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JUNIPER NETWORKS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This Quarterly Report on Form 10-Q ("Report"), including "Management's Discussion and Analysis of Financial Condition and Results of Operations," contains forward-looking statements regarding future events and the future results of Juniper Networks, Inc. ("we," "us," or the "Company") that are based on our current expectations, estimates, forecasts, and projections about our business, our results of operations, the industry in which we operate and the beliefs and assumptions of our management. Words such as "expects," "anticipates," "targets," "goals," "projects," "would," "could," "intends," "plans," "believes," "seeks," "estimates," variations of such words, and similar expressions are intended to identify such forward-looking statements. Forward-looking statements by their nature address matters that are, to different degrees, uncertain, and these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in this Report under the section entitled "Risk Factors" in Item 1A of Part II and elsewhere, and in other reports we file with the U.S. Securities and Exchange Commission ("SEC"), specifically our most recent Annual Report on Form 10-K. While forward-looking statements are based on reasonable expectations of our management at the time that they are made, you should not rely on them. We undertake no obligation to revise or update publicly any forward-looking statements for any reason, except as required by applicable law. The following discussion is based upon our unaudited Condensed Consolidated Financial Statements included in Part 1, Item I, of this Report, which have been prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP"). In the course of operating our business, we routinely make decisions as to the timing of the payment of invoices, the collection of receivables, the manufacturing and shipment of products, the fulfillment of orders, the purchase of supplies, and the building of inventory and spare parts, among other matters. Each of these decisions has some impact on the financial results for any given period. In making these decisions, we consider various factors, including contractual obligations, customer satisfaction, competition, internal and external financial targets and expectations, and financial planning objectives. To aid in understanding our operating results for the periods covered by this Report, we have provided an executive overview and summary of our business and market environment along with a financial results overview. These sections should be read in conjunction with the more detailed discussion and analysis of our condensed consolidated financial condition and results of operations in this Item 2, our "Risk Factors" section included in Item 1A of Part II, and our unaudited Condensed Consolidated Financial Statements and Notes included in Item 1 of Part I of this Report, as well as our audited Consolidated Financial Statements and Notes included in Item 8 of Part II of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. Business and Market Environment At Juniper Networks, we design, develop, and sell products and services for high-performance networks, which combine scale and performance with agility and efficiency, so customers can build the best networks for their businesses. Our routing, switching, and security products address high-performance networking requirements, which include High-IQ networking and cloud environments for global service providers, enterprises, governments, and research and public sector organizations that view the network as critical to their success. Our silicon, systems, and software represent innovations that transform the economics and experience of networking, helping customers achieve superior performance, greater choice, and flexibility, while reducing overall total cost of ownership. We do business in three geographic regions: Americas; Europe, Middle East and Africa ("EMEA"); and Asia Pacific ("APAC"). We sell our high-performance network products and service offerings across routing, switching, and security to service provider and enterprise markets. Integrated Operating Plan In the first quarter of 2014, we announced an integrated operating plan ("IOP") to refocus our strategy, optimize our structure, and improve operational efficiencies. In connection with the IOP, we realigned our organization into a One-Juniper structure, which included consolidating our R&D and go-to-market functions to reduce complexity, increase clarity of responsibilities, and improve efficiency. As a result of these changes, our consolidated business is considered to be one reportable segment. Future organizational changes, if any, could impact how the chief operating decision maker ("CODM") allocates resources and assesses performance. During the first quarter of 2014, we also initiated the 2014 Restructuring Plan. Our 2014 Restructuring Plan consists of workforce reductions, facility consolidations or closures, asset write-downs, contract terminations and other charges of which $178.6 million was recorded in the nine months ended September 30, 2014 in cost of sales and restructuring and other (credit) charges. This charge consists of $22.2 million of inventory write-downs, $96.5 million of asset impairment, $12.6 million of facility consolidation and 35-------------------------------------------------------------------------------- Table of Contents closures, $45.0 million of severance costs, and $2.3 million of contract terminations. In connection with our 2014 Restructuring Plan, we expect to record aggregate future charges of approximately $7.0 million to $9.0 million related to severance, consolidation and closure of facilities, and contract terminations and other charges. As part of the IOP and our new cost reduction initiative, we have increased our total annualized operating expense savings commitment to $260.0 million, compared to the fourth quarter of 2013. On July 22, 2014, we entered into a definitive agreement to sell our Junos® Pulse product portfolio to an affiliate of Siris Capital, a private equity firm, for approximately $250.0 million, subject to certain working capital adjustments. The sale was completed on October 1, 2014, and we received total consideration of $228.1 million, of which $103.1 million was in cash, net of a $21.9 million working capital adjustment, and $125.0 million was in the form of an 18-month non-contingent interest bearing promissory note. The related assets and liabilities sold have been presented as held for sale in the Condensed Consolidated Balance Sheet as of September 30, 2014. The quarterly revenue impact of the Junos Pulse business is approximately $30.0 million and the impact of the sale of the business on gross margin is not significant. In addition to our cost reduction activities, we introduced a capital allocation program to return capital to our stockholders through share repurchases and dividends. In the first quarter of 2014, we announced our intention to return $3.0 billion to stockholders over the next three years. In October 2014, our Board of Directors ("Board") authorized a $1.1 billion increase to our previously authorized capital return program of $3.0 billion. This brings our total capital return commitment to stockholders, for the period from February 2014 through 2016, including dividends, to $4.1 billion. In October 2014, we announced our intention to repurchase an additional $1.5 billion shares before the end of the second quarter of 2015 as part of this three year capital return program, as well as a cash dividend of $0.10 per share payable December 23, 2014 to shareholders of record as of the close of business on December 2, 2014. During the nine months ended September 30, 2014, we completed a $1.2 billion accelerated share repurchase program ("ASR"), repurchased an additional $550.0 million of our common stock subsequent to the ASR, and paid our first ever quarterly cash dividend of $0.10 per share for an aggregate amount of $43.8 million. We also issued $350.0 million aggregate principal amount of 4.50% senior notes due 2024 ("2024 Notes"), which allowed us to partially fund the ASR. Quarterly Results The third quarter of 2014 was challenging from a revenue perspective with total revenue for the quarter of $1,125.9 million, down 5% year-over-year primarily due to reduced spending by service providers, particularly in APAC and EMEA. Despite the decline in net revenue this quarter, we believe that the long-term fundamentals for our product portfolio remain intact. In the third quarter of 2014, compared to the same period in 2013, we saw strong revenues from our MX2020 and PTX routers and higher demand from our U.S. federal customers. We expect the overall revenue environment to be challenging over the next several quarters, as near-term factors are impacting demand from our largest service provider customers. We believe our product gross margins may continue to vary in the future due to competitive pricing pressures, which may be offset by additional cost efficiencies. Nevertheless, we are focused on executing our strategy on high-performance networking. We believe our product portfolio continues to be strong, and we remain focused on innovation and executing to our IOP. 36-------------------------------------------------------------------------------- Table of Contents Financial Results and Key Performance Metrics Overview The following table provides an overview of our key financial metrics (in millions, except per share amounts, percentages, days sales outstanding ("DSO"), and book-to-bill): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 $ Change % Change 2014 2013 $ Change % Change Net revenues $ 1,125.9 $ 1,185.6 $ (59.7 ) (5 )% $ 3,525.5 $ 3,395.5 $ 130.0 4 % Gross Margin $ 714.8 $ 746.5 $ (31.7 ) (4 )% $ 2,183.1 $ 2,137.8 $ 45.3 2 % Percentage of net revenues 63.5 % 63.0 % 61.9 % 63.0 % Operating income $ 172.4 $ 145.0 $ 27.4 19 % $ 282.1 $ 370.5 $ (88.4 ) (24 )% Percentage of net revenues 15.3 % 12.2 % 8.0 % 10.9 % Net income $ 103.6 $ 99.1 $ 4.5 5 % $ 435.3 $ 288.0 $ 147.3 51 % Percentage of net revenues 9.2 % 8.4 % 12.3 % 8.5 % Net income per share: Basic $ 0.23 $ 0.20 $ 0.03 15 % $ 0.93 $ 0.57 $ 0.36 63 % Diluted $ 0.23 $ 0.19 $ 0.04 21 % $ 0.91 $ 0.56 $ 0.35 63 % Cash dividends declared $ 0.10 $ - $ 0.10 - % $ 0.10 $ - $ 0.10 - % per common stock Stock repurchase plan $ 850.0 $ 92.9 $ 757.1 815 % $ 1,750.0 $ 328.4 $ 1,421.6 433 % activity Operating cash flows $ 472.5 $ 451.9 $ 20.6 5 % DSO 49 42 7 17 % Book-to-bill 1 >1 September 30, December 31, 2014 2013 $ Change % Change Deferred revenue $ 1,074.0 $ 1,069.3 $ 4.7 0.4 % • Net Revenues: During the three months ended September 30, 2014, compared to the same period in 2013, we experienced a decline in net revenue in the service provider and enterprise market in both APAC and EMEA, partially offset by an increase in the Americas market. The year-over-year decline in our net revenues was primarily due to a decrease in net revenues from our routing and security products, partially offset by an increase in our switching products. During the nine months ended September 30, 2014, compared to the same period in 2013, we experienced strong net revenue growth in the Americas service provider and enterprise market and an increase in EMEA's service provider, partially offset by a decline in APAC's service provider and enterprise market. The increase in net revenues for the nine months ended is primarily due to an increase in sales from our edge routing and switching products, partially offset by a decline in our core routing and security products. • Gross Margin: Our gross margin as a percentage of net revenues increased during the three months ended September 30, 2014, compared to the same period in 2013, as a result of change in product mix and strong growth in service revenues, partially offset by charges related to an industry-wide memory product quality defect for a component from a third party supplier. Our gross margin as a percentage of net revenues decreased during the nine months ended September 30, 2014, compared to the same period in 2013, as a result of higher inventory charges driven by product rationalizations in connection with our 2014 Restructuring Plan and charges related to the memory product quality defect discussed above. • Operating Income: During the three months ended September 30, 2014, compared to the same period in 2013, we experienced an increase in operating income, primarily due to better efficiencies and cost reduction initiatives. Our operating income as a percentage of net revenues decreased during the nine months ended September 30, 2014, compared 37-------------------------------------------------------------------------------- Table of Contents to the same period in 2013, primarily due to restructuring and other (credit) charges of $178.6 million, related to severance, facility consolidations and closures, asset write-offs, and contract terminations in connection with our 2014 Restructuring Plan, as well as a component remediation charge of $20.7 million relating to the memory product quality defect discussed above. • Cash Dividends Declared per Common Stock: On July 22, 2014, we declared a quarterly cash dividend of $0.10 per share payable on September 23, 2014 to stockholders of record on September 2, 2014 in the aggregate amount of $43.8 million. • Stock Repurchase Plan Activity: Pursuant to our $1.2 billion ASR program, we received and retired 33.3 million shares of our common stock during the three months ended March 31, 2014 at a cost of $900.0 million. On July 23, 2014, the ASR was completed, and we received an additional 16.0 million shares from the financial institutions for a total of 49.3 million shares, which resulted in a volume weighted average repurchase price, less an agreed upon discount, of $24.35 per share. The 16.0 million shares received were retired in the third quarter of 2014. Subsequent to the completion of the ASR, we repurchased 23.5 million shares of our common stock in the open market at an average price of $23.44 per share for an aggregate purchase price of $550.0 million during the three months ended September 30, 2014. • Operating Cash Flows: Operating cash flows increased during the nine months ended September 30, 2014, compared to the same period in 2013, primarily due to higher net income which included the gain on patent litigation settlement, lower taxes paid, partially offset by higher payments related to all restructuring plans, lower cash collections due to the timing of receipts from customers and lower deferred revenue. • DSO: DSO is calculated as the ratio of ending accounts receivable, net of allowances, divided by average daily net sales for the preceding 90 days. DSO for the third quarter of 2014 increased by 7 days, or 17% compared to the same period in 2013, primarily due to shipment linearity and invoice delays as a result of our enterprise resource planning implementation. • Book-to-bill: Book-to-bill represents the ratio of product orders booked divided by product revenues during the respective period. Book-to-bill was approximately one for the three months ended September 30, 2014 and greater than one for the three months ended September 30, 2013. • Deferred Revenue: Total deferred revenue increased by $4.7 million to $1,074.0 million as of September 30, 2014, compared to $1,069.3 million as of December 31, 2013, primarily due to an increase in deferred service revenue of $27.2 million, driven by the execution of several multi-year support agreements and annual agreement renewals. The increase in deferred service revenue was partially offset by a decrease in deferred product revenue of $22.5 million as a result of timing of future feature releases and to a lesser extent lower distributor inventory. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. GAAP requires us to make judgments, assumptions, and estimates that affect the amounts reported in the condensed consolidated financial statements and the accompanying notes. On an ongoing basis, we evaluate our estimates and assumptions. These estimates and assumptions are based on current facts, historical experience, and various other factors that we believe are reasonable under the circumstances to determine reported amounts of assets, liabilities, revenue and expenses that are not readily apparent from other sources. An accounting policy is considered to be critical if the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and the effect of the estimates and assumptions on financial condition or operating performance is material. The accounting policies that we believe reflect our more significant estimates, judgments, and assumptions and are most critical to understanding and evaluating our reported financial results are as follows: • Goodwill; • Inventory Valuation and Contract Manufacturer Liabilities; • Revenue Recognition; • Income Taxes; and • Loss Contingencies. 38-------------------------------------------------------------------------------- Table of Contents During the nine months ended September 30, 2014, there were no significant changes to our critical accounting policies and estimates as compared to the critical accounting policies and estimates disclosed in 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 the year ended December 31, 2013. Recent Accounting Pronouncements See Note 2, Summary of Significant Accounting Policies, in the Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report, for a full description of recent accounting pronouncements, including the actual and expected dates of adoption and estimated effects on our consolidated results of operations and financial condition, which is incorporated herein by reference. Results of Operations The following table presents product and service net revenues (in millions, except percentages): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 $ Change % Change 2014 2013 $ Change % Change Routing $ 533.2 $ 609.0 $ (75.8 ) (12 )% $ 1,700.8 $ 1,700.2 $ 0.6 - % Switching 155.0 147.6 7.4 5 % 546.8 439.3 107.5 24 % Security 121.3 144.2 (22.9 ) (16 )% 367.1 406.9 (39.8 ) (10 )% Total Product 809.5 900.8 (91.3 ) (10 )% 2,614.7 2,546.4 68.3 3 % Percentage of net revenues 71.9 % 76.0 % 74.2 % 75.0 % Total Service 316.4 284.8 31.6 11 % 910.8 849.1 61.7 7 % Percentage of net revenues 28.1 % 24.0 % 25.8 % 25.0 % Total net revenues $ 1,125.9 $ 1,185.6 $ (59.7 ) (5 )% $ 3,525.5 $ 3,395.5 $ 130.0 4 % Three Months Ended September 30, 2014 Compared with the Three Months Ended September 30, 2013 Routing Routing product net revenues decreased during the three months ended September 30, 2014, compared to the same period in 2013, due to lower net revenues from core and edge routing products, primarily driven by lower sales in the service provider market of our T and MX product lines. Despite the decline in MX product revenue, the MX2020 and our PTX product lines showed strong net revenues in the third quarter of 2014, compared to the same period in 2013. Switching Switching product net revenues increased during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to strong net revenues from QFabric, but partially offset by a decrease in EX. Demand for switching products showed a high demand by service providers, which was primarily a result of strong growth from our service provider customers. Security Security product net revenues decreased during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to decline in demand for our non-Junos based security products and Pulse products, and a decline for our SRX platform due the timing of large service provider deployments. Service The increase in service net revenues during the three months ended September 30, 2014, compared to the same period in 2013, was primarily driven by new service contracts and strong contract renewals from our installed base across routing and switching products. 39-------------------------------------------------------------------------------- Table of Contents Nine Months Ended September 30, 2014 Compared with the Nine Months Ended September 30, 2013 Routing Routing product net revenues slightly increased during the nine months ended September 30, 2014, compared to the same period in 2013, due to higher net revenues from edge routing products, primarily driven by higher sales of our MX products. The increase in edge routing product net revenues was partially offset by a decrease in sales of core routing and older edge routing products. Switching Switching product net revenues increased during the nine months ended September 30, 2014, compared to the same period in 2013, primarily due to higher net revenues from our QFabric and EX products, fueled by strong demand for switching products by our service provider customers and, to a lesser extent, the enterprise market. Security Security product net revenues decreased during the nine months ended September 30, 2014, compared to the same period in 2013, as demand for our non-Junos-based security products declined. This decline was partially offset by an increase in net revenues from our SRX platform and security software. Service The increase in service net revenues during the nine months ended September 30, 2014, compared to the same period in 2013, was primarily driven by new service contracts and strong contract renewals. Net Revenues by Geographic Region The following table presents net revenues by geographic region (in millions, except percentages): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 $ Change % Change 2014 2013 $ Change % Change Americas: United States $ 621.3 $ 604.6 $ 16.7 3 % $ 1,905.7 $ 1,761.8 $ 143.9 8 % Other 57.0 56.7 0.3 1 % 165.1 166.7 (1.6 ) (1 )% Total Americas 678.3 661.3 17.0 3 % 2,070.8 1,928.5 142.3 7 % Percentage of net revenues 60.2 % 55.8 % 58.7 % 56.8 % EMEA 290.5 306.5 (16.0 ) (5 )% 911.0 898.0 13.0 1 % Percentage of net revenues 25.8 % 25.8 % 25.8 % 26.4 % APAC 157.1 217.8 (60.7 ) (28 )% 543.7 569.0 (25.3 ) (4 )% Percentage of net revenues 14.0 % 18.4 % 15.4 % 16.8 % Total net revenues $ 1,125.9 $ 1,185.6 $ (59.7 ) (5 )% $ 3,525.5 $ 3,395.5 $ 130.0 4 % Three Months Ended September 30, 2014 Compared with the Three Months Ended September 30, 2013 Americas Net revenues in the Americas increased during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to an increase in net revenues from both the service provider and the enterprise market. The increase in service provider net revenues was driven primarily by Web 2.0 and cable providers, partially offset by sharp declines with large carriers in the U.S. The increase in the Americas enterprise market was driven by continued strength in the U.S. federal market and traction in financial services, with a slight decline in the broader market. 40-------------------------------------------------------------------------------- Table of Contents EMEA Net revenues in EMEA decreased during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to a decline in net revenues from both the service provider and enterprise markets. The decline in the EMEA's service provider market was due to a decline in demand from smaller providers, and a decline in the broader enterprise market. We, however, experienced an increase in service provider demand with large service providers, and greater stability in the enterprise market with smaller sector accounts. APAC Net revenues in APAC decreased during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to a decline in net revenues from both the service provider and enterprise market. Nine Months Ended September 30, 2014 Compared with the Nine Months Ended September 30, 2013 Americas The increase in net revenues in the Americas during the nine months ended September 30, 2014, compared to the same period in 2013, was primarily due to an increase in net revenues in both the service provider and enterprise markets. The increase in net revenues in the service provider market was primarily due to strong demand from Web 2.0 and cable providers, partially offset by a decrease in demand with carriers. The increase in net revenues in the Americas enterprise market resulted from an improving broad-based market demand, partially offset by a decline in net revenues from Federal customers due to recognition of revenue from a large U.S. federal government contract in 2013. EMEA Net revenues in EMEA increased during the nine months ended September 30, 2014, compared to the same period in 2013, primarily due to stronger demand from larger carriers, partially offset by a decrease in net revenues from the enterprise market. APAC Net revenues in APAC decreased during the nine months ended September 30, 2014, compared to the same period in 2013, primarily due to a decline in net revenues from both the service provider and enterprise market. Net Revenues by Market and Customer The following table presents net revenues by market (in millions, except percentages): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 $ Change % Change 2014 2013 $ Change % Change Service provider $ 741.5 $ 788.3 $ (46.8 ) (6 )% $ 2,356.0 $ 2,227.2 $ 128.8 6 % Percentage of net revenues 65.9 % 66.5 % 66.8 % 65.6 % Enterprise 384.4 397.3 (12.9 ) (3 )% 1,169.5 1,168.3 1.2 - % Percentage of net revenues 34.1 % 33.5 % 33.2 % 34.4 % Total net revenues $ 1,125.9 $ 1,185.6 $ (59.7 ) (5 )% $ 3,525.5 $ 3,395.5 $ 130.0 4 % We sell our high-performance network products and service offerings across routing, switching, and security to two primary markets: service provider and enterprise. Determination of which market a particular revenue transaction relates to is based primarily upon the customer's industrial classification code, but may also include subjective factors such as the intended use of the product. The service provider market generally includes wireline and wireless carriers, and cable operators, as well as major Internet content and application providers, including those that provide social networking and search engine services. The enterprise market is generally comprised of businesses; federal, state, and local governments; research and education institutions; and financial services. 41-------------------------------------------------------------------------------- Table of Contents Three Months Ended September 30, 2014 Compared with the Three Months Ended September 30, 2013 Service provider Net revenues from sales to the service provider market decreased during the three months ended September 30, 2014, compared to the same period in 2013, due to a decline in EMEA and APAC, partially offset by a slight increase in the Americas service provider market. The decline in EMEA was due to a decline in demand with smaller service providers, while the decline in APAC was broader among small and large service providers. The increase in service provider net revenues in the Americas was driven by an increase in sales to Web 2.0 and cable providers, partially offset by declines with large carriers. In addition, service provider demand for switching and data center solutions were strong, while routing and security products declined during the three months ended September 30, 2014, compared to the same period in 2013. Enterprise Net revenues from the enterprise market decreased during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to a decline in the broader enterprise market in EMEA and APAC, partially offset by an increase in the Americas enterprise. The increase in net revenues in the Americas enterprise was primarily due to stronger U.S. Federal demand, especially for routing products in defense and intelligence applications. Nine Months Ended September 30, 2014 Compared with the Nine Months Ended September 30, 2013 Service Provider Net revenues from the service provider market increased during the nine months ended September 30, 2014, compared to the same period in 2013, with growth in the Americas and EMEA. The increase in service provider net revenues in the Americas was driven by growth with Web 2.0 and cable providers, partially offset by large carriers. The increase in service provider net revenues in EMEA was attributable to growth with large carriers, while in APAC net revenues in the service provider market declined as a result of lower demand with large carriers. In addition, service provider demand for switching products continued to be strong, particularly in the Americas. Enterprise Net revenues from the enterprise market increased slightly during the nine months ended September 30, 2014, compared to the same period in 2013, primarily due to broad-based growth in the Americas, including strong financial services demand for security products. Public sector net revenues grew in APAC, but declined in EMEA. Customer No customer accounted for 10% or more of our net revenues during the three and nine months ended September 30, 2014 and September 30, 2013. Gross Margins The following table presents gross margins (in millions, except percentages): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 $ Change % Change 2014 2013 $ Change % Change Product gross margin $ 519.5 $ 575.3 $ (55.8 ) (10 )% $ 1,638.8 $ 1,621.4 $ 17.4 1 % Percentage of product revenues 64.2 % 63.9 % 62.7 % 63.7 % Service gross margin 195.3 171.2 24.1 14 % 544.3 516.4 27.9 5 % Percentage of service revenues 61.7 % 60.1 % 59.8 % 60.8 % Total gross margin $ 714.8 $ 746.5 $ (31.7 ) (4 )% $ 2,183.1 $ 2,137.8 $ 45.3 2 % Percentage of net revenues 63.5 % 63.0 % 61.9 % 63.0 % 42-------------------------------------------------------------------------------- Table of Contents Our gross margins have been and will continue to be affected by a variety of factors, including the mix and average selling prices of our products and services, new product introductions and enhancements, manufacturing costs, expenses for inventory obsolescence and warranty obligations, cost of support and service personnel, and the mix of distribution channels through which our products are sold. Three Months Ended September 30, 2014 Compared with the Three Months Ended September 30, 2013 Product gross margin in dollars declined during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to the decline in net revenues. Product gross margin increased as a percentage of product net revenues during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to a decline in cost of sales, as a result of general cost reductions, offset by an inventory charge of $7.0 million in connection with an industry-wide memory product quality defect in a component from a third-party supplier, resulting in higher product gross margin percentage. Service gross margin as a percentage of service net revenues increased during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to a slower increase in labor and logistics delivery costs to support new contracts and product introductions, partially offset by increased service net revenues. Nine Months Ended September 30, 2014 Compared with the Nine Months Ended September 30, 2013 Product gross margin decreased as a percentage of product net revenues during the nine months ended September 30, 2014, compared to the same period in 2013, primarily due to an increase in cost of revenues. The increase in cost of revenues was primarily due to inventory charges of $22.2 million for product rationalizations in connection with our 2014 Restructuring Plan and $20.7 million in connection with an industry-wide memory product quality defect in a component from a third-party supplier. Excluding the costs of the restructuring and component defect, the product gross margin as a percentage of net revenues improved slightly, primarily due to the impact of a lower margin U.S. government contract and higher discounts offered in the nine months ended September 30, 2013 that were not repeated in the 2014 period, as well as favorability in product mix in the 2014 period. Product gross margin in dollars remained flat during the nine months ended September 30, 2014, compared to the same period in 2013. Service gross margin as a percentage of service net revenues decreased during the nine months ended September 30, 2014 compared to the same period in 2013, primarily due to an increase in labor and logistics delivery costs to support new contracts and product introductions, offset by increased services net revenues. Operating Expenses The following table presents operating expenses (in millions, except percentages): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 $ Change % Change 2014 2013 $ Change % Change Research and development $ 253.2 $ 264.6 $ (11.4 ) (4 )% $ 772.7 $ 784.5 $ (11.8 ) (2 )% Percentage of net revenues 22.5 % 22.3 % 21.9 % 23.1 % Sales and marketing 249.2 269.5 (20.3 ) (8 )% 780.6 792.7 (12.1 ) (2 )% Percentage of net revenues 22.1 % 22.7 % 22.1 % 23.3 % General and administrative 55.0 61.4 (6.4 ) (10 )% 190.5 169.1 21.4 13 % Percentage of net revenues 4.9 % 5.2 % 5.4 % 5.0 % Restructuring and other (credit) charges (15.0 ) 6.0 (21.0 ) (350 )% 157.2 21.0 136.2 649 % Percentage of net revenues (1.3 )% 0.5 % 4.5 % 0.6 % Total operating expenses $ 542.4 $ 601.5 $ (59.1 ) (10 )% $ 1,901.0 $ 1,767.3 $ 133.7 8 % Percentage of net revenues 48.2 % 50.7 % 53.9 % 52.0 % Our operating expenses have historically been driven in large part by personnel-related costs, including wages, commissions, bonuses, benefits, share-based compensation, and travel, particularly with respect to research and development and sales and marketing activities. Facilities and information technology ("IT") costs are allocated to each department based on usage and headcount. 43-------------------------------------------------------------------------------- Table of Contents Three Months Ended September 30, 2014 Compared with the Three Months Ended September 30, 2013 Research and Development Research and development expense decreased slightly during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to a decrease in personnel-related expenses as a result of headcount reductions. Sales and Marketing Sales and marketing expense decreased during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to lower salaries and lower share-based compensation expense resulting from headcount reductions, and lower commission expense, resulting from a decrease in net revenues. General and Administrative General and administrative expense decreased during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to a decline in legal outside services and to a lesser extent lower personnel-related expenses as a result of headcount reductions. Restructuring and Other Charges Restructuring and other (credit) charges decreased during the three months ended September 30, 2014, compared to the same period in 2013. We completed the restructuring of our Sunnyvale campus, by assigning certain property leases to a third party. Concurrently with the assignment, we executed a sublease with the assignee for one of the properties, for a period of two years, with a one-time right to extend the term for up to six months. As a result of these arrangements, we recorded a benefit of approximately $25.0 million, which includes a reversal of our previously recorded restructuring liability and additional charges relating to facility consolidation activities in the third quarter of 2014. See Note 10, Restructuring and Other Charges, in Notes to Condensed Consolidated Financial Statements in Item 1 Part I of this Report, for further discussion of our restructuring activities. Nine Months Ended September 30, 2014 Compared with the Nine Months Ended September 30, 2013 Research and Development Research and development expense decreased during the nine months ended September 30, 2014, compared to the same period in 2013, due to lower personnel-related expenses and lower depreciation expense attributable to the extended useful lives of computers and equipment adopted in 2013, partially offset by higher share-based compensation expense and engineering program costs. Sales and Marketing Sales and marketing expense decreased during the nine months ended September 30, 2014, compared to the same period in 2013, primarily due to lower personnel-related expenses, lower share-based compensation expense, and lower travel and other discretionary expenses, partially offset by an increase in marketing related expenses. General and Administrative General and administrative expense increased by $21.4 million during the nine months ended September 30, 2014, compared to the same period in 2013, primarily due to higher litigation and investigation related costs incurred in the current period in connection with the investigations into possible violations of the U.S. Foreign Corrupt Practices Act and, to a lesser extent, our patent litigation case with Palo Alto Networks, Inc., as well as other litigation matters. Restructuring and Other Charges Restructuring and other (credit) charges increased during the nine months ended September 30, 2014, compared to the same period in 2013, primarily due to expenses recorded in connection with our 2014 Restructuring Plan. During the nine months ended September 30, 2014, we incurred $156.4 million of restructuring and other (credit) charges related to our 2014 Restructuring Plan, 44-------------------------------------------------------------------------------- Table of Contents of which $12.6 million was recorded for facility consolidation and closures, $84.7 million was recorded for asset impairment charges related to licensed software, $45.0 million for severance costs, $11.8 million of asset write-downs, and $2.3 million for contract terminations. We expect to record aggregate future charges of approximately $7.0 million to $9.0 million related to severance, facility consolidations or closures, contract terminations and other charges. See Note 10, Restructuring and Other Charges, in Notes to Condensed Consolidated Financial Statements in Item 1 Part I of this Report, for further discussion of our restructuring activities. Share-Based Compensation Share-based compensation expense associated with equity incentive awards ("awards"), which include stock options, restricted stock units ("RSUs"), restricted stock awards ("RSAs") and performance share awards ("PSAs"), as well as our Employee Stock Purchase Plan ("ESPP") was recorded in the following cost and expense categories (in millions, except percentages): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 $ Change % Change 2014 2013 $ Change % Change Cost of revenues - Product $ 1.3 $ 1.4 $ (0.1 ) (7 )% $ 3.9 $ 3.5 $ 0.4 11 % Cost of revenues - Service 3.6 3.4 0.2 6 % 10.7 11.5 (0.8 ) (7 )% Research and development 37.1 36.6 0.5 1 % 100.8 93.2 7.6 8 % Sales and marketing 15.9 20.4 (4.5 ) (22 )% 44.9 53.0 (8.1 ) (15 )% General and administrative 7.4 7.5 (0.1 ) (1 )% 25.1 19.5 5.6 29 % Total $ 65.3 $ 69.3 $ (4.0 ) (6 )% $ 185.4 $ 180.7 $ 4.7 3 % Shared-based compensation expense decreased during the three months ended September 30, 2014, compared to the same period in 2013, primarily due to a decline in shares vested, partially offset by expense related to RSUs, RSAs, and PSAs assumed in connection with our acquisition of WANDL during the first quarter of 2014 as well as expense related to market-based RSUs granted during the first quarter of 2014. Share-based compensation expense increased during the nine months ended September 30, 2014, compared to the same periods in 2013, primarily due to expense related to RSUs, RSAs, and PSAs assumed in connection with our acquisition of WANDL during the first quarter of 2014 as well as expense related to market-based RSUs granted during the first quarter of 2014, partially offset by a decline in shares vested. Other (Expense) Income, Net and Income Tax Provision The following table presents other (expense) income, net, and income tax provision (in millions, except percentages): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 $ Change % Change 2014 2013 $ Change % Change Interest income $ 2.7 $ 2.3 $ 0.4 17 % $ 6.9 $ 6.1 $ 0.8 13 % Interest expense (16.9 ) (14.2 ) (2.7 ) 19 % (50.2 ) (43.4 ) (6.8 ) 16 % Net gain on legal settlement 0.8 - 0.8 - % 196.1 - 196.1 - % (Loss) gain on investments (1.9 ) 4.0 (5.9 ) (148 )% 165.1 7.8 157.3 2,017 % Other 8.5 0.4 8.1 2,025 % 8.1 (0.7 ) 8.8 1,257 % Total other (expense) income, net $ (6.8 ) $ (7.5 ) $ 0.7 9 % $ 326.0 $ (30.2 ) $ 356.2 1,179 % Percentage of net revenues (0.6 )% (0.6 )% 9.2 % (0.9 )% Income tax provision $ 62.0 $ 38.4 $ 23.6 61 % $ 172.8 $ 52.3 $ 120.5 230 % Effective tax rate 37.4 % 27.9 % 28.4 % 15.4 % Other (Expense) Income, Net Interest income primarily includes interest earned from our cash, cash equivalents, and investments. Interest expense primarily includes interest, net of capitalized interest expense, from our long-term debt and customer financing arrangements. Other typically consists of foreign exchange gains and losses and other non-operational income and expense items. 45-------------------------------------------------------------------------------- Table of Contents During the nine months ended September 30, 2014, we entered into a settlement agreement with Palo Alto Networks, Inc. ("PAN") resolving patent litigation, which resulted in a realized gain on legal settlement and subsequent sale of related securities of $196.1 million, net of legal fees. Under the terms of the settlement, PAN made a one-time payment to us of $75.0 million in cash and issued PAN common stock and warrants to the Company. The fair value of the PAN common stock and warrants at the date of receipt was included in the net realized gain. All such PAN securities have been sold in the third quarter of 2014, and we recorded an additional $0.8 million gain during the three months ended September 30, 2014. Other (expense) income, net also includes a gain of $163.0 million, related to the sale of investments which were converted from privately-held investments to publicly-traded equity upon IPO and subsequently sold. During the three and nine months ended September 30, 2013, we recognized a net gain on investments of $3.6 million and $4.9 million, respectively, related to the Company's privately-held investments. Income Tax Provision The effective tax rate for the three and nine months ended September 30, 2014, differs from the federal statutory rate of 35% and the effective tax rates for the same periods in 2013, primarily due to the recognition of a discrete tax expense of approximately $9.2 million related to the reversal of restructuring charges in the three months ended September 30, 2014, and the tax on income from equity investments offset by the benefit from the Section 199 deduction for U.S. production activities and earnings in foreign jurisdictions, which are subject to lower tax rates. The effective tax rate for the period does not reflect the benefit of the federal R&D credit, which expired on December 31, 2013. The effective tax rate for the three and nine months ended September 30, 2013, differs from the federal statutory rate of 35% primarily due to the benefit from the Section 199 deduction for U.S. production activities, earnings in foreign jurisdictions, which are subject to lower tax rates, the impact of our recognition of tax benefits related to a tax settlement with the Internal Revenue Service ("IRS") and the reinstatement of the U.S. federal research and development ("R&D") tax credit on January 2, 2013. Our effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected to the extent earnings are lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates. Our effective tax rate could also fluctuate due to changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, or accounting principles, as well as certain discrete items. See Item1A of Part II, "Risk Factors" of this Report for a description of relevant risks which may adversely affect our results. For further explanation of our income tax provision, see Note 15, Income Taxes, in Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report. Liquidity and Capital Resources Historically, we have funded our business primarily through cash generated by our operating activities, the issuance of our common stock, and the issuance of our long-term debt. The following table presents our capital resources (in millions, except percentages): As of September 30, December 31, 2014 2013 $ Change % Change Working capital $ 1,614.3 $ 2,262.5 $ (648.2 ) (29 )% Cash and cash equivalents $ 1,615.9 $ 2,284.0 $ (668.1 ) (29 )% Short-term investments 299.5 561.9 (262.4 ) (47 )% Long-term investments 1,405.6 1,251.9 153.7 12 % Total cash, cash equivalents, and investments 3,321.0 4,097.8 (776.8 ) (19 )% Long-term debt 1,348.9 999.3 349.6 35 % Net cash, cash equivalents, and investments $ 1,972.1 $ 3,098.5 $ (1,126.4 ) (36 )% The significant components of our working capital are cash and cash equivalents, short-term investments, and accounts receivable, reduced by accounts payable, accrued liabilities, and short-term deferred revenue. Working capital decreased by $648.2 million during the nine months ended September 30, 2014, primarily due to a decrease in cash and cash equivalents as a result of our stock repurchase activities, tax payments, our first dividend payment, and a lower balance in our short term investments. 46-------------------------------------------------------------------------------- Table of Contents |