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SPLUNK INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. The following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Statements that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements are often identified by the use of words such as, but not limited to, "anticipate," "believe," "can," "continue," "could," "estimate," "expect," "intend," "may," "might," "plan," "project," "seek," "should," "target," "will," "would" and similar expressions or variations intended to identify forward-looking statements. Such statements include, but are not limited to, statements concerning our market opportunity, our future financial and operating results; our planned investments, particularly in our product development efforts; our planned expansion of our sales and marketing organization; our growth and integration strategies; our continued efforts to market and sell both domestically and internationally; our expectations about seasonal trends; our expectations regarding our revenues mix; use of non-GAAP financial measures; our expectations regarding our operating expenses, including changes in research and development, sales and marketing, and general and administrative expenses; sufficiency of cash to meet cash needs for at 13-------------------------------------------------------------------------------- Table of Contents least the next 12 months; exposure to interest rate changes; inflation; anticipated income tax rates; our expectations regarding our leases; and our expected capital expenditures, cash flows and liquidity. These statements are based on the beliefs and assumptions of our management based on information currently available to us. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled "Risk Factors" included under Part II, Item 1A below. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances that occur after the date of this report. Overview Splunk provides innovative software products that enable organizations to gain real-time operational intelligence by harnessing the value of their data. Our products enable users to collect, index, search, explore, monitor and analyze data regardless of format or source. Our products address large and diverse data sets, commonly referred to as big data, and are specifically tailored for machine-generated data. Machine data is produced by nearly every software application and electronic device in an organization and contains a definitive, time-stamped record of various activities, such as transactions, customer and user activities and security threats. Outside of an organization's traditional IT and security infrastructure, every processor-based system, including HVAC controllers, smart electrical meters, GPS devices and radio-frequency identification tags, and many consumer-oriented systems, such as mobile devices, automobiles and medical devices that contain embedded electronic devices, are also continuously generating machine data. We believe the market for software that provides operational intelligence presents a substantial opportunity as data grows in volume and diversity, creating new risks, opportunities and challenges for organizations. Since our inception, we have invested a substantial amount of resources developing our products and technology to address this market, specifically with respect to machine data. Our products are designed to accelerate return-on-investment for our customers. They generally do not require customization, long deployment cycles or extensive professional services commonly associated with traditional enterprise software applications. Users can simply download and install the software, typically in a matter of hours, to connect to their relevant machine data sources. Alternatively, they can sign up for our Splunk Cloud service and avoid the need to provision, deploy and manage internal infrastructure. They can also provision a computing instance on Amazon Web Services and use Splunk Enterprise as an Amazon Machine Image. We also offer support, training and professional services to our customers to assist in the deployment of our software. For Splunk Enterprise, we base our license fees on the estimated daily data indexing capacity our customers require. Prospective customers can download a trial version of our software that provides a full set of features but limited data indexing capacity. Following the 60-day trial period, prospective customers can purchase a license for our product or continue using our product with reduced features and limited data indexing capacity. We primarily license our software under perpetual licenses whereby we generally recognize the license fee portion of these arrangements upfront. As a result, the timing of when we enter into large perpetual licenses may lead to fluctuations in our revenues and operating results because our expenses are largely fixed in the short-term. Additionally, we license our software under term licenses which are generally recognized ratably over the contract term. From time to time, we also enter into transactions that are designed to enable broad adoption of our software within an enterprise, referred to as enterprise adoption agreements. These agreements typically include provisions that require revenue deferral and recognition over time. Splunk Cloud delivers the core functionalities of Splunk Enterprise as a scalable, reliable cloud service. During fiscal 2014, we also introduced Hunk: Splunk Analytics for Hadoop, which is a new software product that enables exploration, analysis and visualization of data in Hadoop. We intend to continue investing for long-term growth. We have invested and expect to continue to invest heavily in our product development efforts to deliver additional compelling features, address customer needs and enable solutions that can address new end markets. In addition, we expect to continue to aggressively expand our sales and marketing organizations to market and sell our software both in the United States and internationally. Our goal is to make our software the platform for delivering operational intelligence and real-time business insights from machine data. The key elements of our growth strategy are to: • Extend our technological capabilities. 14-------------------------------------------------------------------------------- Table of Contents • Continue to expand our direct and indirect sales organization, including our channel relationships, to acquire new customers. • Further penetrate our existing customer base and drive enterprise-wide adoption. • Build premium apps on our core platforms that enable organizations to realize additional value from our software and to use our products in different ways. • Grow our user communities and partner ecosystem to increase awareness of our brand, target new use cases, drive operational leverage and deliver more targeted, higher value solutions. • Continue to deliver a rich developer environment to enable rapid development of enterprise applications that leverage machine data and the Splunk platform. We believe the factors that will influence our ability to achieve our goals include, among other things, our ability to deliver additional functionality; acquire new customers across geographies and industries; cultivate incremental sales from our existing customers by driving increased use of our software within organizations; provide additional solutions that leverage our core machine data engine to help organizations understand and realize the value of their machine data in specific end markets and use cases; add additional OEM and strategic relationships to enable new sales channels for our software as well as extend our integration with third party products; and help software developers leverage the functionality of our machine data engine through software development kits ("SDKs") and application programming interfaces ("APIs"). For the three months ended July 31, 2014 and 2013, our total revenues were $101.5 million and $66.9 million, respectively, representing year-over-year growth of approximately 52%. For the three months ended July 31, 2014 and 2013, approximately 25% and 21% of our total revenues were derived from customers located outside the United States, respectively. Our customers and end-users represent the public sector and a wide variety of industries, including financial services, manufacturing, retail and technology, among others. As of July 31, 2014, we had over 7,900 customers. For the three months ended July 31, 2014 and 2013, our GAAP operating loss was $60.4 million and $13.3 million, respectively. Our non-GAAP operating income was $1.6 million for the three months ended July 31, 2014 and our non-GAAP operating loss was $0.8 million for the three months ended July 31, 2013. For the three months ended July 31, 2014 and 2013, our GAAP net loss was $60.8 million and $13.7 million, respectively. Our non-GAAP net income was $1.2 million for the three months ended July 31, 2014 and our non-GAAP net loss was $1.2 million for the three months ended July 31, 2013. Our quarterly results reflect seasonality in the sale of our products and services. Historically, a pattern of increased license sales in the fourth fiscal quarter as a result of industry buying patterns has positively impacted sales activity in that period, which can result in lower sequential revenues in the first fiscal quarter. Our gross margins and operating losses have been affected by these historical trends because the majority of our expenses are relatively fixed in the short-term. The majority of our expenses are personnel-related and include salaries, stock-based compensation, benefits and incentive-based compensation plan expenses. As a result, we have not experienced significant seasonal fluctuations in the timing of expenses from period to period. Non-GAAP Financial Results To supplement our condensed consolidated financial statements, which are prepared and presented in accordance with GAAP, we provide investors with certain non-GAAP financial measures, including non-GAAP gross margin, non-GAAP operating income (loss), non-GAAP net income (loss), non-GAAP operating margin and non-GAAP net income (loss) per share (collectively the "non-GAAP financial measures"). These non-GAAP financial measures exclude all or a combination of the following (as reflected in the following reconciliation table): stock-based compensation expense, employer payroll tax expense related to employee stock plans, amortization of acquired intangible assets and ground lease expense related to a build-to-suit lease obligation. In addition, non-GAAP financial measures include free cash flow, which represents cash from operations less purchases of property and equipment. The presentation of the non-GAAP financial measures is not intended to be considered in isolation or as a substitute for, or superior to, the financial information prepared and presented in accordance with GAAP. We use these non-GAAP financial measures for financial and operational decision-making purposes and as a means to evaluate period-to-period comparisons. We believe that these non-GAAP financial measures provide useful information about our operating results, enhance the overall understanding of past financial performance and future prospects and allow for greater 15-------------------------------------------------------------------------------- Table of Contents transparency with respect to key metrics used by our management in its financial and operational decision making. In addition, these non-GAAP financial measures facilitate comparisons to competitors' operating results. We exclude stock-based compensation expense because it is non-cash in nature and excluding this expense provides meaningful supplemental information regarding our operational performance. In particular, because of varying available valuation methodologies, subjective assumptions and the variety of award types that companies can use under FASB ASC Topic 718, we believe that providing non-GAAP financial measures that exclude this expense allows investors the ability to make more meaningful comparisons between our operating results and those of other companies. We exclude employer payroll tax expense related to employee stock plans in order for investors to see the full effect that excluding that stock-based compensation expense had on our operating results. These expenses are tied to the exercise or vesting of underlying equity awards and the price of our common stock at the time of vesting or exercise, which may vary from period to period independent of the operating performance of our business. We exclude amortization of acquired intangible assets from our non-GAAP financial measures because it is considered by management to be outside of our core operating results. We further exclude the ground lease expense related to our build-to-suit lease obligation from our non-GAAP operating income (loss), non-GAAP operating margin and non-GAAP net income (loss) because it is also considered by management to be outside of our core operating results. Accordingly, we believe that excluding these expenses provides investors and management with greater visibility to the underlying performance of our business operations, facilitates comparison of our results with other periods and may also facilitate comparison with the results of other companies in our industry. We consider free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that can be used for strategic opportunities, including investing in our business, making strategic acquisitions and strengthening our balance sheet. There are limitations in using non-GAAP financial measures because the non-GAAP financial measures are not prepared in accordance with GAAP, may be different from non-GAAP financial measures used by our competitors and exclude expenses that may have a material impact upon our reported financial results. Further, stock-based compensation expense has been and will continue to be for the foreseeable future a significant recurring expense in our business and an important part of the compensation provided to our employees. The non-GAAP financial measures are meant to supplement and be viewed in conjunction with GAAP financial measures. The following table reconciles net cash provided by operating activities to free cash flow for the three and six months ended July 31, 2014 and 2013 (in thousands): Three Months Six Months Ended July 31, Ended July 31, 2014 2013 2014 2013 Net cash provided by operating activities $ 9,336 $ 6,251 $ 28,247 $ 26,102 Less purchases of property and equipment (2,908 ) (1,967 ) (7,146 ) (3,230 ) Free cash flow (Non-GAAP) 6,428 4,284 21,101 22,872 Net cash used in investing activities (43,478 ) (1,967 ) (298,599 ) (3,230 ) Net cash provided by financing activities $ 11,803 $ 11,636 $ 18,118 $ 18,354 The following table reconciles GAAP gross margin to non-GAAP gross margin for the three and six months ended July 31, 2014 and 2013: Three Months Six Months Ended July 31, Ended July 31, 2014 2013 2014 2013 GAAP gross margin 85.2 % 88.9 % 84.4 % 88.6 % Stock-based compensation expense 3.7 1.3 4.1 1.3 Employer payroll tax on employee stock plans 0.1 - 0.1 - Amortization of acquired intangible assets 0.7 - 0.7 - Non-GAAP gross margin 89.7 % 90.2 % 89.3 % 89.9 % The following table reconciles GAAP operating loss to non-GAAP operating income (loss) for the three and six months ended July 31, 2014 and 2013 (in thousands): 16-------------------------------------------------------------------------------- Table of Contents Three Months Six Months Ended July 31, Ended July 31, 2014 2013 2014 2013 GAAP operating loss $ (60,357 ) $ (13,304 ) $ (110,460 ) $ (29,001 ) Stock-based compensation expense 59,510 11,957 102,749 21,792 Employer payroll tax on employee stock plans 1,341 586 3,729 1,166 Amortization of acquired intangible assets 922 - 1,825 - Ground lease expense related to build-to-suit lease obligation 222 - 222 - Non-GAAP operating income (loss) $ 1,638 $ (761 ) $ (1,935 ) $ (6,043 ) The following table reconciles GAAP operating margin to non-GAAP operating margin for the three and six months ended July 31, 2014 and 2013: Three Months Six Months Ended July 31, Ended July 31, 2014 2013 2014 2013 GAAP operating margin (59.4 )% (19.9 )% (58.9 )% (23.4 )% Stock-based compensation expense 58.6 17.9 54.8 17.6 Employer payroll tax on employee stock plans 1.3 0.9 2.0 0.9 Amortization of acquired intangible assets 0.9 - 1.0 - Ground lease expense related to build-to-suit lease obligation 0.2 - 0.1 - Non-GAAP operating margin 1.6 % (1.1 )% (1.0 )% (4.9 )% The following table reconciles GAAP net loss to non-GAAP net income (loss) for the three and six months ended July 31, 2014 and 2013 (in thousands): Three Months Six Months Ended July 31, Ended July 31, 2014 2013 2014 2013 GAAP net loss $ (60,782 ) $ (13,693 ) $ (111,537 ) $ (29,827 ) Stock-based compensation expense 59,510 11,957 102,749 21,792 Employer payroll tax on employee stock plans 1,341 586 3,729 1,166 Amortization of acquired intangible assets 922 - 1,825 - Ground lease expense related to build-to-suit lease obligation 222 - 222 - Non-GAAP net income (loss) $ 1,213 $ (1,150 ) $ (3,012 ) $ (6,869 ) The following table reconciles the shares used in computing basic and diluted GAAP and non-GAAP net income (loss) per share for the three and six months ended July 31, 2014 and 2013 (in thousands, except per share amounts): 17-------------------------------------------------------------------------------- Table of Contents Three Months Six Months Ended July 31, Ended July 31, 2014 2013 2014 2013 Weighted-average shares used in computing GAAP basic net loss per share 119,012 104,100 118,165 103,075 Effect of dilutive securities: Employee stock awards 6,606 - - - Weighted-average shares used in computing Non-GAAP basic and diluted net income (loss) per share 125,618 104,100 118,165 103,075 GAAP basic and diluted net loss per share $ (0.51 ) $ (0.13 ) $ (0.94 ) $ (0.29 ) Non-GAAP basic and diluted net income (loss) per share $ 0.01 $ (0.01 ) $ (0.03 ) $ (0.07 ) Components of Operating Results Revenues License revenues. License revenues reflect the revenues recognized from sales of licenses to new customers and additional licenses to existing customers. We are focused on acquiring new customers and increasing revenues from our existing customers as they realize the value of our software by indexing higher volumes of machine data and expanding the use of our software through additional use cases and broader deployment within their organizations. A majority of our license revenues consists of revenues from perpetual licenses, under which we generally recognize the license fee portion of the arrangement upfront, assuming all revenue recognition criteria are satisfied. Customers can also purchase term license agreements, under which we recognize the license fee ratably, on a straight-line basis, over the term of the license. Due to the differing revenue recognition policies applicable to perpetual and term licenses, shifts in the mix between perpetual and term licenses from quarter to quarter could produce substantial variation in revenues recognized even if our sales remain consistent. In addition, seasonal trends that contribute to increased sales activity in the fourth fiscal quarter often result in lower sequential revenues in the first fiscal quarter, and we expect this trend to continue. Comparing our revenues on a period-to-period basis may not be meaningful, and you should not rely on our past results as an indication of our future performance. Maintenance and services revenues. Maintenance and services revenues consist of revenues from maintenance agreements and, to a lesser extent, professional services and training. Typically, when purchasing a perpetual license, a customer also purchases one year of maintenance service for which we charge a percentage of the license fee. When a term license is purchased, maintenance service is typically bundled with the license for the term of the license period. Customers with maintenance agreements are entitled to receive support and unspecified upgrades and enhancements when and if they become available during the maintenance period. We recognize the revenues associated with maintenance agreements ratably, on a straight-line basis, over the associated maintenance period. In arrangements involving a term license, we recognize both the license and maintenance revenues over the contract period. We have a professional services organization focused on helping some of our largest customers deploy our software in highly complex operational environments and train their personnel. We recognize the revenues associated with these professional services on a time and materials basis as we deliver the services or provide the training. We expect maintenance and services revenues to become a larger percentage of our total revenues as our installed customer base grows. Professional services and training revenues as a percentage of total revenues were 7% and 6% for the three months ended July 31, 2014 and 2013, respectively. We have experienced continued growth in our professional services revenues primarily due to the deployment of our software with some customers that have large, highly complex IT environments. Cost of Revenues Cost of license revenues. Cost of license revenues includes all direct costs to deliver our product, including salaries, benefits, stock-based compensation and related expenses such as employer taxes, allocated overhead for facilities and IT and amortization of acquired intangible assets. We recognize these expenses as they are incurred. Cost of maintenance and services revenues. Cost of maintenance and services revenues includes salaries, benefits, stock-based compensation and related expenses such as employer taxes for our maintenance and services organization, allocated overhead for depreciation of equipment, facilities and IT, and amortization. We recognize expenses related to our maintenance and services organization as they are incurred. 18-------------------------------------------------------------------------------- Table of Contents Operating Expenses Our operating expenses are classified into three categories: research and development, sales and marketing and general and administrative. For each category, the largest component is personnel costs, which include salaries, employee benefit costs, bonuses, commissions as applicable, stock-based compensation and related expenses such as employer taxes. Operating expenses also include allocated overhead costs for depreciation of equipment, facilities and IT. Allocated costs for facilities consist of leasehold improvements and rent. Our allocated costs for IT include costs for compensation of our IT personnel and costs associated with our IT infrastructure. Operating expenses are generally recognized as incurred. Research and development. Research and development expenses primarily consist of personnel and facility-related costs attributable to our research and development personnel. We have devoted our product development efforts primarily to enhancing the functionality and expanding the capabilities of our software and services. We expect that our research and development expenses will continue to increase, in absolute dollars, as we increase our research and development headcount to further strengthen and enhance our software and services and invest in the development of our solutions and apps. Sales and marketing. Sales and marketing expenses primarily consist of personnel and facility-related costs for our sales, marketing and business development personnel, commissions earned by our sales personnel, and the cost of marketing and business development programs. We expect that sales and marketing expenses will continue to increase, in absolute dollars, as we continue to hire additional personnel and invest in marketing programs. General and administrative. General and administrative expenses primarily consist of personnel and facility-related costs for our executive, finance, legal, human resources and administrative personnel; our legal, accounting and other professional services fees; and other corporate expenses. We anticipate continuing to incur additional expenses due to growing our operations and being a publicly traded company, including higher legal, corporate insurance and accounting expenses and costs related to maintaining compliance with Section 404 of the Sarbanes-Oxley Act and related regulations. Interest and other income (expense), net Interest and other income (expense), net consists primarily of foreign exchange gains and losses, interest income on our investments and cash and cash equivalents balances, and interest expense on outstanding debt. Provision for income taxes The provision for income taxes consists of federal, state and foreign income taxes. We recognize deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax basis of assets and liabilities and their reported amounts using enacted tax rates in effect for the year in which we expect the differences to reverse. We record a valuation allowance to reduce the deferred tax assets to the amount that we are more-likely-than-not to realize. Because of our history of U.S. net operating losses, we have established, in prior years, a full valuation allowance against potential future benefits for U.S. deferred tax assets including loss carry-forwards and research and development and other tax credits. We regularly assess the likelihood that our deferred income tax assets will be realized based on the realization guidance available. To the extent that we believe any amounts are not more-likely-than-not to be realized, we record a valuation allowance to reduce the deferred income tax assets. We regularly assess the need for the valuation allowance on our deferred tax assets, and to the extent that we determine that an adjustment is needed, such adjustment will be recorded in the period that the determination is made. Results of Operations The following tables set forth our results of operations for the periods presented and as a percentage of our total revenues for those periods. The period-to-period comparison of financial results is not necessarily indicative of financial results to be achieved in future periods. 19-------------------------------------------------------------------------------- Table of Contents Three Months Six Months Ended July 31, Ended July 31, 2014 2013 2014 2013 (in thousands) Condensed Consolidated Statement of Operations Data: Revenues License $ 62,081 $ 43,185 $ 113,355 $ 79,357 Maintenance and services 39,466 23,688 74,099 44,723 Total revenues 101,547 66,873 187,454 124,080 Cost of revenues License 72 76 150 145 Maintenance and services 14,999 7,345 29,108 13,957 Total cost of revenues 15,071 7,421 29,258 14,102 Gross profit 86,476 59,452 158,196 109,978 Operating expenses Research and development 34,179 16,210 63,921 30,674 Sales and marketing 79,978 44,634 151,056 85,947 General and administrative 32,676 11,912 53,679 22,358 Total operating expenses 146,833 72,756 268,656 138,979 Operating loss (60,357 ) (13,304 ) (110,460 ) (29,001 ) Interest and other income (expense), net Interest income 163 58 293 119 Other income (expense), net (54 ) (82 ) (274 ) (176 ) Total interest and other income (expense), net 109 (24 ) 19 (57 ) Loss before income taxes (60,248 ) (13,328 ) (110,441 ) (29,058 ) Income tax provision 534 365 1,096 769 Net loss $ (60,782 ) $ (13,693 ) $ (111,537 ) $ (29,827 ) 20-------------------------------------------------------------------------------- Table of Contents Three Months Six Months Ended July 31, Ended July 31, 2014 2013 2014 2013 (as % of revenues) Condensed Consolidated Statement of Operations Data: Revenues License 61.1 % 64.6 % 60.5 % 64.0 % Maintenance and services 38.9 35.4 39.5 36.0 Total revenues 100.0 100.0 100.0 100.0 Cost of revenues License (1) 0.1 0.2 0.1 0.2 Maintenance and services (1) 38.0 31.0 39.3 31.2 Total cost of revenues 14.8 11.1 15.6 11.4 Gross profit 85.2 88.9 84.4 88.6 Operating expenses Research and development 33.7 24.2 34.1 24.7 Sales and marketing 78.7 66.8 80.6 69.3 General and administrative 32.2 17.8 28.6 18.0 Total operating expenses 144.6 108.8 143.3 112.0 Operating loss (59.4 ) (19.9 ) (58.9 ) (23.4 ) Interest and other income (expense), net Interest income (expense), net 0.2 0.1 0.2 0.1 Other income (expense), net (0.1 ) (0.1 ) (0.1 ) (0.1 ) Total interest and other income (expense), net 0.1 - 0.1 - Loss before income taxes (59.3 ) (19.9 ) (58.8 ) (23.4 ) Provision for income taxes 0.5 0.5 0.6 0.6 Net loss (59.8 )% (20.4 )% (59.4 )% (24.0 )% (1) Calculated as a percentage of the associated revenues. Comparison of the Three Months Ended July 31, 2014 and 2013 Revenues Three Months Ended July 31, 2014 2013 % Change ($ amounts in thousands) Revenues License $ 62,081 $ 43,185 43.8 % Maintenance and services 39,466 23,688 66.6 % Total revenues $ 101,547 $ 66,873 51.9 % Percentage of revenues License 61.1 % 64.6 % Maintenance and services 38.9 35.4 Total 100.0 % 100.0 % Total revenues increased $34.7 million due to growth in license revenues, as well as maintenance and services revenues. The increase in license revenues was primarily driven by increases in our total number of customers, sales to existing customers and an increase in the number of large orders. For example, we had 226 and 163 orders greater than $100,000 for the three months ended July 31, 2014 and 2013, respectively. Our total number of customers increased from approximately 6,000 at 21-------------------------------------------------------------------------------- Table of Contents July 31, 2013 to more than 7,900 at July 31, 2014. The increase in maintenance and services revenues was due to increases in sales of maintenance agreements as well as sales of professional services resulting from the growth of our installed customer base. Cost of Revenues and Gross Margin Three Months Ended July 31, 2014 2013 % Change ($ amounts in thousands) Cost of revenues License $ 72 $ 76 (5.3 )% Maintenance and services 14,999 7,345 104.2 % Total cost of revenues $ 15,071 $ 7,421 103.1 % Gross margin License 99.9 % 99.8 % Maintenance and services 62.0 % 69.0 % Total gross margin 85.2 % 88.9 % Total cost of revenues increased $7.7 million due to the increase in cost of maintenance and services revenues. The increase in cost of maintenance and services revenues was primarily related to an increase of $4.8 million in salaries and benefits expense, which includes a $2.9 million increase in stock-based compensation expense, due to increased headcount, an increase of $1.3 million related to professional services expense and an increase of $0.8 million related to overhead costs. Operating Expenses Three Months Ended July 31, 2014 2013 % Change ($ amounts in thousands) Operating expenses (1) Research and development $ 34,179 $ 16,210 110.9 % Sales and marketing 79,978 44,634 79.2 % General and administrative 32,676 11,912 174.3 % Total operating expenses $ 146,833 $ 72,756 101.8 % Percentage of revenues Research and development 33.7 % 24.2 % Sales and marketing 78.7 66.8 General and administrative 32.2 17.8 Total 144.6 % 108.8 % (1) Includes stock-based compensation expense: Research and development $ 13,578 $ 3,547 Sales and marketing 21,263 5,156 General and administrative 20,861 2,389 Total stock-based compensation expense $ 55,702 $ 11,092 Research and development expense. Research and development expense increased $18.0 million primarily due to a $14.4 million increase in salaries and benefits, which includes a $10.0 million increase in stock-based compensation expense, as we increased headcount as part of our focus on further developing and enhancing our products. We also had an increase of $2.2 million related to overhead costs and an increase of $1.1 million due to payroll related taxes as a result of increased headcount. 22-------------------------------------------------------------------------------- Table of Contents Sales and marketing expense. Sales and marketing expense increased $35.3 million primarily due to a $28.9 million increase in salaries and benefits, which includes a $16.1 million increase in stock-based compensation expense, as we increased headcount to expand our field sales organization and experienced higher commission expense as a result of increased customer orders. We experienced an increase of $3.8 million in expenses due to increased facilities and overhead as a result of our international expansion efforts and increased headcount. Additionally, we had an increase of $1.6 million in travel expenses due to increased travel from our growing field sales organization. Finally, we also incurred a $0.4 million increase in marketing program fees in conjunction with increased marketing and advertising efforts. General and administrative expense. General and administrative expense increased $20.8 million due primarily to an increase of $22.5 million related to salaries and benefits, which includes a $18.5 million increase in stock-based compensation expense, in part due to an acceleration of stock-based compensation expense of $13.1 million related to the return of two restricted stock unit grants from our Chief Executive Officer, covering a total of 242,500 unvested shares of our common stock, as well as increased headcount. This increase was partially offset by a decrease of $2.1 million related to overhead allocation between operating expense categories. Interest and Other Income (Expense), net Three Months Ended July 31, 2014 2013 (in thousands) Interest and other income (expense), net: Interest income $ 163 $ 58 Other income (expense), net (54 ) (82 ) Total interest and other income (expense), net $ 109 $ (24 ) Interest and other income (expense), net reflects a net increase in income primarily due to an increase in total interest income from our investments. Income Tax Provision Three Months Ended July 31, 2014 2013 (in thousands) Income tax provision $ 534 $ 365 For the three months ended July 31, 2014, we recorded an income tax expense that was primarily attributable to an increase in tax expense from our increased activity in our foreign operations and state franchise tax. Comparison of the Six Months Ended July 31, 2014 and 2013 Revenues 23-------------------------------------------------------------------------------- Table of Contents Six Months Ended July 31, 2014 2013 % Change ($ amounts in thousands) Revenues License $ 113,355 $ 79,357 42.8 % Maintenance and services 74,099 44,723 65.7 % Total revenues $ 187,454 $ 124,080 51.1 % Percentage of revenues License 60.5 % 64.0 % Maintenance and services 39.5 36.0 Total 100.0 % 100.0 % Total revenues increased $63.4 million due to growth in license revenues, as well as maintenance and services revenues. The increase in license revenues was primarily driven by increases in our total number of customers, sales to existing customers and an increase in the number of large orders. For example, we had 393 and 295 orders greater than $100,000 for the six months ended July 31, 2014 and 2013, respectively. Our total number of customers increased from approximately 6,000 at July 31, 2013 to more than 7,900 at July 31, 2014. The increase in maintenance and services revenues was due to increases in sales of maintenance agreements as well as sales of professional services resulting from the growth of our installed customer base. Cost of Revenues and Gross Margin Six Months Ended July 31, 2014 2013 % Change ($ amounts in thousands) Cost of revenues License $ 150 $ 145 3.4 % Maintenance and services 29,108 13,957 108.6 % Total cost of revenues $ 29,258 $ 14,102 107.5 % Gross margin License 99.9 % 99.8 % Maintenance and services 60.7 % 68.8 % Total gross margin 84.4 % 88.6 % Total cost of revenues increased $15.2 million due to the increase in cost of maintenance and services revenues. The increase in cost of maintenance and services revenues was primarily related to an increase of $9.9 million in salaries and benefits expense, which includes a $6.0 million increase in stock-based compensation expense, due to increased headcount, an increase of $2.8 million related to professional services expense and an increase of $1.4 million related to overhead costs. Operating Expenses 24-------------------------------------------------------------------------------- Table of Contents Six Months Ended July 31, 2014 2013 % Change ($ amounts in thousands) Operating expenses (1) Research and development $ 63,921 $ 30,674 108.4 % Sales and marketing 151,056 85,947 75.8 % General and administrative 53,679 22,358 140.1 % Total operating expenses $ 268,656 $ 138,979 93.3 % Percentage of revenues Research and development 34.1 % 24.7 % Sales and marketing 80.6 69.3 General and administrative 28.6 18.0 Total 143.3 % 112.0 % (1) Includes stock-based compensation expense: Research and development $ 26,165 $ 6,590 Sales and marketing 40,383 9,478 General and administrative 28,587 4,154 Total stock-based compensation expense $ 95,135 $ 20,222 Research and development expense. Research and development expense increased $33.2 million primarily due to a $27.9 million increase in salaries and benefits, which includes a $19.6 million increase in stock-based compensation expense, as we increased headcount as part of our focus on further developing and enhancing our products. We also had an increase of $4.0 million related to overhead and facilities cost and an increase of $1.1 million due to payroll related taxes as a result of increased headcount. Sales and marketing expense. Sales and marketing expense increased $65.1 million primarily due to a $52.6 million increase in salaries and benefits, which includes a $30.9 million increase in stock-based compensation expense, as we increased headcount to expand our field sales organization and experienced higher commission expense as a result of increased customer orders. We experienced an increase of $5.9 million in expenses due to increased facilities and overhead as a result of our international expansion efforts and an increase of $0.7 million in employment related expenses as a result of increased headcount. Additionally, we had an increase of $2.9 million in travel expenses due to increased travel from our growing field sales organization. We also incurred a $2.1 million increase in marketing program fees in conjunction with increased marketing and advertising efforts. General and administrative expense. General and administrative expense increased $31.3 million due primarily to an increase of $32.2 million related to salaries and benefits, which includes a $24.4 million increase in stock-based compensation expense, in part due to an acceleration of stock-based compensation expense of $13.1 million related to the return of two restricted stock unit grants from our Chief Executive Officer, covering a total 242,500 unvested shares of our common stock, as well as increased headcount. Interest and Other Income (Expense), net Six Months Ended July 31, 2014 2013 (in thousands) Interest and other income (expense), net: Interest income $ 293 $ 119 Other income (expense), net (274 ) (176 ) Total interest and other income (expense), net $ 19 $ (57 ) Interest and other income (expense), net reflects a net increase in income primarily due to an increase in total interest income from our investments. 25-------------------------------------------------------------------------------- Table of Contents Income Tax Provision Six Months Ended July 31, 2014 2013 (in thousands) Income tax provision $ 1,096 $ 769 For the six months ended July 31, 2014, we recorded an income tax expense that was primarily attributable to an increase in tax expense from our increased activity in our foreign operations and state franchise tax. Liquidity and Capital Resources July 31, 2014 January 31, 2014 (in thousands) Cash and cash equivalents $ 645,398 $ 897,453 Three Months Ended July 31, 2014 2013 (in thousands)Cash provided by operating activities $ 28,247 $ 26,102 Cash used in investing activities (298,599 ) (3,230 ) Cash provided by financing activities 18,118 18,354 Since fiscal 2010 we have funded our operations primarily through cash generated from operations. At July 31, 2014, our cash and cash equivalents of $645.4 million were held for working capital purposes, a majority of which was invested in money market funds. We intend to increase our capital expenditures for the remainder of fiscal 2015, consistent with the growth in our business and operations. We believe that our existing cash and cash equivalents will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors including our growth rate, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced software and services offerings, the continuing market acceptance of our products and our planned investments, particularly in our product development efforts or acquisitions of complementary businesses, applications or technologies. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us if at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition could be adversely affected. Operating Activities In the six months ended July 31, 2014, cash inflows from our operating activities were $28.2 million, which reflects our net loss of $111.5 million, adjusted by non-cash charges of $107.0 million, consisting primarily of $102.7 million for stock-based compensation, $5.5 million for depreciation and amortization, partially offset by $0.5 million for deferred income taxes and $0.9 million for excess tax benefits from employee stock plans. Sources of cash inflows were from changes in our working capital, including a $14.7 million increase in deferred revenue, a $13.5 million decrease in accounts receivable due to strong collections, a $9.3 million increase in accrued expenses and other liabilities, $1.5 million decrease in prepaid expense and other current and non-current assets and $0.4 million increase in accounts payable. These cash inflows were offset by a $6.7 million decrease in accrued payroll and compensation. In the six months ended July 31, 2013, cash inflows from our operating activities were $26.1 million, which reflects our net loss of $29.8 million, adjusted by non-cash charges of $24.3 million, consisting primarily of $21.8 million for stock-based compensation and $2.9 million for depreciation and amortization. Sources of cash inflows were from changes in our working capital, including a $23.2 million decrease in accounts receivable due primarily to the collection of a $20.0 million order booked in the fourth quarter of fiscal 2013, a $12.9 million increase in deferred revenue and a $5.4 million increase in 26-------------------------------------------------------------------------------- Table of Contents accrued expenses and other liabilities. These cash inflows were partially offset by a $6.2 million decrease in accrued payroll and compensation and a $3.5 million increase in prepaid expense and other current and non-current assets. Investing Activities In the six months ended July 31, 2014, cash used in investing activities of $298.6 million was primarily attributable to $304.0 million of investments in U.S. treasury securities, $7.1 million of capital expenditures for the purchase of technology and hardware as well as purchases related to our facilities and infrastructure and $2.5 million which was used for a technology asset acquisition. These cash outflows were partially offset by $15.0 million cash inflow due to the maturities of our investments. In the six months ended July 31, 2013, cash used in investing activities included $3.2 million of capital expenditures for technology and hardware to support the growth of our business. Financing Activities In the six months ended July 31, 2014, cash provided by financing activities of $18.1 million consisted primarily of $9.4 million of proceeds from the exercise of stock options, $8.4 million of proceeds from our employee stock purchase plan and $0.9 million of proceeds from excess tax benefits from employee stock plans, partially offset by a $0.5 million lease deposit payment which, for accounting purposes only, is treated as a payment related to a build-to-suit lease obligation. In the six months ended July 31, 2013, cash provided by financing activities of $18.4 million consisted primarily of $12.5 million of proceeds from the exercise of stock options and $6.1 million of proceeds from our employee stock purchase plan. Additionally, we paid $0.5 million of taxes related to the net settlement of RSUs. Loan and Security Agreement On May 9, 2013 we entered into a Loan Agreement with Silicon Valley Bank. The agreement provides for a revolving line of credit facility, which expires May 9, 2015. Under the agreement, we are able to borrow up to $25 million. Interest on any drawdown under the revolving line of credit accrues either at the prime rate (3.25% in July 2014) or the LIBOR rate plus 2.75%. As of July 31, 2014, we had no balance outstanding under this agreement. The agreement includes restrictive covenants, in each case subject to certain exceptions that limit our ability to: • sell or otherwise dispose of our business or property; • change our business, liquidate or dissolve or undergo a change in control; • enter into mergers, consolidations and acquisitions; • incur indebtedness; • create liens; • pay dividends or make distributions; • make investments; • enter into material transactions with affiliates; • pay any subordinated debt or amend certain terms thereof; or • become an investment company. In addition, the agreement contains customary financial covenants and other affirmative and negative covenants. We were in compliance with all covenants as of July 31, 2014. Contractual Payment Obligations 27-------------------------------------------------------------------------------- Table of Contents We lease our office spaces under non-cancelable leases with rent expense recognized on a straight-line basis over the lease term. Rent expense was $2.7 million and $1.2 million for the three months ended July 31, 2014 and 2013, respectively, and $4.9 million and $2.4 million for the six months ended July 31, 2014 and 2013, respectively. On April 29, 2014, we entered into an office lease (the "Lease") for approximately 182,000 square feet located at 270 Brannan Street, San Francisco, California (the "Premises"). The Premises will be allocated to approximately 95,000 square feet of rentable space (the "Initial Premises") which we expect to occupy in January 2016 and approximately 87,000 square feet of rentable space (the "Must-Take Premises") which we expect to occupy one year thereafter, for a term of 84 months, subject to the completion of certain pre-occupancy improvements by our landlord. Our total obligation for the base rent is approximately $92.0 million. On May 13, 2014, we entered into an irrevocable, standby letter of credit with Silicon Valley Bank for $6.0 million to serve as a security deposit for our office lease with 270 Brannan Street, LLC, San Francisco, California. As a result of our involvement during the construction period, we are considered, for accounting purposes only, the owner of the construction project under build-to-suit lease accounting. We recorded estimated project construction costs incurred by the landlord as an asset and a corresponding long term liability in "Property and equipment, net" and "Other liabilities, non-current" respectively, on our condensed consolidated balance sheets. We will increase the asset and corresponding long term liability as additional building costs are incurred by the landlord during the construction period. Once the landlord completes the construction of the Initial Premises, which is estimated to be in January 2016, we will evaluate the Lease in order to determine whether or not the Lease meets the criteria for "sale-leaseback" treatment. The following summarizes our contractual commitments and obligations as of July 31, 2014: Payments Due by Period* Less Than 1 More Than 5 Total year 1-3 years 3-5 years years (in thousands) Office lease obligations $ 150,785 $ 9,379 $ 33,664 $ 43,133 $ 64,609 _________________________ *We entered into a sublease agreement on November 16, 2012 for a portion of our office space in the United Kingdom, and the future sublease rental income of $1.0 million has been included as an offset to our future minimum rental payments. Off-Balance Sheet Arrangements During the three months and six months ended July 31, 2014 and 2013, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities, that have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Indemnification Arrangements During the ordinary course of business, we may indemnify, hold harmless and agree to reimburse for losses suffered or incurred, our customers, channel partners, vendors and each of their affiliates for certain intellectual property infringement and other claims by third parties with respect to our products and services, in connection with our commercial license arrangements or related to general business dealings with those parties. As permitted under Delaware law, we have entered into indemnification agreements with our officers, directors and certain employees, indemnifying them for certain events or occurrences while they serve as our officers or directors. To date, there have not been any costs incurred in connection with such indemnification obligations; therefore, there is no accrual of any amounts at July 31, 2014. We are unable to estimate the maximum potential impact of these indemnifications on our future results of operations. Critical Accounting Policies and Estimates We prepare our condensed consolidated financial statements in accordance with U.S. GAAP. The preparation of condensed consolidated financial statements also requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could 28-------------------------------------------------------------------------------- Table of Contents differ significantly from the estimates made by our management. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. There have been no material changes to our critical accounting policies and estimates as compared to the critical accounting policies and estimates described in our Annual Report on Form 10-K, filed with the SEC on March 31, 2014. |