 31, 2014, compared to $10.3 million for the prior year period, an increase of $4.3 million, or 42%. The increase was primarily due to $3.1 million in higher employee compensation costs due to higher headcount and $1.5 million in higher consulting fees. Core operating expenses in general and administrative were $28.1 million for the six months ended July 31, 2014, compared to $19.4 million for the prior year period, an increase of $8.7 million, or 45%. The increase was primarily due to $5.6 million in higher employee compensation costs due to higher headcount and $3.9 million in facility and IT-related expenses. We expect general and administrative expenses will increase in absolute dollars as we invest in our infrastructure and incur additional employee-related costs, professional fees and insurance costs related to the growth of our business and international expansion. Share-Based Compensation Expenses Share-based compensation expenses were $40.8 million and $69.7 million, respectively, for the three and six months ended July 31, 2014, compared to $9.8 million and $17.2 million, respectively, for the prior year periods. The increase in share-based compensation expenses was primarily due to grants of restricted stock units to existing and new employees during fiscal 2014 and the six months ended July 31, 2014. We changed the cycle in which we grant additional equity awards to existing employees resulting in two grants within the last four fiscal quarters. The next grant to existing employees is planned for the first quarter of fiscal 2016. During the three and six months ended July 31, 2014, the realized excess tax benefits related to share-based compensation was immaterial. 25 -------------------------------------------------------------------------------- Table of Contents Other Operating Expenses Other operating expenses include employer payroll tax on employee stock transactions of $1.6 million and $2.0 million, respectively, for the three and six months ended July 31, 2014 and $0.8 million and $1.5 million, respectively for the prior year periods. In addition, other operating expenses included amortization of acquisition-related intangible assets of $0.3 million and $0.5 million, respectively, for the three and six months ended July 31, 2014. Other Expense, Net Other expense, net, increased by $3.5 million and $10.2 million for the three and six months ended July 31, 2014, compared to the prior year respective periods. The increases were primarily due to the increased interest expense related to our 0.75% convertible senior notes due July 15, 2018 (2018 Notes) and 1.50% convertible senior notes due July 15, 2020 (2020 Notes, and together with the 2018 Notes, the Notes), as we incurred a full period of interest expense in the three and six months ended July 31, 2014. We issued the Notes in June 2013, and therefore incurred interest on the Notes for only a portion of the three and six months ended July 31, 2013. The contractual cash interest expense was $1.6 million and $3.2 million, respectively, for the three and six months ended July 31, 2014, and $0.8 million for both prior year periods. The non-cash interest expense related to amortization of the debt discount and amortization of debt issuance costs was $6.0 million and $11.9 million, respectively, for the three and six months ended July 31, 2014, and $2.8 million for the both prior year periods. Liquidity and Capital Resources As of July 31, 2014, our principal sources of liquidity were cash, cash equivalents and marketable securities totaling $1.8 billion, which were held for working capital purposes. Our cash equivalents and marketable securities are comprised primarily of U.S. agency obligations, U.S. treasury securities, commercial paper, money market funds, and U.S. corporate securities. We have financed our operations primarily through sales of equity securities, customer payments, and issuance of debt. Our future capital requirements will depend on many factors, including our customer growth rate, subscription renewal activity, the timing and extent of development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced services offerings, and the continuing market acceptance of our services. We may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies, and intellectual property rights. We may choose to seek additional equity or debt financing. Our cash flows for the three and six months ended July 31, 2014 and 2013 were as follows: Three Months Ended Six Months Ended July 31, July 31, 2014 2013 2014 2013 (in thousands) Net cash provided by (used in): Operating activities $ (9,011 ) $ (12,916 ) $ 12,686 $ 4,394 Investing activities 18,192 (301,433 ) (334,174 ) (184,371 ) Financing activities 7,467 532,517 2,772 533,337 Effect of exchange rate changes (15 ) - 24 (86 ) Net increase (decrease) in cash and cash equivalents $ 16,633 $ 218,168 $ (318,692 ) $ 353,274 In evaluating our performance internally, we focus on long-term, sustainable growth in free cash flows. We define free cash flows, a non-GAAP financial measure, as net cash provided by (used in) operating activities minus purchases of property and equipment, property and equipment acquired under capital leases and purchases of other (non-acquisition-related) intangible assets. See "Non-GAAP Financial Measures" below for further information. 26-------------------------------------------------------------------------------- Table of Contents Three Months Ended Six Months Ended July 31, July 31, 2014 2013 2014 2013GAAP cash flows from operating activities $ (9,011 ) $ (12,916 ) $ 12,686 $ 4,394 Capital expenditures (28,409 ) (29,732 ) (38,282 ) (31,627 ) Property and equipment acquired under capital lease - - - (115 ) Free cash flows $ (37,420 ) $ (42,648 ) $ (25,596 ) $ (27,348 ) Trailing Twelve Months Ended July 31, 2014 2013GAAP cash flows from operating activities $ 54,555 $ 976 Capital expenditures (67,380 ) (41,523 ) Property and equipment acquired under capital lease - (14,608 ) Purchase of other intangible assets (15,000 ) - Free cash flows $ (27,825 ) $ (55,155 ) Operating Activities For the three months ended July 31, 2014, cash used in operating activities was $9.0 million as compared to $12.9 million for the prior year period. The improvement in cash flow was primarily due to increased cash collections driven by growth in the number of our customer sales contracts, partially offset by increases in our headcount and other operational expenses. During the three months ended July 31, 2014, there was a one-time use in net cash provided by operating activities of approximately $18 million to pay out certain accrued but unused paid time off balances as of May 31, 2014. This payout was due to a recent change on our paid time off policy for US exempt employees such that we no longer track or accrue paid time off. For the six months ended July 31, 2014, cash provided by operating activities was $12.7 million as compared to $4.4 million for the prior year period. The improvement in cash flow was primarily due to increased cash collections driven by growth in our customer sales contracts, partially offset by increases in our headcount and other operational expenses. Investing Activities Cash provided by investing activities for the three months ended July 31, 2014 was $18.2 million, which was primarily the result of the timing of purchases and maturities and the $8.1 million proceeds from the sale of one available-for-sale securities, partially offset by capital expenditures of $28.4 million and a $10.0 million of cost method investment. We expect capital expenditures will be approximately $100 million to $110 million for the year ended January 31, 2015. We expect that these capital outlays will largely be used to expand the infrastructure of our data centers and to build out additional office space to support our growth. We acquired a leasehold interest in land in Pleasanton adjacent to our existing office space during the three months ended January 31, 2014. We are actively evaluating construction alternatives for this site and therefore have not yet factored any related development costs into our expected capital expenditures described above. Cash used in investing activities for the three months ended July 31, 2013 was $301.4 million, which was primarily the result of investing the proceeds of our June 2013 convertible senior notes offerings and capital expenditures of $29.7 million. Cash used in investing activities for the six months ended July 31, 2014 was $334.2 million, which was primarily the result of the timing of purchases and maturities of marketable securities, capital expenditures of $38.3 million and a $10.0 million of cost method investment. These payments were partially offset by proceeds of $8.1 million from the sale of one available-for-sale securities. Cash used in investing activities for the six months ended July 31, 2013 was $184.4 million, which was primarily the result of investing the proceeds of our June 2013 convertible senior notes offerings, the timing of maturities and purchases of marketable securities and capital expenditures of $31.6 million. Financing Activities For the three months ended July 31, 2014, cash provided by financing activities was $7.5 million, which was primarily due to $15.2 million of proceeds from the issuance of common stock from employee equity plans, partially offset by $3.3 million of Class A common share repurchases for tax withholdings on vesting of restricted stock and $4.4 million in principal payments on our capital lease obligations. 27 -------------------------------------------------------------------------------- Table of Contents For the three months ended July 31, 2013, cash provided by financing activities was $532.5 million, which was primarily a result of $584.3 million in net proceeds from issuance of the Notes, $92.7 million in proceeds from the issuance of warrants related to the Notes and $2.1 million of proceeds from the exercise of stock options. These proceeds were partially offset by $143.7 million used to purchase convertible senior notes hedges and $2.9 million in principal payments on our capital lease obligations. We purchased the convertible senior notes hedges to offset potential economic dilution to our Class A Common Stock upon any conversion of the Notes. For the six months ended July 31, 2014, cash provided by financing activities was $2.8 million, which was primarily due to $18.2 million of proceeds from the issuance of common stock from employee equity plans, partially offset by $8.3 million of Class A common share repurchases for tax withholdings on vesting of restricted stock and $7.2 million in principal payments on our capital lease obligations. For the six months ended July 31, 2013, cash provided by financing activities was $533.3 million, which was primarily due to $584.3 million in net proceeds from issuance of the Notes, $92.7 million in proceeds from the issuance of warrants related to the Notes and $6.7 million of proceeds from the exercise of stock options. These proceeds were partially offset by $143.7 million used to purchase convertible senior notes hedges and $6.7 million in principal payments on our capital lease obligations. Free Cash Flows In addition to net cash used by operating activities, management uses free cash flows as a key financial metric. Free cash flows improved by $5.2 million to $(37.4) million for the three months ended July 31, 2014, compared to $(42.6) million for the prior year period. The improvement was primarily due to increased sales and the related cash collections, partially offset by increased capital expenditures and higher operating expenses, driven primarily by increased headcount. Free cash flows increased by $1.7 million to $(25.6) million for the six months ended July 31, 2014, compared to $(27.3) million for the prior year period. The improvement was primarily due to increased sales and the related cash collections, partially offset by increased capital expenditures. Non-GAAP Financial Measures Item 10(e) of Regulation S-K, "Use of non-GAAP financial measures in Commission filings," defines and prescribes the conditions for use of non-GAAP financial information. Our measures of core operating expenses, core operating margin and free cash flows each meet the definition of a non-GAAP financial measure. Core Operating Expenses We define core operating expenses as our total operating expenses excluding the following components, which we believe are not reflective of our ongoing operational expenses. In each case, for the reasons set forth below, management believes that excluding the component provides useful information to investors and others in understanding and evaluating our operating results and future prospects in the same manner as management, in comparing financial results across accounting periods and to those of peer companies and to better understand the long-term performance of our core business. • Share-Based Compensation Expenses. Although share-based compensation is an important aspect of the compensation of our employees and executives, management believes it is useful to exclude share-based compensation in order to better understand the long-term performance of our core business and to facilitate comparison of our results to those of peer companies. For restricted share awards, the amount of share-based compensation expenses is not reflective of the value ultimately received by the grant recipients. Moreover, determining the fair value of certain of the share-based instruments we utilize involves a high degree of judgment and estimation and the expense recorded may bear little resemblance to the actual value realized upon the vesting or future exercise of the related share-based awards. Unlike cash compensation, the value of stock options and the Employee Stock Purchase Plan, which is an element of our ongoing share-based compensation expenses, is determined using a complex formula that incorporates factors, such as market volatility and forfeiture rates, that are beyond our control. 28 -------------------------------------------------------------------------------- Table of Contents • Other Operating Expenses. Other operating expenses included employer payroll taxes on employee stock transactions for the three and six months ended July 31, 2014 and 2013 and amortization of acquisition-related intangible assets for the three and six months ended July 31, 2014. The amount of employer payroll taxes on share-based compensation is dependent on our stock price and other factors that are beyond our control and do not correlate to the operation of the business. For business combinations, we generally allocate a portion of the purchase price to intangible assets. The amount of the allocation is based on estimates and assumptions made by management and is subject to amortization. The amount of purchase price allocated to intangible assets and the term of its related amortization can vary significantly and are unique to each acquisition and thus we do not believe it is reflective of the ongoing operations. Free cash flows We define free cash flows as net cash provided by (used in) operating activities minus purchases of property and equipment, property and equipment acquired under capital leases and purchases of other (non-acquisition-related) intangible assets. Management uses free cash flows as a measure of financial progress in our business, as it balances operating results, cash management and capital efficiency. When calculating free cash flows, we subtract the gross value of all equipment acquired in the period, even when acquired under capital leases, so we can evaluate our progress on free cash flows independent of our capital financing decisions. Management believes information regarding free cash flows provides investors and others with an important perspective on the cash available to make strategic acquisitions and investments, to fund ongoing operations and to fund other capital expenditures. Limitations on the use of non-GAAP financial measures A limitation of our non-GAAP financial measures of core operating expenses, core operating margin and free cash flows is that they do not have uniform definitions. Our definitions will likely differ from the definitions used by other companies, including peer companies, and therefore comparability may be limited. Thus, our non-GAAP measures of core operating expenses, core operating margin and free cash flows should be considered in addition to, not as a substitute for, or in isolation from, measures prepared in accordance with GAAP. Additionally, in the case of share-based compensation, if we did not pay out a portion of compensation in the form of share-based compensation and related employer payroll taxes, the cash salary expense included in costs of revenues and operating expenses would be higher, which would affect our cash position. Further, the non-GAAP measure of core operating expenses has certain limitations because it does not reflect all items of expense that affect our operations and are reflected in the GAAP measure of total operating expenses. We compensate for these limitations by reconciling core operating expenses to the most comparable GAAP financial measure and reviewing these measures in conjunction with GAAP financial information. Management encourages investors and others to review our financial information in its entirety, not to rely on any single financial measure and to view our non-GAAP financial measures in conjunction with the most comparable GAAP financial measures. See "Results of Operations-Core Operating Expenses" for a reconciliation of the non-GAAP financial measure of core operating expenses to the most comparable GAAP measure, "total operating expenses," for the three and six months ended July 31, 2014 and 2013. See "Liquidity and Capital Resources" for a reconciliation of free cash flows to the most comparable GAAP measure, "GAAP cash flows from operating activities," for the three and six months ended July 31, 2014 and 2013. Commitments Our principal commitments primarily consist of obligations under leases for office space and co-location facilities for data center capacity and our development and test data center, as well as computer equipment. As of July 31, 2014, the future non-cancelable minimum payments under operating leases were $118.8 million. During the remainder of the year ended January 31, 2015, we anticipate leasing additional office space near our headquarters and in various other locations around the world to support our growth. In addition, our existing lease agreements often provide us with an option to renew. We expect our future operating lease obligations will increase as we expand our operations. We are not required to make principal payments under the Notes prior to maturity. If the Notes are not converted to Class A common stock prior to their maturity dates, we are required to repay $350.0 million in principal on July 15, 2018 and $250.0 million in principal on July 15, 2020. We are also required to make interest payments on a semi-annual basis at the interest rates noted above. We do not consider outstanding purchase orders to be purchase commitments as they represent authorizations to purchase rather than binding agreements. 29-------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements Through July 31, 2014, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with GAAP. The preparation of these condensed consolidated financial statements requires us to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses, and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions. During the six months ended July 31, 2014, there were no significant changes to our critical accounting policies and estimates as described in financial statements contained in the Annual Report on Form 10-K for the year ended January 31, 2014 filed with the Securities and Exchange Commission (SEC) on March 31, 2014. Subsequent to the filing of our Annual Report on Form 10-K, we added a policy related to business combinations (see Note 1). 30-------------------------------------------------------------------------------- Table of Contents |