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RIVERBED TECHNOLOGY, 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 the condensed consolidated financial statements and related notes included elsewhere in this Form 10-Q. The information in this Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (Securities Act) and Section 21E of the Securities Exchange Act of 1934 (Exchange Act). Such forward-looking statements include statements related to: our business and strategy, trends affecting our business and financial results, international expansion plans, direct and indirect sales plans and strategies, growth of our revenue, costs and expenses (including sales and marketing expenses), gross margins, review of our strategic and financial alternatives, our restructuring plan, our share repurchase program, our acquisitions, the effect of fluctuations in exchange rates and our hedging activities on our financial results, our effective tax rate and our liquidity and capital requirements. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical facts may be deemed to be forward-looking statements. For example, words such as "may," "will," "could," "would," "should," "estimates," "predicts," "potential," "continue," "strategy," "believes," "anticipates," "plans," "expects," "intends" and similar expressions are intended to identify forward-looking statements. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those discussed elsewhere in this Form 10-Q in the section titled "Risk Factors" and the risks discussed in our other SEC filings. We disclaim any obligation to publicly release any revisions or updates to the forward-looking statements after the date of this Form 10-Q. Overview We were founded on May 23, 2002 and are a leader in application performance infrastructure. Riverbed enables organizations to embrace location-independent computing through the Riverbed Application Performance Platform, a set of integrated solutions that give companies the flexibility to host applications and data in the locations that best serve the business while ensuring the flawless delivery of those applications to better leverage global resources, radically reduce the cost of running their business, and maximize employee productivity. Riverbed's solutions dramatically improve application performance, reduce IT costs, and substantially increase business agility. We have two product lines: •Application Acceleration product line, which includes our wide area network (WAN) optimization products, including SteelHead and SteelFusion (formerly Granite), SteelApp (formerly Stingray) virtual application delivery controllers (ADCs); and SteelStore (formerly Whitewater) cloud storage delivery products (which were sold to NetApp, Inc. on October 27, 2014); and •Performance Management product line, which includes our SteelCentral performance management and control suite. The Performance Management product line combines our former Cascade products and the products acquired from OPNET Technologies, Inc. (OPNET). We are headquartered in San Francisco, California. Our personnel are located throughout the U.S. and in more than 35 countries worldwide. We expect to continue to add personnel in the U.S. and internationally to provide additional geographic sales, research and development, general and administrative and technical support coverage. The Riverbed Strategy Our goal is to develop solutions that are widely recognized as the preeminent performance and efficiency standard for organizations of all sizes and geographies. Key elements of our strategy include: • Enhance our customers' performance - Riverbed is the performance company. Our vision is to provide the most complete platform for location independent computing to ensure flawless application performance and the best user experience. This will allow customers to turn distance and location into competitive advantage by letting business objectives - not technical constraints - drive where and how applications and data are hosted and delivered for optimal business performance. Our vision focuses on the intersection of applications, networks, and storage, and brings customers a single, unified view of performance in their distributed environment. • Maintain and extend our technological advantages - We believe that we offer the broadest ability to enable rapid and reliable access to applications and data for our customers. We intend to enhance our position as a leader and innovator in the WAN optimization, branch converged infrastructure, application delivery controller and performance management markets. We also intend to continue to sell new capabilities, such as our solutions oriented toward cloud environments, into our installed base and to new customers. Continuing investments in research and development are critical to maintaining our technological advantage. 18 -------------------------------------------------------------------------------- Table of Contents • Transform from a single-product to platform company - We have introduced enhancements to our product capabilities in order to address our customers' size and application requirements. We have also introduced new products to extend our market and utilize our technology platform to extend our capabilities. • Extend our technology partner ecosystem - We work with a broad and diverse ecosystem of partners to extend the value of our platform and deliver a range of implementation, integration and value added services. We have enhanced our product capabilities via integration of and interoperability with partner technologies. • Increase market awareness - To generate increased demand for our products, we will continue to market the effectiveness of our comprehensive IT performance solutions. • Scale our sales force and distribution channels - We sell our products directly through our sales force and indirectly through channel partners. We intend to leverage, innovate and grow our sales force and our indirect channels to extend our geographic reach and market penetration.• Enhance and extend our support and services capabilities - On an ongoing basis, we plan to enhance and extend our support and services capabilities to continue to support our growing global customer base. For example, we host Splash, a new feature-rich community site for customers. Major Trends Affecting Our Financial Results Company Outlook We believe that our current value proposition, which enables customers to improve the performance of their applications and access to their data across WANs by integrating performance acceleration and performance management solutions, while also offering the ability to simplify IT infrastructure and realize significant capital and operating cost savings, should allow us to continue to grow our business. Our product revenue growth rate will depend significantly on continued growth in the WAN optimization, storage delivery, performance management and control, and virtual ADC markets, our ability to continue to attract new customers in those markets and our ability to generate additional sales from existing customers. Our growth in support and services revenue is dependent upon increasing the number of products under support contracts, which is dependent on both growing our installed base of customers and renewing existing support contracts. Our future profitability and rate of growth will be directly affected by the continued acceptance of our products in the marketplace, as well as the timing and size of orders, product mix, average selling prices and costs of our products and general economic conditions. Our ability to achieve profitability in the future will also be affected by the extent to which we must incur additional expenses to expand our sales, support, marketing, development, and general and administrative capabilities to grow our business. The largest component of our expenses is typically personnel costs. Personnel costs consist of salaries, benefits and incentive compensation for our employees, including commissions for sales personnel and stock-based compensation. Revenue Our revenue grew rapidly over the past decade. Revenue increased from $2.6 million in 2004, when we began shipping products, to $1.0 billion in 2013. Revenue grew by 6% in the three months ended September 30, 2014 to $276.4 million from $261.7 million in the three months ended September 30, 2013. Revenue grew by 6% in the nine months ended September 30, 2014 to $805.8 million from $757.8 million in the nine months ended September 30, 2013. We believe that our revenue growth is a positive sign that our products, support and services have a significant value proposition to our customers and that the markets we compete in are still expanding. Costs and Expenses Operating expenses consist of sales and marketing, research and development, general and administrative expenses, and acquisition-related costs. Personnel-related costs, including stock-based compensation, are the most significant components of each of these expense categories. The timing and number of additional hires has and could materially affect our operating expenses, both in dollar amount and as a percentage of revenue, in any particular period. On October 9, 2014, we announced that we have initiated a plan in order to reduce annual costs by $20 million to $25 million and improve annual operating margins by 1% to 2%. We are consolidating and eliminating certain outside services and streamlining our sales and marketing efforts to better align with the business needs. We are making a reduction to our work force of between 80 to 100 positions worldwide. We expect that actions related to our restructuring efforts to be substantially complete by the end of the fourth quarter of 2014 and we expect to take a restructuring charge in the range of $4.0 million to $6.0 million in the fourth quarter of 2014. Stock-based Compensation Expense Stock-based compensation expense and related payroll taxes were $24.4 million and $25.2 million in the three months ended September 30, 2014 and 2013, respectively, and $69.2 million and $76.7 million in the nine months ended September 30, 19-------------------------------------------------------------------------------- Table of Contents 2014 and 2013, respectively. We expect stock-based compensation to continue to play an important part in the overall compensation structure for our employees. Seasonality Our operating results may be affected by seasonal buying patterns. Historically, we have experienced a stronger seasonal revenue cycle in the fourth fiscal quarter and lowest in our first fiscal quarter. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP). These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates and judgments that we make and upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our condensed consolidated financial statements could be adversely affected. The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following: revenue recognition, accounting for business combinations, stock-based compensation, accounting for income taxes, and inventory valuation. Please refer to Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Annual Report on Form 10-K for our year ended December 31, 2013 for a more complete discussion of our critical accounting policies and estimates including revenue recognition, accounting for business combinations including the fair value measurement of contingent consideration, goodwill, intangible assets and impairment assessments, stock-based compensation, accounting for income taxes, and inventory valuation. Our critical accounting policies have been discussed with the Audit Committee of the Board of Directors. We believe there have been no material changes to our critical accounting policies and estimates during the three and nine months ended September 30, 2014, compared to those discussed in our Form 10-K for the year ended December 31, 2013. 20-------------------------------------------------------------------------------- Table of Contents Results of Operations Revenue We derive our revenue from sales of our appliances and software licenses and from support and services. Product revenue primarily consists of revenue from sales of our Application Acceleration and Performance Management products and is typically recognized upon delivery. Support revenue provides customers the right to receive unspecified software product upgrades, maintenance releases issued when-and-if-available during the support period, hardware repair, and access to technical support personnel. Support revenue is recognized ratably over the contractual period, which is typically one to three years. Service revenue includes professional services and training and is recognized as the services are performed. Three months ended Nine months ended September 30, September 30, (in thousands) 2014 2013 2014 2013 Total Revenue $ 276,374 $ 261,723 $ 805,816 $ 757,772 Total Revenue by Type: Product $ 153,383 $ 153,167 $ 448,458 $ 444,690 Support and services $ 122,991 $ 108,556 $ 357,358 $ 313,082 % Revenue by Type: Product 55 % 59 % 56 % 59 % Support and services 45 % 41 % 44 % 41 % Total Revenue by Geography: United States $ 166,397 $ 154,843 $ 464,580 $ 452,812 Other Americas $ 8,153 $ 9,172 $ 25,531 $ 26,244 Americas $ 174,550 $ 164,015 $ 490,111 $ 479,056 Europe, Middle East and Africa $ 71,185 $ 64,179 $ 209,637 $ 181,445 Asia Pacific $ 30,639 $ 33,529 $ 106,068 $ 97,271 % Revenue by Geography: United States 60 % 59 % 58 % 60 % Other Americas 3 % 4 % 3 % 3 % Americas 63 % 63 % 61 % 63 % Europe, Middle East and Africa 26 % 25 % 26 % 24 % Asia Pacific 11 % 12 % 13 % 13 % Total Revenue by Product Line: Application Acceleration $ 209,686 $ 209,387 $ 619,179 $ 590,856 Performance Management $ 66,688 $ 52,336 $ 186,637 $ 166,916 % Revenue by Product Line: Application Acceleration 76 % 80 % 77 % 78 % Performance Management 24 % 20 % 23 % 22 % Total Revenue by Sales Channel: Direct $ 26,060 $ 28,654 $ 79,979 $ 120,611 Indirect $ 250,314 $ 233,069 $ 725,837 $ 637,161 % Revenue by Sales Channel: Direct 9 % 11 % 10 % 16 % Indirect 91 % 89 % 90 % 84 % Quarter Ended September 30, 2014 Compared to the Quarter Ended September 30, 2013: Total revenue increased by 5.6% in the three months ended September 30, 2014 as compared to the prior year period. Product revenue in the three months ended September 30, 2014, increased slightly as compared to the three months ended September 30, 2013. As of September 30, 2014, our products have been sold to over 25,000 customers, compared to over 24,000 customers as of September 30, 2013. 21-------------------------------------------------------------------------------- Table of Contents Substantially all of our customers purchase support when they purchase our products. Support and services revenue increased 13% in the three months ended September 30, 2014, as compared to the same period in the prior year due primarily to growth in our customer base. Support and services revenue as a percentage of total revenues increased over the prior year due primarily to growth in our customer base. As our customer base grows, we expect our revenue generated from support and services to increase. In the three months ended September 30, 2014, we derived 91% of our revenue from indirect channels compared to 89% for the three months ended September 30, 2013. The increase in revenue from indirect channels is primarily due to the conversion of the customers acquired from OPNET to relationships with our channel partners. We expect indirect channel revenue to continue to represent a substantial majority of our revenue. We generated 40% of our revenue in the three months ended September 30, 2014 from international locations, compared to 41% in the three months ended September 30, 2013. The decrease in international revenue as a percent of total revenue was due primarily to a lower proportion of Asian-Pacific-based sales. We continue to expand into international locations and introduce our products in new markets and expect international revenue to increase in dollar amount over time. Nine months ended September 30, 2014 Compared to the Nine months ended September 30, 2013: Revenue increased by 6% in the nine months ended September 30, 2014 as compared to the prior year period. Product revenue increased by approximately 1% in the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. Support and services revenue increased 14% in the nine months ended September 30, 2014, and as a percentage of total revenues as compared to the same period in the prior year due primarily to growth in our customer base. In the nine months ended September 30, 2014, we derived 90% of our revenue from indirect channels compared to 84% for the nine months ended September 30, 2013. The increase in revenue from indirect channels is primarily due to the conversion of the customers acquired from OPNET to relationships with our channel partners. We generated 42% of our revenue in the nine months ended September 30, 2014 from international locations, compared to 40% in the nine months ended September 30, 2013. The increase in international revenue as a percent of total revenue was due primarily to a higher proportion of European-based sales. Cost of Revenue and Gross Margin Cost of product revenue consists of the costs of the appliance hardware, personnel costs of manufacturing management, manufacturing, shipping and logistics costs, expenses for inventory obsolescence, warranty obligations, and amortization of acquisition-related intangibles. We utilize third parties to assist in the design and manufacture of our appliance hardware, embed our proprietary software on our appliance hardware and perform shipping logistics. Cost of support and service revenue consists of personnel costs of technical support and professional services personnel, spare parts, and logistics services. As we expand internationally and into other sectors, we may incur additional costs to conform our products to comply with local laws or local product specifications. In addition, as we expand internationally, we will continue to hire additional technical support personnel to support our growing international customer base. Our gross margin has been and will continue to be affected by a variety of factors, including the mix and average selling prices of our products, new product introductions and enhancements, the cost of our appliance hardware, expenses for inventory obsolescence and warranty obligations, cost of support and services personnel, and the mix of distribution channels through which our products are sold. 22-------------------------------------------------------------------------------- Table of Contents Three months ended Nine months ended September 30, September 30, (in thousands) 2014 2013 2014 2013 Cost of revenue: Cost of product $ 36,945 $ 41,772 111,614 123,135 Cost of support and services 33,393 29,085 97,657 87,020 Total cost of revenue $ 70,338 $ 70,857 209,271 210,155 Gross profit: $ 206,036 $ 190,866 $ 596,545 $ 547,617 Gross margin for product: 76 % 73 % 75 % 72 % Gross margin for support and services 73 % 73 % 73 % 72 % Total gross margin 75 % 73 % 74 % 72 % Quarter Ended September 30, 2014 Compared to the Quarter Ended September 30, 2013: The total cost of product revenue decreased $4.8 million, or 12%, in the three months ended September 30, 2014 compared to the three months ended September 30, 2013, due primarily to a decrease in inventory write-downs of $2.0 million, a decrease in the amortization of certain acquisition-related intangible assets of $1.4 million, and a decrease in component costs of $1.0 million. Cost of support and services revenue increased $4.3 million, or 14.8%, due primarily to increased logistics and spare parts costs and higher headcount and payroll related costs to support the installed base growth. Gross margin increased to 75% in the three months ended September 30, 2014 as compared to 73% in the three months ended September 30, 2013. Product gross margin increased to 76% in the three months ended September 30, 2014 from 73% in the three months ended September 30, 2013 primarily as a result of a decrease in amortization of the acquisition-related intangible assets and a decrease in inventory write-downs. Gross margins for support and services remained flat at 73% in the three months ended September 30, 2014 as compared to 73% in the three months ended September 30, 2013. Nine months ended September 30, 2014 Compared to the Nine months ended September 30, 2013: The total cost of product revenue decreased $11.5 million, or 9%, in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, due primarily to a decrease in inventory write-downs of $2.4 million, a decrease in the amortization of certain acquisition-related intangible assets of $3.7 million, a decrease in the inventory fair value adjustment related to the acquisition of OPNET of $1.7 million, and a decrease in component costs of $1.0 million. Cost of support and services revenue increased $10.6 million, or 12%, due primarily to increased logistics and spare parts costs and higher headcount and payroll related costs to support the installed base growth. Gross margin increased to 74% in the nine months ended September 30, 2014 as compared to 72% in the nine months ended September 30, 2013. Product gross margin increased to 75% in the nine months ended September 30, 2014 from 72% in the nine months ended September 30, 2013 primarily as a result of a decrease in amortization of the acquisition-related intangible assets, a decrease in the inventory fair value adjustment related to the acquisition of OPNET, and a decrease in inventory write-downs. Gross margins for support and services increased to 73% in the nine months ended September 30, 2014 from 72% in the nine months ended September 30, 2013. Gross margin for support and services was positively impacted by the growth in support revenue due to an increased installed base. Additionally, the gross margin in 2013 was impacted by the reduction to service revenue related to the fair value adjustment to the deferred support revenue as required by the business combination accounting for the OPNET acquisition. Sales and Marketing Expenses Sales and marketing expenses represent the largest component of our operating expenses and include personnel costs, sales commissions, marketing programs and facilities costs. Marketing programs are intended to generate revenue from new and existing customers, and are expensed as incurred. We plan to continue to make investments in sales and marketing with the intent to add new customers and increase penetration within our existing customer base by further leveraging sales personnel worldwide, expanding our domestic and international sales and marketing activities, increasing channel penetration, building brand awareness and sponsoring additional marketing events. We expect future sales and marketing expenses to increase and continue to be our most significant operating expense. Generally, sales personnel are not immediately productive and sales and marketing expenses do not immediately result in increased revenue. Hiring additional sales personnel reduces short-term 23-------------------------------------------------------------------------------- Table of Contents operating margin until the sales personnel become productive and generate revenue. Accordingly, the timing of sales personnel hiring and the rate at which they become productive will affect our future performance. Three months ended Nine months ended September 30, September 30, ($ in thousands) 2014 2013 2014 2013 Sales and marketing expenses $ 113,100 $ 116,257 $ 338,535 $ 345,351 Percent of total revenue 41 % 44 % 42 % 46 % Quarter Ended September 30, 2014 Compared to the Quarter Ended September 30, 2013: Sales and marketing expenses decreased by $3.2 million, or 3%, in the three months ended September 30, 2014 compared to the three months ended September 30, 2013, primarily due to decreases in amortization of the intangibles acquired in the OPNET acquisition of $3.3 million. Nine months ended September 30, 2014 Compared to the Nine months ended September 30, 2013: Sales and marketing expenses decreased by $6.8 million, or 2%, in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, primarily due to decreases in amortization of the intangibles acquired in the OPNET acquisition of $10.1 million and decreases in marketing costs of $1.1 million, offset by increases in information technology and facilities costs of $4.9 million. Research and Development Expenses Research and development (R&D) expenses primarily include personnel costs and facilities costs. We expense R&D costs as incurred. We are devoting substantial resources to the continued development of additional functionality for existing products and the development of new products. We intend to continue to invest significantly in our R&D efforts because we believe they are essential to maintaining our competitive position. Three months ended Nine months ended September 30, September 30, ($ in thousands) 2014 2013 2014 2013Research and development expenses $ 53,354 $ 49,461 $ 155,299 $ 149,440 Percent of total revenue 19 % 19 % 19 % 20 % Quarter Ended September 30, 2014 Compared to the Quarter Ended September 30, 2013: R&D expenses increased by $3.9 million, or 7.9%, in the three months ended September 30, 2014 compared to the three months ended September 30, 2013, primarily due to increases in personnel and human resource-related costs of $2.4 million and increases in information technology and facilities costs of $1.5 million. Nine months ended September 30, 2014 Compared to the Nine months ended September 30, 2013: R&D expenses increased by $5.9 million, or 3.9%, in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, primarily due to increases in information technology and facilities costs of $4.4 million and increases in personnel and human resource-related costs of $1.4 million. General and Administrative Expenses General and administrative (G&A) expenses consist primarily of compensation for personnel and facilities costs related to our executive, finance, human resources, information technology and legal organizations, and fees for professional services. Professional services include legal, audit and information technology consulting costs. Three months ended Nine months ended September 30, September 30, ($ in thousands) 2014 2013 2014 2013General and administrative expenses $ 18,698 $ 17,729 $ 58,102 $ 55,164 Percent of total revenue 7 % 7 % 7 % 7 % Quarter Ended September 30, 2014 Compared to the Quarter Ended September 30, 2013: G&A expenses increased by $1.0 million in the three months ended September 30, 2014 compared to the three months ended September 30, 2013, primarily due to increases in professional service fees related to non-routine corporate governance and shareholder matters of $0.6 million. 24-------------------------------------------------------------------------------- Table of Contents Nine months ended September 30, 2014 Compared to the Nine months ended September 30, 2013: G&A expenses increased by $2.9 million in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, primarily due to increases in increases in professional service fees related to non-routine corporate governance and shareholder matters of $3.6 million and increases in outside services related to litigation fees of $1.6 million associated with the defense of our intellectual property, offset by a decrease in personnel-related costs of $2.2 million as a result of our workforce rationalization from the OPNET acquisition and a decrease in travel and entertainment costs of $0.3 million. Acquisition-Related Costs Acquisition-related costs include transaction costs and integration costs. Transaction costs include advisory, legal and other professional fees directly associated with acquisitions. Integration related costs include integration project management consulting, acquired employee retention bonuses, one-time termination benefits, facility exit costs and other non-recurring, or redundant costs to integrate an acquired company into Riverbed's systems and operations. We expect to continue to incur integration costs primarily associated with our facilities rationalization and sales force integration plans, but expect the ongoing costs to be lower than in prior quarters. The following table summarizes the acquisition-related costs, including transaction costs and integration-related costs in the periods presented: Three months ended Nine months ended September 30, September 30, (in thousands) 2014 2013 2014 2013 Acquisition-related costs $ 1,866 $ 4,882 $ 4,806 $ 16,085 Quarter Ended September 30, 2014 Compared to Quarter Ended September 30, 2013: During the three months ended September 30, 2014, we recorded acquisition-related costs of $1.9 million, primarily related to legal fees associated with the defense of the Zeus shareholder litigation related to acquisition-related contingent consideration, and facility exit costs. We expect to continue to incur integration costs primarily associated with our work force and facilities rationalization plans. Nine months ended September 30, 2014 Compared to the Nine months ended September 30, 2013: During the nine months ended September 30, 2014, we recorded acquisition-related costs of $4.8 million, primarily related to legal fees associated with the defense of the Zeus shareholder litigation and integration-related costs associated with our acquisition of OPNET. Interest Expense and Other, Net Interest expense and other, net, consists primarily of interest income on our cash and marketable securities, interest expense on our credit facility, and foreign currency exchange gains or losses. Three months ended Nine months ended September 30, September 30, (in thousands) 2014 2013 2014 2013 Interest income $ 421 $ 216 $ 920 $ 629 Interest expense (2,761 ) (5,895 ) (8,419 ) (18,006 ) Foreign exchange losses and other (433 ) 616 (700 ) 41 Total interest expense and other, net $ (2,773 ) $ (5,063 ) $ (8,199 ) $ (17,336 ) Quarter Ended September 30, 2014 Compared to the Quarter Ended September 30, 2013: Interest expense and other, net, decreased in the three months ended September 30, 2014 compared to the three months ended September 30, 2013, primarily due to the decrease in interest expense resulting from the refinancing of our borrowings in the fourth quarter of 2013, which decreased our rate of interest. Nine months ended September 30, 2014 Compared to the Nine months ended September 30, 2013: Interest expense and other, net, decreased in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, primarily due to the decrease in interest expense resulting from the refinancing of our borrowings in the fourth quarter of 2013, which decreased our rate of interest. Provision for (Benefit from) Income Taxes Our provision for (benefit from) income taxes is based on our estimated annual effective tax rate, adjusted for discrete tax items recorded in the period. The provision for (benefit from) income taxes for the three months ended September 30, 2014, and 2013 was $4.8 million and $(6.3) million, respectively. The provision for (benefit from) income taxes for the nine months ended September 30, 2014 and 2013 was $10.1 million and $(14.9) million, respectively. Our provision for (benefit from) 25-------------------------------------------------------------------------------- Table of Contents income taxes consists of federal, foreign, and state income taxes. Our effective tax rate was 29.3% and 251.1% for the three months ended September 30, 2014, and 2013, respectively. The effective tax rate was 31.9% and 41.8% for the nine months ended September 30, 2014 and 2013, respectively. Our effective tax rate for the three and nine months ended September 30, 2014, differed from the federal statutory rate due to state taxes and significant permanent differences. Significant permanent differences included taxes in foreign jurisdictions with a tax rate different than the U.S. federal statutory rate, nondeductible stock-based compensation expense, tax charges related to our intercompany transfer of intellectual property rights, the domestic production activities deduction and changes in tax liability associated with uncertain tax positions. Our effective tax rate for the three and nine months ended September 30, 2013, differed from the federal statutory rate due to state taxes and significant permanent differences. Significant permanent differences included taxes in foreign jurisdictions with a tax rate different than the U.S. federal statutory rate, nondeductible stock-based compensation expense, tax charges related to our intercompany transfer of intellectual property rights, the domestic production activities deduction, and the federal R&D tax credit. The federal R&D tax credit was retroactively reinstated and extended to December 31, 2013 during the first quarter of 2013. As a result of the reinstatement, we recorded a discrete tax benefit of $4.3 million related to 2012 in the first quarter of 2013. In the second quarter of 2013, we recorded a discrete tax benefit of $6.2 million as a result of a change in tax status of one of our subsidiaries, OPNET Technologies. The tax rate for the three and nine months ended September 30, 2014, is lower than the tax rate for the three and nine months ended September 30, 2013 primarily due to the difference in the annual projected mix of earnings between jurisdictions of varying tax rates, partially offset by the current year loss of tax benefits attributable to the expiration of the federal R&D tax credit as of December 31, 2013 which had not been renewed as of September 30, 2014. Our effective tax rate in 2014 and in future periods may fluctuate on a quarterly basis. The effective tax rate could be affected by the geographic distribution of our worldwide earnings or losses, our stock-based compensation expense, changes in the valuation of our deferred tax assets, changes in actual results versus our estimates, or changes in tax laws, regulations, accounting principles, or interpretations thereof. We record a valuation allowance to reduce our deferred tax assets to the amount we believe is more likely than not to be realized. In assessing the need for a valuation allowance, we have considered our historical levels of income and expectations of future taxable income. In determining future taxable income, we make assumptions to forecast federal, state and international operating income, the reversal of temporary differences, and the implementation of any feasible and prudent tax planning strategies. The assumptions require significant judgment regarding the forecasts of taxable income, and are consistent with our forecasts used to manage our business. We are subject to income tax in the U.S. as well as numerous state and foreign jurisdictions. We are no longer subject to federal examinations for years before 2009. With the exception of several states, we are no longer subject to state and local income tax examinations for years before 2010, although carryforward attributes that were generated prior to 2010 may still be adjusted upon examination by the California Franchise Tax Board if the attributes either have been or will be used in a future period. In addition, we file tax returns in multiple foreign taxing jurisdictions. In our most significant foreign jurisdictions, the UK and Singapore, the open tax years range from 2009 to 2012. Liquidity and Capital Resources September 30, December 31, (in thousands) 2014 2013 Working capital $ 217,572 $ 268,303 Cash and cash equivalents $ 207,782 $ 208,022 Short and long-term investments $ 268,886 $ 324,014 Nine months ended September 30, (in thousands) 2014 2013 Cash provided by operating activities $ 149,785 $ 128,389 Cash provided by (used in) investing activities $ 9,695 $ (85,076 ) Cash used in financing activities $ (155,656 ) $ (117,585 ) 26-------------------------------------------------------------------------------- Table of Contents Cash and Cash Equivalents Cash and cash equivalents consist of money market mutual funds, government-sponsored enterprise obligations, treasury bills, commercial paper, corporate bonds and notes, and other money market securities with remaining maturities at date of purchase of 90 days or less. Short and long-term investments consist of certificates of deposit, government-sponsored enterprise obligations, municipal bonds, treasury bills, commercial paper, and corporate bonds and notes. The fair value of investments is determined as the exit price in the principal market in which we would transact. The fair value of our investments has not materially fluctuated from historical cost. Cash and cash equivalents, short-term investments and long-term investments as of September 30, 2014 were $476.7 million, a decrease of $55.4 million as compared to December 31, 2013. As of September 30, 2014 and December 31, 2013, $125.7 million and $93.8 million, respectively of the Company's cash and cash equivalents, short-term and long-term investments were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. Restricted cash primarily represents collateralized letters of credit for the security deposits in connection with lease agreements for our facilities. Current restricted cash, which is included in the Prepaid expenses and other current assets in the condensed consolidated balance sheets, totaled $3.7 million and $3.3 million at September 30, 2014 and December 31, 2013, respectively. Long-term restricted cash totaled $8.6 million and $9.1 million at September 30, 2014 and at December 31, 2013, respectively, and was included in Other assets in the condensed consolidated balance sheets. We have significant international operations. Our sales contracts are principally denominated in U.S. dollars and therefore changes in foreign exchange rates have not materially affected our cash flows from operations. As we fund our international operations, our cash and cash equivalents are affected by changes in exchange rates. To date, the foreign currency effect on our cash and cash equivalents has not been significant. Cash Provided by Operating Activities Our largest source of operating cash flows is cash collections from our customers. Our primary uses of cash from operating activities are for personnel related expenditures, product costs, outside services, and rent payments. Our cash flows from operating activities will continue to be affected principally by the extent to which we grow our revenue and spend on hiring personnel in order to grow our business. The timing of hiring sales personnel in particular affects cash flows as there is a lag between the hiring of sales personnel and the generation of revenue and related cash flows from their sales efforts. Cash provided by operating activities was $149.8 million in the nine months ended September 30, 2014, an increase of $21.4 million compared to $128.4 million in the nine months ended September 30, 2013. Cash provided from the statement of operations for the nine months ended September 30, 2014, after adjustments for certain non-cash income items, including depreciation and amortization, stock-based compensation expense, excess tax benefits from employee stock plans and deferred taxes was $149.9 million, an increase of $48.7 million from the prior year period. The increase in cash provided from the statement of operations was primarily due to an improvement in operating income, lower interest expense on borrowings, and a change in deferred taxes. Cash used in operating activities associated with changes in operating assets and liabilities in the nine months ended September 30, 2014 was $0.1 million, a decrease of $27.3 million from the prior year period. Cash Provided by (Used in) Investing Activities Cash provided by investing activities primarily relate to sales and maturities of marketable securities, net of purchases, offset by capital expenditures, and acquisitions. Cash provided by investing activities was $9.7 million in the nine months ended September 30, 2014, a $94.8 million increase in cash provided compared to $85.1 million of cash used in investing activities in the nine months ended September 30, 2013. The increase in cash provided by investing activities is substantially attributable to reduced purchases of investment securities of $76.1 million and increased proceeds from the sale and maturities of marketable securities of $43.3 million for the nine months ended September 30, 2014, as compared to the prior year period, which was offset by increased capital expenditures of $25.0 million primarily related to our new corporate headquarters. Cash Used in Financing Activities Cash used in financing activities in the nine months ended September 30, 2014 totaled $155.7 million and consisted of cash of $195.6 million used to repurchase shares of our common stock and $11.3 million of cash used to pay down long-term 27-------------------------------------------------------------------------------- Table of Contents borrowings, which was offset by $53.4 million of cash provided from the proceeds from the issuance of common stock under employee stock plans and $5.9 million of excess tax benefit from employee stock plans. We believe that our net cash flows from operations, together with our cash and investments balance at September 30, 2014, will be sufficient to fund our projected operating requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of expansion into new territories, the timing of introductions of new products and enhancements to existing products, and the continuing market acceptance of our products. In December 2013, we entered into a new credit agreement and related security and other agreements for a $600.0 million credit facility (the 2013 Credit Facility) that includes a $300.0 million senior secured term loan facility and a $300.0 million senior secured revolving loan facility. The 2013 Credit Facility has a five year term and has an initial interest rate for both the term loan and revolving loan of LIBOR plus 175 basis points. In the fourth quarter 2013, we drew down $300.0 million on the term loans, and $225.0 million under the revolving credit facility. The terms of the 2013 Credit Facility require us to make scheduled quarterly payments on the term loan of 1.25% of the original principal amount in the first two years, or $3.8 million per quarter, increasing to 2.50% thereafter, with the balance due on December 20, 2018. Refer to Contractual Obligations, below, for the minimum payment requirements. As of September 30, 2014, the outstanding borrowings were $513.8 million. This quarterly payment provision will result in the use of an increased portion of our cash flows from operations to pay principal payments on our credit facilities (limiting our flexibility in planning for, or reacting to, changes in our business and industry) making the payments unavailable for operations, working capital, capital expenditures, expansion, acquisitions, or other purposes. On March 4, 2014, the Board of Directors announced a $250.0 million increase to the Share Repurchase Program (the Program). The maximum dollar value of shares of common stock that remain available for purchase under the Program is $192.2 million as of September 30, 2014. The share repurchases were and will continue to be funded by available cash balances and cash from operations. In the future, we may enter into other arrangements for potential investments in, or acquisitions of, complementary businesses, services or technologies, which could require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all. Contractual Obligations The following is a summary of our contractual obligations as of September 30, 2014: Remaining three Total months of 2014 2015 2016 2017 2018 Thereafter (in thousands) Contractual Obligations Principal payments on borrowings $ 513,750 $ 3,750 $ 15,000 $ 30,000 $ 30,000 $ 435,000 $ - Interest payments on borrowings (1) 39,732 2,496 10,227 9,836 9,200 7,973 - Operating leases 205,093 5,515 28,953 27,464 25,560 23,813 93,788 Purchase obligations (2) 11,014 10,991 17 6 - - - Total contractual obligations $ 769,589 $ 22,752 $ 54,197 $ 67,306 $ 64,760 $ 466,786 $ 93,788 (1) Assumes an interest rate of 2.0% over the term of the loan (see Note 9 - Borrowings in the Notes to Condensed Consolidated Financial Statements). The actual interest rate is a variable rate of interest based on LIBOR (with no floor) plus an applicable margin (varying from 1.25% to 2.00%). (2) Represents amounts associated with agreements that are enforceable, legally binding and specify terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of payment. Obligations under contracts that we can cancel without a significant penalty are not included in the table above. 28 -------------------------------------------------------------------------------- Table of Contents As of September 30, 2014, we had $53.7 million of unrecognized tax benefits, including interest and penalties, related to uncertain tax positions. Because of the high degree of uncertainty regarding the settlement of these liabilities, we are unable to estimate the years in which future cash outflows may occur. As a result, this amount is not included in the table above. Off-Balance Sheet Arrangements At September 30, 2014 and December 31, 2013, we did not have any 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 other contractually narrow or limited purposes, nor did we have any undisclosed material transactions or commitments involving related persons or entities. Other At September 30, 2014 and December 31, 2013, we did not have commercial commitments under lines of credit, standby repurchase obligations or other such debt arrangements. Recent Accounting Pronouncements See Note 2 - Recent Accounting Pronouncements in the Notes to Condensed Consolidated Financial Statements for recent accounting pronouncements that could have an effect on us. 29-------------------------------------------------------------------------------- Table of Contents |