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EMULEX CORP /DE/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Executive Overview Emulex is a leader in network connectivity, monitoring and management solutions for global networks that support enterprise, cloud, government and telecommunications. During fiscal 2013, Emulex acquired 100% of the outstanding common stock of Endace Limited (Endace), a leading supplier of network visibility infrastructure products. Prior to the acquisition of Endace, Emulex operated within a single business segment. With the acquisition of Endace, Emulex formed the Visibility operating segment, which includes Network Visibility Products. Emulex's products enable end-to-end application visibility, optimization and acceleration in the data center. The Company's Input/Output (I/O) connectivity products, including its line of ultra high-performance Ethernet and Fibre Channel-based connectivity products, have been designed into server and storage solutions from leading original equipment manufacturers (OEMs), including Cisco Systems, Inc. (Cisco), Dell Inc. (Dell), EMC Corporation (EMC), Fujitsu Ltd. (Fujitsu), Hewlett-Packard Company (Hewlett-Packard), Hitachi Data Systems (HDS), Huawei Technologies Company Ltd. (Huawei), International Business Machines Corporation (IBM), Network Appliance, Inc. (NetApp) and Oracle Corporation (Oracle), and can be found in the data centers of nearly all of the Fortune 1000. Emulex's monitoring and management solutions, including its portfolio of network visibility and recording products, provide organizations with complete network performance management at speeds up to 100Gb Ethernet (100GbE). We rely on OEMs and sales through distribution channels for the majority of our revenue. Our significant OEM customers include the world's leading server and storage providers, including Cisco, Dell, EMC, Fujitsu, Hewlett-Packard, HDS, Hitachi Limited (Hitachi), Huawei, Intel Corporation (Intel), IBM, Lenovo, Micron Technology, Inc. (Micron), NEC Corporation (NEC), NetApp, Oracle, and Unisys Corporation (Unisys). Our significant distributors include ASI Computer Technologies, Inc. (ASI), Avnet, Inc. (Avnet), Digital China Technology Limited, Info X Distribution, LLC (Info X), Ingram Micro Inc. (Ingram Micro), SYNNEX Corporation (SYNNEX), and Tech Data Corporation (Tech Data). The market for networking infrastructure solutions is concentrated among large OEMs, and as such, a significant portion of our revenues are generated from sales to a limited number of customers. Our corporate headquarters are located at 3333 Susan Street, Costa Mesa, California 92626. Our periodic and current reports filed with, or furnished to, the Securities and Exchange Commission pursuant to the requirements of the Securities and Exchange Act of 1934 are available free of charge through our website (www.emulex.com) as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission. The information on our website is not incorporated in this quarterly report on Form 10-Q. References contained herein to "Emulex," the "Company," the "Registrant," "we," "our," and "us" refer to Emulex Corporation and its subsidiaries. Business Operating Segments With our acquisition of Endace, our network connectivity, monitoring and management solutions are now broken into two business operating segments consisting of three product lines. Beginning with the first quarter of fiscal 2014, our Connectivity Segment (formerly referred to as the Networking segment), which consists of legacy Emulex products, includes two product lines - Network Connectivity Products (NCP) and Storage Connectivity and Other Products (SCOP). We believe that this new product line reporting is more consistent with how third party analysts view our addressable networking segment markets, and will provide a more transparent view of our business. Our Visibility Segment consists of Network Visibility Products (NVP) acquired through the Endace acquisition. Connectivity Segment Products: NCP includes industry standard Fibre Channel and Ethernet-based solutions that provide server I/O and target storage array connectivity to create networks for mission-critical enterprise and cloud data centers. These products enable servers to reliably and efficiently connect to Local Area Networks (LANs), Storage Area Networks (SANs), and Network Attached Storage (NAS) by offloading data communication processing tasks from the server as information is delivered and sent to the network. Our NCP use industry standard protocols including Fibre Channel Protocol (FCP), Internet Protocol (IP), Transmission Control Protocol (TCP)/IP, internet Small Computer System Interface (iSCSI), Fibre Channel over Ethernet (FCoE), overlay networking standards including Network Virtualization using Generic Routing Encapsulation (NVGRE) and Virtual Extensible Local Area Network (VXLAN) and Remote Direct Memory Access (RDMA) over Converged Ethernet (RoCE). RoCE bring many of the same low-latency capabilities typically associated with InfiniBand (IB) to Ethernet networks. NVGRE and VXLAN support overlay networks, which is a computer network which is built on the top of another network. Our Ethernet-based products include OneConnect® Ethernet Adapters and Converged Network Adapters (CNAs) and Local Area Network (LAN) on Motherboard (LOM) application specific integrated circuits, and custom form factor solutions for OEM blade servers. These Ethernet-based products enable higher virtual machine (VM) densities, secure hybrid clouds with Virtual Network Fabrics, leverage a RoCE-based low latency architecture to deliver application acceleration, and provide an 18-------------------------------------------------------------------------------- Table of Contents open application performance interface (API) that integrates with next generation software-defined networking (SDN) solutions. Our Fibre Channel-based products include LightPulse® Host Bus Adapters (HBAs), Fibre Channel application specific integrated circuits (ASICs) and custom form factor solutions for OEM blade servers. SCOP includes Emulex InSpeed®, switch-on-a-chip (SOC) and backend connectivity, bridge and router products, Pilot™ Integrated Baseboard Management Controllers (iBMCs), certain legacy products and other products and services. Many of these products are deployed inside storage arrays, tape libraries, and other storage appliances, connecting storage controllers to storage capacity, delivering improved performance, reliability, and connectivity. Such products use industry standard protocols including Fibre Channel, Serial Attached Small Computer Interface (SAS), and Serial Advanced Technology Attachment (SATA), and support the broadest range of Hard Disk Drive (HDD) and Solid State Disk (SSD) technologies. Our iBMC solutions revolutionized the industry for enterprise servers by integrating the BMC, super I/O, graphics controller and Remote Keyboard, Video, Mouse and Storage (KVMS) functionality into a single ASIC, providing significant cost savings to data center managers. Like a standard BMC, when embedded in a server system or appliance, the iBMC simplifies the management of the remote server systems and appliances, whether physical or virtual servers, thereby reducing operational costs. Visibility Segment Products: NVP consists entirely of the recently acquired Endace® family of network visibility products that address Networking Recording Market (NRM) for high speed networks. The EndaceProbe™ Intelligent Network Recorder (INR) captures, indexes and stores network traffic history in order to help organizations troubleshoot problems and respond to network security breaches. EndaceVision™ Network Visibility Software is a browser-based network traffic search engine that provides users with a unique 'window' into high speed networks. Through EndaceVision, users can search and receive packets of interest from anywhere across a globally distributed network of Endace systems through a single, browser-based user interface. The EndaceODE™ Open Application Platform is designed specifically to host packet-processing applications in managed data center environments. These flexible and scalable systems are used extensively by organizations that demand the very highest levels of packet capture accuracy and processing performance of their hosting platforms. EndaceAccess™ Network Visibility Head-End systems give organizations access to 40GbE and 100GbE network segments that they need to measure, monitor and protect their networks with industry standard 10Gb per second capable monitoring and security tools. EndaceFlow™ NetFlow Generator Appliances are designed to specifically offload the work from network elements and deliver 100% accurate NetFlow in the right format to the tools that need to consume it. Underpinning all of the Endace family of network visibility and recording products are the EndaceDAG™ Data Capture Cards that are integrated into the EndaceProbe INR appliances and sold as stand-alone components for use in a wide range of monitoring and security systems. For additional information about our operating segments, please see Note 13 in the accompanying notes to condensed consolidated financial statements under the caption "Operating Segment Information" in Part I, Item 1 of this Form 10-Q. Product Redesign Activities and Potential Royalty Obligations During fiscal 2010, Broadcom Corporation (Broadcom) filed a patent infringement lawsuit containing 300 claims against us alleging infringement of eleven patents. On April 3, 2012, United States District Court in the Central District of California (District Court) issued a permanent injunction (2012 Permanent Injunction) against further sale of products found to infringe U.S. Patent 7,058,150 (the '150 patent) and 7,471,691 (the '691 patent), but permitting sales of products manufactured outside the U.S. to customers located outside the U.S., design around efforts including modifications and design, development, and testing to eliminate infringement, and service and technical support for certain products. This injunction remains in place but the effects have been mitigated in a number of ways. First, with product redesigns. Second, with license agreements from Broadcom to our customers whose products were affected by the injunction. Third, Broadcom and Emulex entered into a settlement agreement on July 3, 2012 which provided us with a worldwide limited license to the '691 patent, the '150 patent, and U.S. Patents 6,424,194; 7,486,124 and 7,724,057 [collectively, the '194 Patent family], for certain fields of use including Fibre Channel applications. Through September 28, 2014, we incurred approximately $21.9 million in mitigation, product redesign and appeal related expenses of which approximately $0.2 million and $2.5 million were recorded during the three months ended September 28, 2014 and September 29, 2013, respectively. We expect to incur incremental mitigation and appeal related expenses up to approximately $0.3 million, to be recorded within operating expenses, and expect the majority of such expenses to be incurred in fiscal 2015. In addition, we have agreed to participate in certain customer royalty obligations arising under their licensing agreements with Broadcom related to certain Emulex infringing products. Through September 28, 2014, Emulex has recorded approximately $5.2 million in cost of sales related to such customer obligations, of which approximately $0.8 million and $0.5 million were recorded in cost of sales for the three months ended September 28, 2014 and September 29, 2013, respectively. We may incur additional amounts related to these obligations of approximately $5 million in future periods, all of which will reduce gross margins in the periods accrued. 19-------------------------------------------------------------------------------- Table of Contents Effective March 30, 2014, Emulex and Broadcom entered into a Dismissal and Standstill Agreement (the "Dismissal Agreement") pursuant to which Emulex and Broadcom entered into certain understandings with respect to the outstanding claims relating to arising out of the patent infringement suit. Pursuant to the terms of the Dismissal Agreement, we agreed to pay Broadcom a non-refundable, non-cancelable dismissal and standstill fee in the amount of $5 million, of which approximately $3.8 million was included in Accrued and Other Current Liabilities as of September 28, 2014. While we have contractual commitments from our suppliers concerning the defense and indemnification of certain Broadcom claims relating to certain technology provided by such suppliers, and is pursuing certain claims for reimbursement against certain of our suppliers, it cannot be certain that such defense and indemnification obligations will be honored by such suppliers or that any related legal proceedings will result in any material reimbursement to us. This lawsuit continues to present risks with respect to U.S. sales of certain Ethernet products that could have a material adverse affect on our business, financial condition, or results of operations, including loss of patent rights, monetary damages, potential reimbursement of customer indemnification liabilities or royalty obligations, and injunction against the sale of accused products. See Note 7 in the accompanying notes to condensed consolidated financial statements under the caption "Litigation" in Part I, Item 1 of this Form 10-Q. Results of Operations The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements included elsewhere herein. Percentage of Net Revenues Three Months Ended September 28, 2014 September 29, 2013 Net revenues 100 % 100 % Cost of sales: Cost of goods sold 35 % 35 % Amortization of core and developed technology intangible assets 6 % 5 % Patent litigation settlement, damages and royalties 2 % 1 % Total cost of sales 43 % 41 % Gross profit 57 % 59 % Operating expenses: Engineering and development 32 % 35 % Selling and marketing 16 % 17 % General and administrative 7 % 9 % Amortization of other intangible assets 1 % 1 % Total operating expenses 56 % 62 % Operating income (loss) 1 % (3 )% Non-operating (expense) income, net: Interest income - % - % Interest expense (3 )% - % Other (expense) income, net - % - % Total non-operating (expense) income, net (3 )% - % Loss before income taxes (2 )% (3 )% Income tax (benefit) provision (1 )% - % Net loss (1 )% (3 )% Three months ended September 28, 2014, compared to three months ended September 29, 2013 Net Revenues. Net revenues for the three months ended September 28, 2014, decreased by approximately $11.0 million, or 10%, to approximately $103.8 million, compared to approximately $114.8 million for the three months ended September 29, 2013. 20-------------------------------------------------------------------------------- Table of Contents Net Revenues by Operating Segment and Product LineNet revenues by operating segment and product line were as follows: Net Revenues by Operating Segment and Product Line Three Months Three Months Ended Ended September 28, Percentage of September 29, Percentage of Increase/ Percentage 2014 Net Revenues 2013 Net Revenues (Decrease) Change Connectivity Segment: Network Connectivity Products $ 75,800 73 % $ 77,980 68 % $ (2,180 ) (3 )% Storage Connectivity and Other Products 22,135 21 % 26,755 23 % (4,620 ) (17 )% Total Connectivity Segment 97,935 94 % 104,735 91 % (6,800 ) (6 )% Visibility Segment: Network Visibility Products 5,874 6 % 10,097 9 % (4,223 ) (42 )% Total Net Revenues $ 103,809 100 % $ 114,832 100 % $ (11,023 ) (10 )% Connectivity segment revenues decreased by approximately 6% for the three months ended September 28, 2014 compared to the three months ended September 29, 2013, primarily due to continuing weakness in the UNIX server and high-end storage markets. Fibre Channel based products account for the majority, ranging from 70% - 80%, of our NCP revenues. For the three months ended September 28, 2014, Fibre Channel based product revenue decreased by approximately 4% reflecting a decrease in units shipped of approximately 5% and an increase in average selling price of approximately 1%. The Ethernet based product revenues were consistent with the three months ended September 29, 2013. SCOP revenues for the three months ended September 28, 2014 decreased by approximately $4.6 million, or 17%, compared to the three months ended September 29, 2013. The decrease was primarily due to a decrease in revenue from bridging products of approximately 27%. The Visibility segment consists of NVP and resulted from our acquisition of Endace on February 26, 2013. NVP revenues decreased by approximately $4.2 million, or 42% due to lower sales in the United States and Europe, Middle East and Africa. Net Revenues by Major Customers In addition to direct sales, some of our larger OEM customers purchase or market products indirectly through distributors, resellers or other third parties. If these indirect sales are purchases of customer-specific models, we are able to track these sales. However, if these indirect sales are purchases of our standard models, we are not able to distinguish them by OEM customer. Customers whose direct net revenues, or total direct and indirect net revenues (including customer-specific models purchased or marketed indirectly through distributors, resellers and other third parties), exceeded 10% of our net revenues were as follows: Net Revenues by Major Customers Direct Revenues Total Direct and Indirect Revenues (2) Three Months Ended Three Months Ended September 29, Three Months Ended Three Months Ended September 28, 2014 2013 September 28, 2014 September 29, 2013 Net revenue percentage (1) OEM: EMC - - - 11 % Hewlett-Packard 15 % 17 % 25 % 23 % Hon Hai Precision Industry Co., Ltd. (Foxconn Technology Group) (3) 16 % 14 % - - IBM 25 % 28 % 29 % 32 % (1) Amounts less than 10% are not presented. 21-------------------------------------------------------------------------------- Table of Contents (2) Customer-specific models purchased or marketed indirectly through distributors, resellers, and other third parties are included with the OEM's revenues in these columns rather than as revenue for the distributors, resellers or other third parties. (3) Hon Hai Precision Industry Co., Ltd. is a contract manufacturer that performed manufacturing for some of our OEM customers. Direct sales to our top five customers accounted for approximately 64% of total net revenues for the three months ended September 28, 2014 compared to 67% for the three months ended September 29, 2013. Direct and indirect sales to our top five customers accounted for approximately 75% of total net revenues for the three months ended September 28, 2014, compared to approximately 79% for the three months ended September 29, 2013. Our net revenues from customers can be significantly impacted by changes to our customers' business and their business models. Net Revenues by Sales ChannelNet revenues by sales channel were as follows: Net Revenues by Sales Channel Three Months Three Months Ended Ended September 28, Percentage of September 29, Percentage of Increase/ Percentage (in thousands) 2014 Net Revenues 2013 Net Revenues (Decrease) Change OEM $ 85,785 83 % $ 97,524 85 % $ (11,739 ) (12 )% Distribution 14,555 14 % 11,518 10 % $ 3,037 26 % End-user and Other 3,469 3 % 5,790 5 % $ (2,321 ) (40 )% Total net revenues $ 103,809 100 % $ 114,832 100 % $ (11,023 ) (10 )% The decrease in OEM net revenues for the three months ended September 28, 2014 compared to the three months ended September 29, 2013 reflected a decrease of approximately 10% in NCP revenues and a decrease of approximately 17% in SCOP revenues. The increase in distribution revenues for the three months ended September 28, 2014 compared to the three months ended September 29, 2013 was primarily due to an increase of approximately 69% in NCP revenues generated through distributors. The decrease in end user and other revenues for the three months ended September 28, 2014 compared to the three months ended September 29, 2013 was primarily due to a decrease of approximately 41% in NVP revenues. We believe that the majority of our net revenues are driven by product certifications and qualifications with our OEM customers, which take products directly and indirectly through distribution and contract manufacturers. Although we view product certifications and qualifications as an important indicator of future revenue opportunities and growth for the Company, they do not necessarily ensure continued market acceptance of our products by our OEM customers. It is also very difficult to determine the future impact, if any, of product certifications and qualifications on our revenues. Net Revenues by Geographic Territory Our net revenues by geographic territory based on billed-to location were as follows: Net Revenues by Geographic Territory Three Months Three Months Ended Ended September 28, Percentage of September 29, Percentage of Percentage (in thousands) 2014 Net Revenues 2013 Net Revenues Increase/(Decrease) Change Asia Pacific $ 66,726 64 % $ 67,384 59 % $ (658 ) (1 )% United States 21,694 21 % 28,746 25 % (7,052 ) (25 )% Europe, Middle East, and Africa 13,355 13 % 17,860 15 % (4,505 ) (25 )% Rest of the world 2,034 2 % 842 1 % 1,192 NM Total net revenues $ 103,809 100 % $ 114,832 100 % $ (11,023 ) (10 )% The decrease in net revenues in United States was due to a decrease of approximately 21% in NCP revenue and 38% in NVP revenues. The decrease in net revenues in Europe, Middle East, and Africa was due to a decrease of approximately 68% in NVP revenue and 35% in SCOP revenues. Asia Pacific net revenues for the three months ended September 28, 2014 slightly decreased compared to the three months ended September 29, 2013; however, Asia Pacific net revenues as a percentage of total revenues increased from the prior year quarter. We expect Asia Pacific net revenues as a percentage of total revenues to increase as our OEM customers continue to migrate towards using contract manufacturers that are predominately located in 22-------------------------------------------------------------------------------- Table of Contents Asia Pacific. However, since we sell to OEMs and distributors who ultimately resell our products to their customers, the geographic mix of our net revenues may not be reflective of the geographic mix of end-user demand or installations. Gross Profit. Gross profit consists of net revenues less cost of sales. Our gross profit by segment was as follows (in thousands): Gross Profit Three Months Three Months Ended Ended September 28, September 29, 2014 Gross Profit Margin 2013 Gross Profit Margin Increase/(Decrease) Percentage Change Connectivity $ 56,353 58 % $ 61,995 59 % $ (5,642 ) (1 )% Visibility 2,761 47 % 5,489 54 % (2,728 ) (7 )% Total Gross Profit $ 59,114 57 % $ 67,484 59 % $ (8,370 ) (2 )% Cost of sales includes the costs of producing, supporting, and managing our supply of finished products. Approximately $0.1 million of share-based compensation expense was included in both the three months ended September 28, 2014 and September 29, 2013. Approximately $6.4 million and $6.2 million of amortization of technology intangible assets was included in cost of sales for the three months ended September 28, 2014 and September 29, 2013, respectively. Our gross margin percentage decreased to 57% for the three months ended September 28, 2014 from 59% for the three months ended September 29, 2013 due to product mix and an increase in royalty expense of approximately $0.3 million related to the amended 2012 Permanent Injunction. We expect our gross margin percentage to trend downward as the portion of our revenues generated from lower margin products increases in the future, and to the extent we commit to make additional reimbursements to customers for payments made under any licensing agreement with Broadcom. Engineering and Development. Engineering and development expenses consist primarily of salaries and related expenses for personnel engaged in the design, development and support of our products. These expenses also include third-party fees paid to consultants, prototype development expenses, and computer service costs related to supporting computer tools used in the design process. Engineering and development expenses were as follows (in thousands): Engineering and Development Three Months Ended Percentage of Net Three Months Ended Percentage of Net September 28, 2014 Revenues September 29, 2013 Revenues Increase/(Decrease) Percentage Change $ 33,640 32 % $ 40,411 35 % $ (6,771 ) (3 )% Engineering and development expenses decreased by approximately $6.8 million, or 17%, for the three months ended September 28, 2014 compared to the three months ended September 29, 2013. Approximately $1.6 million and $1.9 million of share-based compensation expense was included in engineering and development costs for the three months ended September 28, 2014 and September 29, 2013, respectively. Salary and related expenses decreased by approximately $4.2 million due to a reduction in engineering and development headcount. In addition, new product development expense decreased by approximately $2.0 million compared to the prior year quarter primarily related to our mitigation activities for the 2012 Permanent Injunction. Selling and Marketing. Selling and marketing expenses consist primarily of salaries, commissions, and related expenses for personnel engaged in the marketing and sales of our products, as well as samples, trade shows, product literature, promotional support costs, and other advertising related costs. Sales and marketing expenses were as follows (in thousands): Selling and Marketing Three Months Ended Percentage of Net Three Months Ended Percentage of Net September 28, 2014 Revenues September 29, 2013 Revenues Increase/(Decrease) Percentage Change $ 16,652 16 % $ 19,092 17 % $ (2,440 ) (1 )% Selling and marketing expenses decreased by approximately $2.4 million, or 13%, for the three months ended September 28, 2014 compared to the three months ended September 29, 2013. Approximately $1.1 million and $1.2 million of share-based compensation expense was included in selling and marketing costs for the three months ended September 28, 2014 and September 29, 2013, respectively. The decrease in selling and marketing expenses was primarily due to a decrease in salary and related expenses of approximately $1.4 million due to reduction in headcount and a decrease in variable compensation of approximately $0.9 million related to sales commissions. 23-------------------------------------------------------------------------------- Table of Contents General and Administrative. Ongoing general and administrative expenses consist primarily of salaries and related expenses for executives, financial accounting support, human resources, administrative services, professional fees, and other corporate expenses. General and administrative expenses were as follows (in thousands): General and Administrative Three Months Ended Percentage of Net Three Months Ended Percentage of Net September 28, 2014 Revenues September 29, 2013 Revenues Increase/(Decrease) Percentage Change $ 7,089 7 % $ 9,629 9 % $ (2,540 ) (2 )% General and administrative expenses decreased by approximately $2.5 million, or 26%, for the three months ended September 28, 2014 compared to the three months ended September 29, 2013. Approximately $0.7 million and $1.4 million of share-based compensation expense was included in general and administrative costs for the three months ended September 28, 2014 and September 29, 2013, respectively. Salary and related expenses and performance-based compensation decreased by approximately $1.6 million due to a reduction in headcount. Amortization of Other Intangible Assets. Amortization of other intangible assets consists of amortization of intangible assets such as patents, customer relationships, and tradenames with estimable lives. Amortization expense was as follows (in thousands): Amortization of intangible assets Three Months Ended Percentage of Net Three Months Ended Percentage of Net September 28, 2014 Revenues September 29, 2013 Revenues Increase/(Decrease) Percentage Change $ 600 1 % $ 1,604 1 % $ (1,004 ) - % Amortization of other intangible assets for the three months ended September 28, 2014 decreased approximately $1.0 million compared to the three months ended September 29, 2013 due to a lower unamortized intangible assets balance at the beginning of the current three month period as a result of certain intangible assets being fully amortized in fiscal 2014. Non-operating (Expense) Income, net. Non-operating (expense) income, net, consists primarily of interest income, interest expense, and other non-operating income and expense items. Our non-operating (expense) income, net, was as follows (in thousands): Non-Operating (Expense) Income, net Three Months Ended Percentage of Net Three Months Ended Percentage of Net September 28, 2014 Revenues September 29, 2013 Revenues (Increase)/Decrease Percentage Change $ (2,751 ) (3 )% $ 154 - % $ (2,905 ) (3 )% Our non-operating expense, net increased by approximately $2.9 million for the three months ended September 28, 2014 compared to the three months ended September 29, 2013. The net increase was primarily due to interest expense and amortization of issuance costs and debt discount of approximately $2.4 million in the three months ended September 28, 2014 related to the Convertible Senior Notes issued in November 2013 (see Note 8 "Convertible Senior Notes" to the Notes to Condensed Consolidated Financial Statements). Income Tax (Benefit) Provision. Income tax (benefit) provision was as follows (in thousands): Income Tax (Benefit) Provision Three Months Ended Percentage of Net Three Months Ended Percentage of Net September 28, 2014 Revenues September 29, 2013 Revenues Increase/(Decrease) Percentage Change $ (899 ) (1 )% $ 543 - % $ (1,442 ) (1 )% Income tax benefit for the three months ended September 28, 2014 was approximately $0.9 million, for an effective rate of 56% compared to income tax expense of approximately $0.5 million, for an effective tax rate of 18%. We generate the majority of our taxable earnings in countries other than the U.S., so our tax expense and effective tax rates reflect the mix of our earnings and losses in the U.S. and various international jurisdictions, including India, Ireland, Isle of Man and New Zealand, as well as our valuation allowance recorded against our U.S. deferred tax assets. The change in our effective tax rate between years was primarily driven by a tax benefit of approximately $1.7 million related to taxable unrealized currency exchange loss resulting from outstanding inter-company loans. We may recognize taxable income/loss on the unrealized foreign exchange gains/losses on our intercompany loans for tax reporting purposes in the future. We have made no provision for U.S. income taxes or foreign withholding taxes on the earnings of our foreign subsidiaries as these amounts are intended to be 24-------------------------------------------------------------------------------- Table of Contents indefinitely reinvested in operations outside the U.S. We also do not forecast discrete events, such as a settlement of tax audits with governmental authorities or changes in tax laws, due to their inherent uncertainty. Critical Accounting Policies The preparation of our consolidated financial statements in accordance with accounting principles generally accepted in the United States requires estimation and judgment that affect the reported amounts of net revenues, expenses, assets and liabilities. We regularly evaluate our estimates and assumptions related to our critical accounting policies including inventory reserves, goodwill and purchased intangible asset valuations, uncertain tax positions, litigation and other loss contingencies. We base our estimates and assumptions on current facts, historical experience and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenue, costs and expenses that are not readily apparent from other sources. Changes in judgments and uncertainties relating to these estimates could potentially result in materially different results under different assumptions and conditions. If these estimates differ significantly from actual results, our consolidated financial statements and future results of operations may be materially impacted. Specific to our goodwill and intangible asset valuations policy, the annual impairment test is performed during the fourth fiscal quarter. Given the recent volatility of our market capitalization, the inherent uncertainty in forecast and identification of triggering events, and the fact that the fair value of our reporting units did not exceed their carrying value by a substantial margin during the annual impairment test during the fourth fiscal quarter, it is possible that our goodwill could become impaired in the near term which could result in a material charge. For a description of our critical accounting policies, please refer to "Critical Accounting Policies" in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our fiscal 2014 Form 10-K. There have been no material changes in any of our critical accounting policies during the three months ended September 28, 2014. Recently Adopted and Recently Issued Accounting Standards See Note 1 in the accompanying notes to condensed consolidated financial statements included in Part I, Item 1 of this Form 10-Q for a description of the recently issued accounting standards. Liquidity and Capital Resources Our principal sources of liquidity consist of our existing cash and cash equivalents balances, as well as funds expected to be generated from operations. At September 28, 2014, we had approximately $224.5 million in working capital and approximately $174.1 million in cash and cash equivalents as compared to approximately $213.6 million in working capital and approximately $158.4 million in cash and cash equivalents at June 29, 2014. Our cash and cash equivalents balances are held in numerous locations throughout the world. As of September 28, 2014, our international subsidiaries held approximately 20% of our total cash and cash equivalents, which will be used to repay obligations to U.S. affiliate entities that arise in the normal course of business and would not result in incremental U.S. tax liabilities when paid. Cash Flow The following table summarizes our cash flows: Three Months Ended September 28, 2014 September 29, 2013 (in thousands) Net cash provided by (used in) provided by: Operating activities $ 20,846 $ 4,969 Investing activities (4,090 ) (4,533 ) Financing activities (719 ) (1,239 ) Effect of foreign currency translation on cash and cash equivalents (336 ) 57 Increase (decrease) in cash and cash equivalents $ 15,701 $ (746 ) Operating Activities Cash provided by operating activities was approximately $20.8 million during the three months ended September 28, 2014 compared to approximately $5.0 million during the three months ended September 29, 2013. The current period cash provided by operating activities resulted from net loss of approximately $0.7 million, non-cash adjustments for amortization of 25-------------------------------------------------------------------------------- Table of Contents intangible assets of approximately $7.0 million, depreciation and amortization of approximately $4.6 million and share-based compensation expense of approximately $3.5 million, and the timing of net working capital requirements. Investing Activities Cash used in investing activities was approximately $4.1 million during the three months ended September 28, 2014 compared to approximately $4.5 million during the three months ended September 29, 2013. The current period usage of cash was related to purchases of property and equipment. We currently expect a similar level of investment in property and equipment in the future to support our strategic objectives, although the timing may be impacted by certain project timelines and other factors. Financing Activities Cash used in financing activities was approximately $0.7 million during the three months ended September 28, 2014 compared to approximately $1.2 million during the three months ended September 29, 2013. The usage of cash for the three months ended September 28, 2014 and September 29, 2013 was primarily due to payroll tax withholdings on behalf of employees for restricted stock of approximately $0.8 million and $1.5 million, respectively. Capital Resources and Prospective Needs In November 2013, we issued $175.0 million aggregate principal amount of 1.75% Convertible Senior Notes due November 2018 (Convertible Senior Notes). Interest is payable semi-annually in arrears on May 15 and November 15 of each year, commencing on May 15, 2014. The initial conversion rate is approximately 97.13 per share of our common stock per $1,000 principal amounts of the Convertible Senior Notes. The initial conversion price is approximately $10.30 per share of our common stock. See Note 8 in Part I, Item 1 on this Form 10-Q. We used a portion of the net proceeds from the offering to repurchase approximately $150.0 million of our common stock at a price per share equal to $6.68 during fiscal 2014. We intend to use the remaining net proceeds from the offering for additional share repurchases. In November 2013, our Board of Directors approved a $200.0 million share repurchase program. At September 28, 2014, we have the authority to repurchase an additional approximately $50.0 million pursuant to this authorization. In November 2013, we announced a cost savings program designed to streamline business operations and achieve operating expense reductions. We plan to continue our cost savings program, which includes simplifying our product portfolio, discontinuing additional programs with lower returns on investment, pursuing consolidation opportunities and identifying further efficiencies which will accordingly impact our strategic investment in research and development, sales and marketing, capital equipment, and facilities. We may also consider internal and external investment opportunities in order to achieve our growth and market leadership goals, including licensing and product development alignment agreements with our suppliers, customers, and other third parties. We believe that our existing cash and cash equivalents, and anticipated cash flows from operating activities will be sufficient to support our working capital needs, capital expenditure requirements and stock repurchases for at least the next 12 months and the foreseeable future based on currently forecasted trends. We may need to pursue additional financing if our business does not generate sufficient cash flow from operations to enable us to pay the principal amount of our Convertible Senior Notes or to fund other liquidity needs. We have disclosed outstanding legal proceedings in Note 7 in the accompanying notes to condensed consolidated financial statements included in Part I, Item 1 of this Form 10-Q, including the consolidated patent infringement lawsuit filed by Broadcom against us. On July 3, 2012, we entered into a Settlement Agreement pursuant to which both parties agreed to settle and release certain claims related to the patent infringement litigation. The Settlement Agreement provided for certain amendments to the April 3, 2012 Permanent Injunction, and dismissals of certain allegations of the lawsuit, including portions of the scheduled re-trial. We also received a worldwide limited license to the '691 patent, the '150 patent, the '194 patent and related families for certain fields of use including Fibre Channel applications. Effective March 30, 2014, Emulex and Broadcom entered into a Dismissal Agreement pursuant to which Emulex and Broadcom entered into certain understandings with respect to the outstanding claims relating to and arising out of the patent infringement suit. Pursuant to the terms of the Dismissal Agreement, we agreed to pay Broadcom a non-refundable, non-cancelable dismissal and standstill fee in the amount of $5 million, of which approximately $3.8 million was included in Accrued and Other Current Liabilities as of September 28, 2014. We expect to incur incremental mitigation and appeal related expenses up to $0.3 million to be recorded within operating expenses, and we expect the majority of such expenses to be incurred in fiscal 2015. In addition, we continue to evaluate certain customer royalty obligations arising under their licensing agreements with Broadcom that could result in additional costs of approximately $5 million in future periods. Such costs will reduce gross margins in the periods accrued. See "Product Redesign Activities and Potential Royalty Obligations" in Part I, Item 2 of this Form 10-Q. Off-Balance Sheet Arrangements 26-------------------------------------------------------------------------------- Table of Contents As part of our ongoing business, we do not participate in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As of September 28, 2014, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. Item 3. Quantitative and Qualitative Disclosures about Market Risk Interest Rate Risk We do not believe our cash equivalents are subject to significant interest rate risk due to their short terms to maturity. As of September 28, 2014, the carrying value of our cash equivalents approximated fair value. The Convertible Senior Notes issued in November 2013 have a fixed interest rate of 1.75%. Exchange Rate Risk Currently, the majority of our sales to customers and arrangements with third-party manufacturers provide for pricing and payment in U.S. dollars (USD), and, therefore, are not subject to exchange rate fluctuations. However, increases in the value of the USD relative to other currencies could make our products more expensive, which could negatively impact our ability to compete. Conversely, decreases in the value of the USD relative to other currencies could result in our suppliers raising their prices to continue doing business with us. In addition, we are also exposed to foreign exchange rate risk specific to our intercompany loans denominated in a currency other than the local tax reporting currency, which results in tax expense or benefit on the unrealized exchange gain or loss in the local jurisdiction. The potential effect on net loss as of September 28, 2014 resulting from a hypothetical 10% adverse change in currency exchange rates is approximately $1.5 million lower tax benefit. As a result, fluctuations in currency exchange rates have affected, and could continue to affect our business and results of operations. Item 4. Controls and Procedures Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of the end of the period covered by this Quarterly Report as a result of an unremediated material weakness related to the annual goodwill impairment test, as described in further detail below. As described in Item 9A in our Annual Report on Form 10-K for the fiscal year ended June 29, 2014, we identified a material weakness in our internal control over financial reporting related to the annual goodwill impairment test. Specifically, our controls were not designed effectively, as management's review controls over the third-party valuation analyses were not designed at a precise enough level to sufficiently address the reasonableness of: (i) certain assumptions estimated by management (ii) certain assumptions and calculations performed by the third-party valuation specialist and (iii) the allocation of net assets assigned to each reporting unit. As discussed in the Form 10-K, we are implementing a remediation plan to improve our internal control over financial reporting. This remediation plan for the annual goodwill impairment test includes: (i) more robust and critical review of internal assumptions and inputs, (ii) specific review procedures with defined precision levels over third-party valuation assumptions and calculations, and (iii) overall assessment of the valuation conclusions. The material weakness will not be considered remediated until our controls are operational for a period of time, tested, and management concludes that these controls are designed and operating effectively. Other than the discussion above, there have been no changes in our internal control over financial reporting during the quarter ended September 28, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 27-------------------------------------------------------------------------------- Table of Contents |