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AVAGO TECHNOLOGIES LTD - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with "Selected Financial Data" and our consolidated financial statements and notes thereto which appear elsewhere in this Annual Report on Form 10-K. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the caption "Risk Factors" or in other parts of this Annual Report on Form 10-K. Overview We are a leading designer, developer and global supplier of a broad range of analog semiconductor devices with a focus on III-V based products. III-V semiconductor materials have higher electrical conductivity and thus tend to have better performance characteristics in radio frequency, or RF, and optoelectronic applications than silicon. We differentiate ourselves through our high performance design and integration capabilities. We serve three primary target markets, with our wireless communications, wired infrastructure and industrial and automotive electronics target markets accounting for the substantial majority of our revenues. Our product portfolio is extensive and includes thousands of products. Applications for our products in these target markets include cellular phones, consumer appliances, data networking and telecommunications equipment, enterprise storage and servers, factory automation and displays. Until recently, we also sold products into the consumer and computing peripherals target market, which has historically represented a small portion of our total net revenue. However, as this became a mature and non-strategic market for us, during fiscal year 2012 we transitioned from developing, manufacturing and selling products into this target market to selling or licensing our intellectual property relevant to this target market, thereby generating royalty revenue instead of product sales revenue. We completed this transition in the fourth quarter of the fiscal year ended October 28, 2012 or fiscal year 2012. We have a 50-year history of innovation, dating back to our origins within Hewlett-Packard Company. Over the years, we have assembled a large team of analog design engineers, and we maintain design and product development engineering resources around the world. Our locations include two design centers in the United States, five in Asia and four in Europe. We have developed an extensive portfolio of intellectual property that currently includes over 4,300 U.S. and foreign patents and patent applications. Our history and market position enable us to strategically focus our research and development resources to address attractive target markets. We leverage our significant intellectual property portfolio to integrate multiple technologies and create component solutions that target growth opportunities. We design products that deliver high-performance and provide mission-critical functionality. In particular, we were among the first to deliver commercial film bulk acoustic resonator, or FBAR, filters which offer technological advantages over competing filters for smartphones to function more efficiently in today's congested RF spectrum. FBAR technology has historically maintained a significant market share within code division multiple access, or CDMA, and 3G/W-CDMA markets. As cellular carriers move to the 4G/long term evolution, or LTE standard worldwide, we believe these advantages will continue to facilitate rapid adoption of FBAR technology throughout the mobile phone ecosystems. In optical solutions, we were a pioneer in commercializing vertical-cavity surface emitting laser, or VCSEL. Our fiber optic products and our VCSEL-based products, including high bandwidth parallel optic transceivers and modules, have been widely adopted throughout the wired infrastructure and computing industries. In optoelectronics, we are a market leader in submarkets such as optocouplers and optical encoders. We have a diversified and well-established customer base of over 25,000 end customers, located throughout the world, which we serve through our multi-channel sales and fulfillment system. However, original equipment manufacturers, or OEMs, and distributors typically account for the substantial majority of our sales. We have established strong relationships with leading OEM customers across multiple target markets. Many of our major customer relationships have been in place multiple years and we have supplied multiple products during that time period. Our close customer relationships have often been built as a result of years of collaborative product development which has enabled us to build our intellectual property portfolio and develop critical expertise regarding our customer's requirements, including substantial system level knowledge. This collaboration has provided us with key insights into our customers and has enabled us to be more efficient and productive and to better serve our target markets and customers. We distribute most of our products through our broad distribution network, and a significant portion of our sales are to two of the largest global electronic components distributors, Avnet, Inc. and Arrow Electronics, Inc. We also have a direct sales force focused on supporting large OEMs. We focus on maintaining an efficient global supply chain and a variable, low-cost operating model. Accordingly, we have outsourced a majority of our manufacturing operations utilizing third-party foundry and assembly and test capabilities, as well as most of our corporate infrastructure functions. We aim to minimize capital expenditures by focusing our internal manufacturing capacity on products utilizing our innovative materials and processes to protect our intellectual property and to develop the technology for manufacturing, while outsourcing standard complementary metal oxide semiconductor, or CMOS, processes. We also have over 40 years of operating history in Asia, where approximately 57% of our employees are located and 34-------------------------------------------------------------------------------- Table of Contents where we produce and source the majority of our products. Our presence in Asia places us in close proximity to many of our customers' manufacturing facilities and at the center of worldwide electronics manufacturing. Our business is impacted by general conditions of the semiconductor industry and seasonal demand patterns in our target markets. We believe that our focus on multiple target markets and geographies helps mitigate our exposure to volatility in any single target market. Erosion of average selling prices of established products is typical of the semiconductor industry. Consistent with trends in the industry, we anticipate that average selling prices will continue to decline in the future. However, as part of our normal course of business, we plan to offset declining average selling prices with efforts to reduce manufacturing costs of existing products and the introduction of new and higher value-added products. Historically, a relatively small number of customers have accounted for a significant portion of our net revenue. Sales to distributors accounted for 32% and 37% of our net revenue for the years ended October 28, 2012 and October 30, 2011, respectively. During the fiscal year ended October 28, 2012, Foxconn Technology Group accounted for 17% of our net revenue, and our top 10 customers, which included three distributors, collectively accounted for 62% of our net revenue. During the fiscal year ended October 30, 2011, our top 10 customers, which included three distributors, collectively accounted for 54% of our net revenue. No customer accounted for 10% or more of our net revenue during the fiscal year ended October 30, 2011.We expect to continue to experience significant customer concentration in future periods. The loss of, or significant decrease in demand from, any of our top ten customers could have a material adverse effect on our business, results of operation and financial condition. The demand for our products has been affected in the past, and is likely to continue to be affected in the future, by various factors, including the following: • general economic and market conditions in the semiconductor industry and in our target markets; • our ability to specify, develop or acquire, complete, introduce and market new products and technologies in a cost-effective and timely manner; • the timing, rescheduling or cancellation of expected customer orders and our ability to manage inventory; • the rate at which our present and future customers and end-users adopt our products and technologies in our target markets; and • the qualification, availability and pricing of competing products and technologies and the resulting effects on sales and pricing of our products. Current uncertainty in global economic conditions, including the ongoing sovereign debt crisis in Europe and the potential fiscal cliff in the United States, still poses significant risks to our business. For example, customers may defer purchases in response to tighter credit and negative financial news, which would in turn negatively affect product demand and our results of operations. Net Revenue Substantially all of our net revenue is derived from sales of semiconductor devices which our customers incorporate into electronic products. We serve three primary target markets. Our wireless communications, wired infrastructure and industrial and automotive electronics account for the substantial majority of our revenues. Applications for our products in these target markets include cellular phones, consumer appliances, data networking and telecommunications equipment, enterprise storage and servers, factory automation and displays. We sell our products primarily through our direct sales force, although we also use manufacturers representatives in particular geographic areas and may use them for new customers. We also use distributors for a portion of our business and recognize revenue upon delivery of product to the distributors. Such revenue is reduced for estimated returns and distributor allowances. Our legacy consumer and computing peripherals target market historically represented a small portion of our total net revenue. As this became a mature and non-strategic market for us, during the fiscal year ended October 28, 2012 or fiscal year 2012, we transitioned from manufacturing and selling products to selling and licensing intellectual property relevant to this market, which was completed in the fourth quarter of fiscal year 2012. As a result of this transition, we now generate royalty revenue instead of product sales from this target market, and due to the structure of these licensing arrangements royalty revenue may fluctuate from period to period. Beginning with the fiscal year ending November 3, 2013, or fiscal year 2013, we will cease to separately present or discuss revenues from the consumer and computing peripherals target market. Instead, they will be combined with revenues from our industrial and automotive electronics target market, which will be referred to as our industrial and other target market. Costs and Expenses Total cost of products sold. Cost of products sold consists primarily of the cost of semiconductor wafers and other materials, and the cost of assembly and test. Cost of products sold also includes personnel costs and overhead related to our 35-------------------------------------------------------------------------------- Table of Contents manufacturing operations, including share-based compensation, and related occupancy, computer services and equipment costs, manufacturing quality, order fulfillment, warranty and inventory adjustments, including write-downs for inventory obsolescence, energy costs and other manufacturing expenses. Total cost of products sold also includes amortization of intangible assets and restructuring charges. Although we outsource a significant portion of our manufacturing activities, we do retain some semiconductor fabrication and assembly and test facilities. If we are unable to utilize our owned fabrication and assembly and test facilities at a desired level, the fixed costs associated with these facilities will not be fully absorbed, resulting in higher average unit costs and lower gross margins. Research and development. Research and development expense consists primarily of personnel costs for our engineers engaged in the design and development of our products and technologies, including share-based compensation expense. These expenses also include project material costs, third-party fees paid to consultants, prototype development expenses, allocated facilities costs and other corporate expenses and computer services costs related to supporting computer tools used in the engineering and design process. Selling, general and administrative. Selling expense consists primarily of compensation and associated costs for sales and marketing personnel, including share-based compensation expense, sales commissions paid to our independent sales representatives, costs of advertising, trade shows, corporate marketing, promotion, travel related to our sales and marketing operations, related occupancy and equipment costs and other marketing costs. General and administrative expense consists primarily of compensation and associated costs for executive management, finance, human resources and other administrative personnel, outside professional fees, allocated facilities costs and other corporate expenses. Amortization of intangible assets. In connection with acquisitions, we recorded intangible assets that are being amortized over their estimated useful lives of six months to 25 years. In connection with these acquisitions, we also recorded goodwill which is not being amortized. Interest expense. Substantially all of our historical interest expense was associated with our borrowings incurred in connection with the SPG Acquisition. This debt had been eliminated as at December 1, 2010, principally through cash flows from operations and net proceeds from our initial public offering, or IPO. On March 31, 2011, we terminated our senior secured revolving credit facility, and Avago Technologies Finance Pte. Ltd., or Avago Finance, and certain other subsidiaries of the Company entered into a new credit agreement which initially provided for a $200 million unsecured revolving credit facility. On August 6, 2012, Avago Finance exercised the accordion feature under this credit agreement to increase the aggregate commitments for its unsecured revolving credit facility from $200 million to $300 million. Interest expense in fiscal year 2012 included commitment fees under our current revolving credit facility and amortization of debt issuance costs associated with this credit facility. Loss on extinguishment of debt. In connection with the repurchase or redemption of our outstanding indebtedness, we incurred a loss on the extinguishment of debt. Other income (expense), net. Other income (expense), net includes interest income, currency gains (losses) on balance sheet remeasurement and other miscellaneous items. Provision for (benefit from) income taxes. We have structured our operations to maximize the benefit from various tax incentives and tax holidays extended to us in various jurisdictions to encourage investment or employment. For example, we have obtained several tax incentives from the Singapore Economic Development Board, an agency of the Government of Singapore, which provide that certain classes of income we earn in Singapore are subject to tax holidays or reduced rates of Singapore income tax. Each such tax incentive is separate and distinct from the others, and may be granted, withheld, extended, modified, truncated, complied with or terminated independently without any effect on the other incentives. In order to retain these tax benefits in Singapore, we must meet certain operating conditions specific to each incentive relating to, among other things, maintenance of a treasury function, a corporate headquarters function, specified intellectual property activities and specified manufacturing activities in Singapore. Some of these operating conditions are subject to phase-in periods through 2015. The Singapore tax incentives are presently scheduled to expire at various dates generally between 2014 and 2025, subject in certain cases to potential extensions. Absent such tax incentives, the corporate income tax rate in Singapore that would otherwise apply to us would be 17%. For the fiscal years ended October 28, 2012, October 30, 2011, and October 31, 2010, the effect of all these tax incentives, in the aggregate, was to reduce the overall provision for (benefit from) income taxes from what it otherwise would have been in such year by approximately $81 million, $82 million and $63 million, respectively. In February 2010, the Malaysian government granted us a tax holiday on our qualifying Malaysian income, which is effective for 10 years beginning with our fiscal year 2009. The tax incentives that we have negotiated in Malaysia and other jurisdictions are also subject to our compliance with various operating and other conditions. If we cannot, or elect not to, comply with the operating conditions included in any particular tax incentive, we will lose the related tax benefits and could be required to refund material tax benefits previously realized by us with respect to that incentive and, depending on the incentive at issue, could likely be required to modify our operational structure and tax strategy. Any such modified structure may not be as 36-------------------------------------------------------------------------------- Table of Contents beneficial to us from an income tax expense or operational perspective as the benefits provided under the present tax concession arrangements. As a result of the tax incentives and tax holidays, if we continue to comply with the operating conditions, we expect the income from our operations to be subject to relatively lower income taxes than would otherwise be the case under ordinary income tax rules. Our interpretations and conclusions regarding the tax incentives are not binding on any taxing authority, and if our assumptions about tax and other laws are incorrect or if these tax incentives are substantially modified or rescinded we could suffer material adverse tax and other financial consequences, which would increase our expenses, reduce our profitability and adversely affect our cash flows. In addition, taxable income in any jurisdiction is dependent upon acceptance of our operational practices and intercompany transfer pricing by local tax authorities as being on an arm's length basis. Due to inconsistencies in application of the arm's length standard among taxing authorities, as well as lack of adequate treaty-based protection, transfer pricing challenges by tax authorities could, if successful, substantially increase our income tax expense. Going forward, our effective tax rate will vary based on a variety of factors, including overall profitability, the geographical mix of income before income taxes and the related tax rates in the jurisdictions where we operate, as well as discrete events, such as settlements of future audits. In particular, we may owe significant taxes in jurisdictions outside Singapore during periods when we are profitable in those jurisdictions even though we may be experiencing low operating profit or operating losses on a consolidated basis, potentially resulting in significant tax liabilities on a consolidated basis during those periods. Our historical provision for (benefit from) income taxes are not necessarily reflective of our future results of operations. Critical Accounting Policies and Estimates The preparation of financial statements in accordance with generally accepted accounting principles in the United States, or GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. We base our estimates and assumptions on current facts, historical experience and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the accrual of costs and expenses that are not readily apparent from other sources. The actual results experienced by us may differ materially and adversely from our estimates. Our critical accounting policies are those that affect our historical financial statements materially and involve difficult, subjective or complex judgments by management. Those policies include revenue recognition, valuation of long-lived assets, intangible assets and goodwill, inventory valuation and warranty reserves, accounting for income taxes, retirement and post-retirement benefit plan assumptions, and share-based compensation. Revenue recognition. We recognize revenue related to sales of our products, net of sales returns and allowances, provided that (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price is fixed or determinable and (iv) collectibility is reasonably assured. Delivery is considered to have occurred when title and risk of loss have transferred to the customer. We consider the price to be fixed or determinable when the price is not subject to refund or adjustments or when any such adjustments can be estimated. We evaluate the creditworthiness of our customers to determine that appropriate credit limits are established prior to the acceptance of an order. Revenue, including sales to resellers and distributors, is reduced for estimated returns and distributor allowances. We recognize revenue from sales of our products to distributors upon delivery of product to the distributors. An allowance for distributor credits covering price adjustments and scrap allowances is made based on our estimate of historical experience rates as well as considering economic conditions and contractual terms. To date, actual distributor claims activity has been materially consistent with the provisions we have made based on our historical estimates. However, because of the inherent nature of estimates, there is always a risk that there could be significant differences between actual amounts and our estimates. Different judgments or estimates could result in variances that might be significant to reported operating results. We enter into development agreements with some of our customers and recognize revenue from these agreements upon completion and acceptance by the customer of contract deliverables or milestones or as services are provided, depending on the terms of the arrangement. Revenue is deferred for any amounts billed or received prior to completion of milestones or delivery of services. As we retain the intellectual property generated from these development agreements, costs related to these arrangements are included in research and development expense. We recognize revenue from the licensing of our intellectual property when the following fundamental criteria are met:(i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the sales price is fixed or determinable, and (iv) collection of resulting receivables is reasonably assured. Revenue from upfront payments for the licensing of our patents is recognized when the arrangement is mutually signed, if there is no future delivery or future performance obligation and all other criteria are met. Revenue from guaranteed royalty streams are recognized when paid, or collection is reasonably assured and all other criteria are met. When patent licensing arrangements include royalties for future sales of the licensees' products 37-------------------------------------------------------------------------------- Table of Contents using our licensed patented technology, revenue is recognized when the royalty report is received from the licensee, at which time the sales price is fixed and determinable, provided that all other criteria have been met. Valuation of long-lived assets, intangible assets and goodwill. We assess the impairment of long-lived assets, intangible assets and goodwill whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors we consider important, and which could trigger an impairment review of our long-lived and intangible assets, include significant underperformance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business, and significant negative industry or economic trends. An impairment loss must be measured if the sum of the expected future cash flows (undiscounted and before interest) from the use of the asset is less than the net book value of the asset. The amount of the impairment loss will generally be measured as the difference between the net book value of the asset (or asset group) and its (their) estimated fair value. We perform an annual impairment review of our goodwill during the fourth fiscal quarter of each year, and more frequently if we believe indicators of impairment exist, and we follow the two-step approach in performing the impairment test in accordance with the accounting guidance on goodwill and other intangible assets. The first step of the goodwill impairment test compares the estimated fair value of the reporting unit with the related carrying amount. If the fair value of the reporting unit exceeds its carrying amount, the reporting unit's goodwill is not considered to be impaired and the second step of the impairment test is unnecessary. If the reporting unit's carrying amount exceeds its estimated fair value, the second step of the test must be performed to measure the amount of the goodwill impairment loss, if any. The second step of the test compares the implied fair value of the reporting unit's goodwill, determined in the same manner as the amount of goodwill recognized in a business combination, with the carrying amount of such goodwill. If the carrying amount of the reporting unit's goodwill exceeds the implied fair value, an impairment loss is recognized in an amount equal to that excess. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment. We have one reporting unit for goodwill impairment testing purposes which is based on the manner in which we operate our business and the nature of those operations, including consideration of how the Chief Operating Decision Maker, as defined in the accounting guidance on segment reporting, manages the business as a whole. We operate as one semiconductor company with sales of semiconductors representing the only material source of revenue. Substantially all products offered incorporate analog functionality and are manufactured under similar manufacturing processes. For fiscal year 2012, we used the quoted market price of our ordinary shares to determine the fair value of our reporting unit, which is the Company as a whole. No impairment of goodwill was identified based on the annual impairment review during the fourth quarter of fiscal year 2012. A 10% decline in the quoted market prices of our ordinary shares would not impact the result of our goodwill impairment assessment. The process of evaluating the potential impairment of long-lived assets under the accounting guidance on property, plant and equipment such as our property, plant and equipment and other intangible assets is also highly subjective and requires significant judgment. In order to estimate the fair value of long-lived assets, we typically make various assumptions about the future prospects about our business or the part of our business that the long-lived asset relates to, consider market factors specific to the business and estimate future cash flows to be generated by the business, which requires significant judgment as it is based on assumptions about market demand for our products over a number of future years. Based on these assumptions and estimates, we determine whether we need to take an impairment charge to reduce the value of the long-lived asset stated on our balance sheet to reflect its estimated fair value. Assumptions and estimates about future values and remaining useful lives are complex and often subjective. They can be affected by a variety of factors, including external factors such as the real estate market, industry and economic trends, and internal factors such as changes in our business strategy and our internal forecasts. Although we believe the assumptions and estimates we have made in the past have been reasonable and appropriate, changes in assumptions and estimates could materially impact our reported financial results. Inventory valuation and warranty reserves. We value our inventory at the lower of the actual cost of the inventory or the current estimated market value of the inventory, with cost being determined under the first-in, first-out method. We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on our forecast of product demand and production requirements. Demand for our products can fluctuate significantly from period to period. A significant decrease in demand could result in an increase in the amount of excess inventory quantities on hand. In addition, our industry is characterized by rapid technological change, frequent new product development and rapid product obsolescence that could result in an increase in the amount of obsolete inventory quantities on hand. Additionally, our estimates of future product demand may prove to be inaccurate, which may cause us to understate or overstate both the provision required for excess and obsolete inventory and cost of products sold. Therefore, although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our results of operations. We establish reserves for estimated product warranty costs at the time revenue is recognized. Although we engage in extensive product quality control programs and processes, our warranty obligation has been and may in the future be affected by product failure rates, product recalls, repair or field replacement costs and additional development costs incurred in correcting any product failure, as well as possible claims 38-------------------------------------------------------------------------------- Table of Contents for consequential costs. Should actual product failure rates, use of materials or service delivery costs differ from our estimates, additional warranty reserves could be required. In that event, our gross margins would be reduced. Accounting for income taxes. We account for income taxes in accordance with the accounting guidance on income taxes. The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Significant management judgment is required in developing our provision for income taxes, including the determination of deferred tax assets and liabilities and any valuation allowances that might be required against the deferred tax assets. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for valuation allowances. If we determine, in the future, a valuation allowance is required, such adjustment to the deferred tax assets would increase tax expense in the period in which such determination is made. Conversely, if we determine, in the future, a valuation allowance exceeds our requirement, such adjustment to the deferred tax assets would decrease tax expense in the period in which such determination is made. In evaluating the exposure associated with various tax filing positions, we accrue an income tax liability when such positions do not meet the more-likely-than-not threshold for recognition. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax law and regulations in a multitude of jurisdictions. We recognize potential liabilities for anticipated tax audit issues in Singapore and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes and interest will be due. If our estimate of income tax liabilities proves to be less than the actual amount ultimately assessed, a further charge to expense would be required. If the payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities no longer exist. The gross unrecognized tax benefit decreased by $3 million during fiscal year 2012 to $27 million as of October 28, 2012 from $30 million as of October 30, 2011. The gross unrecognized tax benefit as of October 31, 2010 was 27 million. We recognize interest and penalties related to unrecognized tax benefits within the provision for (benefit from) income taxes line in the consolidated statement of operations. Accrued interest and penalties are included within the other long-term liabilities line in the consolidated balance sheet. As of October 28, 2012, October 30, 2011, and October 31, 2010, the combined amount of cumulative accrued interest and penalties was approximately $4 million, $6 million and $5 million, respectively. Retirement and post-retirement benefit plan assumptions. Retirement and post-retirement benefit plan costs are a significant cost of doing business. They represent obligations that will ultimately be settled sometime in the future and therefore are subject to estimation. Pension accounting is intended to reflect the recognition of future retirement and post-retirement benefit plan costs over the employees' average expected future service to the Company, based on the terms of the plans and investment and funding decisions. To estimate the impact of these future payments and our decisions concerning funding of these obligations, we are required to make assumptions using actuarial concepts within the framework of GAAP. One critical assumption is the discount rate used to calculate the estimated costs. Other important assumptions include the expected long-term return on plan assets, the health care cost trend rate, expected future salary increases, expected future increases to benefit payments, expected retirement dates, employee turnover, retiree mortality rates, and portfolio composition. We evaluate these assumptions at least annually. The discount rate is used to determine the present value of future benefit payments at the relevant measurement dates - October 28, 2012 and October 30, 2011, for both U.S. and non-U.S. plans, in fiscal years 2012 and 2011, respectively. For fiscal years 2012 and 2011, the U.S. discount rates were based on the results of matching expected plan benefit payments with cash flows from a published pension discount curve. The discount rate for non-U.S. plans was generally based on published rates for high quality corporate bonds. Lower discount rates increase present values of pension liability and subsequent year pension expense; higher discount rates decrease present values of pension liability and subsequent year pension expense. The expected long-term return on plan assets is estimated using current and expected asset allocations as well as historical and expected returns. Plan assets are valued at fair value. A one percent change in the estimated long-term return on plan assets for assumptions set in 2012 would result in a $0 million impact on non-U.S. pension expense for fiscal year 2013. We have no plan assets under our U.S. plans. The net periodic retirement and post-retirement benefit costs recorded in consolidated statement of operations excluding curtailments and settlements were $7 million in fiscal year 2012, $6 million in fiscal year 2011, and $4 million in fiscal year 2010. 39-------------------------------------------------------------------------------- Table of Contents Share-based compensation expense. Share-based compensation expense consists of expense for stock options and restricted share units, or RSUs, granted to both employees and non-employees as well as expense associated with Avago Technologies Limited Employee Share Purchase Plan, or ESPP, which was implemented in September 2010. For stock options granted after November 1, 2006, we recognize compensation expense based on the estimated grant date fair value method required under the authoritative guidance using Black-Scholes valuation model with a straight-line amortization method. Since the authoritative guidance requires that share-based compensation expense be based on awards that are ultimately expected to vest, estimated share-based compensation expense for such awards has been reduced for estimated forfeitures. Changes in the estimated forfeiture rates can have a significant effect on share-based compensation expense since the effect of adjusting the rate is recognized in the period the forfeiture estimate is changed. The weighted-average assumptions utilized for our Black-Scholes valuation model for options and employee share purchase rights granted during the fiscal years ended October 28, 2012, October 30, 2011 and October 31, 2010 are as follows: Options ESPP Year Ended Year Ended October 28, 2012 October 30, 2011 October 31, 2010 October 28, 2012 October 30, 2011 October 31, 2010 Risk-free interest rate 0.8 % 2.0 % 1.9 % 0.1 % 0.1 % 0.2 % Dividend yield 1.4 % 0.9 % - % 1.4 % 0.6 % - % Volatility 53.0 % 45.0 % 45.0 % 50.4 % 42.6 % 42.0 % Expected term (in years) 5.0 5.0 5.0 0.5 0.5 0.5 The dividend yields for the years ended October 28, 2012 and October 30, 2011 are based on the historical and expected dividend payouts as of the respective option grant dates. For the year ended October 31, 2010, the dividend yield of zero is based on the fact that we did not intend to declare any cash dividends as of the respective option grant dates during that period. Expected volatility is based on the combination of historical volatility of guideline publicly-traded companies over the period commensurate with the expected term of the options and the implied volatility of guideline publicly-traded companies from traded options with a term of 180 days or greater measured over the last three months. The risk-free interest rate is derived from the average U.S. Treasury Strips rate during the period, which approximates the rate in effect at the time of grant. Our computation of expected term was based on other data, such as the data of peer companies and company-specific attributes that we believe could affect employees' exercise behavior. In fiscal year 2010, we began to grant RSUs, which are equity awards that are granted with an exercise price equal to zero and represent the right to receive one of our ordinary shares per RSU immediately upon vesting. We recognize compensation expense for RSUs using the straight-line amortization method based on the fair value of RSUs on the date of grant. The fair value of RSUs is the closing market price of our ordinary shares on the date of grant, which is equal to their intrinsic value on the date of grant. We also record share-based compensation expense based on an estimate of the fair value of rights to purchase ordinary shares under the ESPP and recognize this share-based compensation expense using the straight-line amortization method. Employee Bonus Programs. Our employee bonus programs, which are overseen by our Compensation Committee, provide for variable compensation based on the attainment of overall corporate annual targets and functional performance metrics. In the first fiscal quarter of the year, if management determines that it is probable that the targets and metrics will be achieved, the amounts can be reasonably estimated, a variable, proportional compensation accrual is recorded based on an assumed 100 percent achievement of the targets and metrics. The bonus payout levels can be greater if attainment of metrics and targets is greater than 100% and a portion of the payouts may not occur if a minimum floor of performance is not achieved. In subsequent quarters, we monitor and accrue for variable compensation expense based on our actual progress toward the achievement of the annual targets and metrics. The actual achievement of target metrics at the end of the fiscal year, which is subject to approval by our Compensation Committee, may result in the actual variable compensation amounts being significantly higher or lower than the relevant estimated amounts accrued in earlier quarters, which would result in a corresponding adjustment in the fourth fiscal quarter. Fiscal Year Presentation We operate on a 52 or 53-week fiscal year which ends on the Sunday closest to October 31. Each of fiscal years 2012, 2011 and 2010 consisted of 52 weeks. Fiscal year 2013 will consist of 53 weeks, with the extra week falling in the first quarter of fiscal year 2013. The financial statements included in this Annual Report on Form 10-K are presented in accordance with GAAP and expressed in U.S. dollars. 40-------------------------------------------------------------------------------- Table of Contents Results from Operations Year Ended October 28, 2012 Compared to Year Ended October 30, 2011 The following tables set forth our results of operations for the years ended October 28, 2012 and October 30, 2011. Year Ended October 28, 2012 October 30, 2011 October 28, 2012 October 30, 2011 (In millions) (As a percentage of net revenue) Statement of Operations Data: Net revenue $ 2,364 $ 2,336 100 % 100 % Cost of products sold: Cost of products sold 1,164 1,133 49 49 Amortization of intangible assets 56 56 3 2 Restructuring charges 2 - - - Total cost of products sold 1,222 1,189 52 51 Gross margin 1,142 1,147 48 49 Research and development 335 317 14 14 Selling, general and administrative 199 220 8 9 Amortization of intangible assets 21 22 1 1 Restructuring charges 5 4 - - Total operating expenses 560 563 23 24 Income from operations 582 584 25 25 Interest expense (1 ) (4 ) - - Loss on extinguishment of debt - (20 ) - (1 ) Other income, net 4 1 - - Income before income taxes 585 561 25 24 Provision for income taxes 22 9 1 - Net income $ 563 $ 552 24 % 24 % Net revenue. Net revenue was $2,364 million for fiscal year 2012, compared to $2,336 million for fiscal year 2011, an increase of $28 million or 1%. The slight increase in net revenue was primarily due to strength in our wireless communications target market, largely offset by weakness in our industrial target market. Net revenue from our consumer and computing peripherals target market remained relatively flat compared to fiscal year 2011, benefiting from the last time purchases of product due to our transition from manufacturing and sales of products to an intellectual property licensing and royalty business model in this target market. This transition was completed in the fourth quarter of fiscal year 2012. Our three largest target markets, by revenue, are wireless communications, wired infrastructure and industrial and automotive electronics. Our legacy consumer and computing peripherals target market has typically represented a much smaller percentage of our overall net revenue. The percentage of total net revenue generated by sales in each of our target markets varies from quarter to quarter, due largely to fluctuations in end-market demand, including the effects of seasonality. The first fiscal quarter is typically our lowest revenue and cash generating quarter due, in part, to holiday shutdowns at many OEM customers and distributors, and the first half of the fiscal year tends to generate lower revenue than the second half. However, typical seasonality and industry cyclicality may be overshadowed by other factors such as wider macroeconomic effects, timing of significant product transitions and launches by large OEMs and new product launches by our competitors. In fiscal year 2012, strength in the smartphone market and strong product ramps at certain of our OEMs in this market more than offset weakness in our net revenue from industrial target market caused by continued supply chain contraction. Weakness in industrial spending, in China in particular, also adversely impacted revenue from our industrial target market in fiscal year 2012. 41-------------------------------------------------------------------------------- Table of Contents Historically, a relatively small number of customers have accounted for a significant portion of our net revenue. During the fiscal year ended October 28, 2012, Foxconn Technology Group companies accounted for 17% of our net revenue. Our top 10 customers for fiscal year ended October 28, 2012, which included three distributors each, collectively accounted for 62% of our net revenue. However, we believe that aggregate sales of our products to certain of our customers exceeds the amount of our direct sales to them. For example, we believe our aggregate sales to two OEMs, when direct sales are combined with indirect sales to them through the respective contract manufacturers that they utilize, each accounted for more than 10% of our net revenues, for the fiscal year ended October 28, 2012. We expect to continue to experience significant customer concentration in future periods. The loss of, or significant decrease in demand from, any of our top ten customers could have a material adverse effect on our business, results of operation and financial condition. Net revenue by target market data is derived from our understanding of our end customers' primary markets, and was as follows: Year Ended % of Net Revenue October 28, 2012 October 30, 2011 Change Wireless communications 45 % 38 % 7 % Wired infrastructure 28 28 - Industrial and automotive electronics 22 29 (7 ) Consumer and computing peripherals 5 5 - Total net revenue 100 % 100 % Year Ended October 28, October 30, Net Revenue 2012 2011 Change (In millions) Wireless communications $ 1,064 $ 887 $ 177 Wired infrastructure 662 659 3 Industrial and automotive electronics 518 672 (154 ) Consumer and computing peripherals 120 118 2 Total net revenue $ 2,364 $ 2,336 $ 28 Net revenue from our wireless communications target market increased in fiscal year 2012 compared with the corresponding prior year periods due to continued strength in mobile smartphone sales and new handset ramps incorporating our products at major smartphone OEMs. We experienced higher demand for our multi-mode, multi-band power amplifiers, in particular, as well as for our FBAR duplexers in fiscal year 2012. Demand for FBAR duplexers in fiscal year 2012 also benefited from transitions by various cellular carriers to the 4G/LTE standard. Net revenue from our wired infrastructure target market remained relatively flat in fiscal year 2012, compared with fiscal year 2011. During fiscal year 2012, we saw strong growth from sales of our ASICs used in data center applications compared to fiscal year 2011. Revenues from this target market for fiscal year 2012 also reflect an increase in development agreement and intellectual property licensing revenue of $12 million. However for fiscal year 2012, these effects were substantially offset by a decrease in high-performance computing hardware sales, as well as a pullback in sales of proprietary parallel optics at several of our large communications OEM customers due to weak core routing spending with service providers. Net revenue from our industrial and automotive electronics target market decreased in fiscal year 2012 compared with fiscal year 2011. This decrease was due primarily to continued, and worse than expected, supply chain corrections and weakness in industrial spending, in China in particular, in fiscal year 2012 compared with fiscal year 2011. These effects were partially offset by increases in revenue from development agreements and the sale of certain of our intellectual property of approximately $6 million, for fiscal year 2012. Net revenue from our legacy consumer and computing peripherals target market increase slightly in fiscal year 2012 compared with fiscal year 2011. This was largely due to the last time purchases of product in the third quarter of fiscal year 2012, resulting from our transition from manufacturing and sales of products to an intellectual property licensing and royalty business model in this target market. The transition to the intellectual property licensing royalty model was completed in the fourth quarter of fiscal year 2012. During the fiscal year 2012, we generated approximately $23 million in intellectual property- 42-------------------------------------------------------------------------------- Table of Contents related revenue from this target market. Due to the structure of these licensing arrangements, royalty revenue may fluctuate from period to period. Gross margin. Gross margin was $1,142 million for fiscal year 2012 compared to $1,147 million for fiscal year 2011, a decrease of $5 million. As a percentage of net revenue, gross margin decreased slightly to 48% for fiscal year 2012, compared to 49% fiscal year 2011. The slight decrease in gross margin in fiscal year 2012 was driven by product mix, with a higher proportion of sales into our wireless communication target market compared to sales into our higher-margin industrial and automotive electronics target market. This mix effect was substantially offset by (i) an increase in revenue from development agreements and sales and licensing of intellectual property of $51 million in fiscal year 2012 (ii) a $12 million decrease in cost of products sold due to a revision in wafer cost allocation methodology during fiscal year 2012, and (iii) a $8 million decrease in depreciation expense during the fiscal year 2012, resulting from a change in the duration of the useful lives of certain of our manufacturing equipment which occurred in the fourth quarter of fiscal year 2011. During the fiscal quarter ended January 29, 2012, we revised our cost allocation methodology to fully burden with overhead costs the expense for wafers used in research and development projects that are processed through our internal fabrication facilities, or R&D wafer cost allocation methodology. Research and development. Research and development expense was $335 million for fiscal year 2012, compared to $317 million for fiscal year 2011, an increase of $18 million or 6%. As a percentage of net revenue, research and development expenses remained flat at 14% for fiscal year 2012, compared to fiscal year 2011. The majority of this increase, in absolute dollars, resulted from investments in our wired infrastructure and wireless communications solutions. Part of the increase was attributable to a $15 million increase in research and development project consumables and services, $12 million of which was due to the change in R&D wafer cost allocation methodology, as discussed above under Gross margin, which increased gross margin by a corresponding amount. The overall dollar increase in research and development expense was also attributable to an $8 million increase in depreciation expense related to capital expenditures supporting research and development efforts, a $7 million increase in salaries and employee benefits expense, and a $6 million increase in share-based compensation expense attributable to grants of share-based awards at higher fair market values and to our ESPP. These increases were partially offset by a $13 million decrease in accrued incentive compensation expense related to our employee bonus program, which is a variable expense related to our achievement of program performance metrics, and a $3 million decrease in computer software expenses in fiscal year 2012, compared to the fiscal year 2011. The overall dollar increase in research and development expense is also net of $7 million in accrued reimbursements pursuant to research and development grants. We expect research and development expenses to increase in absolute dollars for the foreseeable future, due to the increasing complexity and number of products we plan to develop. Selling, general and administrative. Selling, general and administrative expense was $199 million for the year ended October 28, 2012 compared to $220 million for the year ended October 30, 2011, a decrease of $21 million or 10%. As a percentage of net revenue, selling, general and administrative expense decreased slightly to 8% for the year ended October 28, 2012 compared to 9% for the year ended October 30, 2011. Changes in components of selling, general and administrative expense for the fiscal year 2012, compared to the fiscal year 2011, consisted of a $13 million decrease in legal expenses related to offensive litigation matters, a $8 million decrease in accrued incentive compensation expense related to our performance-based employee bonus program, a $4 million decrease in external services related to consulting and IT, a $3 million decrease in depreciation expense, and a $2 million decrease in salaries and wages expense, partially offset by a $7 million increase in share-based compensation expense attributable to grants of share-based awards at higher fair market values and to our ESPP. Amortization of intangible assets. Total amortization of intangible assets incurred was $77 million and $78 million, respectively, for fiscal years 2012 and 2011. Restructuring charges. We incurred total restructuring charges of $7 million for fiscal year 2012 compared to $4 million for fiscal year 2011, both predominantly representing employee termination costs. Interest expense. Interest expense was $1 million for fiscal year 2012, compared to $4 million for fiscal year 2011, which represents a decrease of $3 million. The decrease is primarily due to the redemption of the remaining $230 million aggregate principal amount of our senior subordinated rate notes on December 1, 2010. Loss on extinguishment of debt. During fiscal year 2011, we redeemed $230 million aggregate principal amount of our senior subordinated notes. The redemption of the senior subordinated notes resulted in a loss on extinguishment of debt of $19 million. During fiscal year 2011, we also terminated our senior secured revolving credit facility. There were no outstanding loan borrowings under this facility at the time of termination. This termination resulted in a loss on extinguishment of debt of $1 million, related to the write-off of debt amortization costs and other related expenses. See Note 7. "Borrowings" to the Consolidated Financial Statements. Other income, net. Other income, net includes interest income, foreign currency gain (loss), loss on other-than-temporary impairment of investment and other miscellaneous items. Other income, net was $4 million for fiscal year 2012 compared to 43-------------------------------------------------------------------------------- Table of Contents other income, net of $1 million for fiscal year 2011. This increase in other income, net for fiscal year 2012 is primarily attributable to an increase in interest income due to higher cash balances compared to prior year. Provision for income taxes. We recorded an income tax expense totaling $22 million for fiscal year 2012 compared to an income tax expense of $9 million for fiscal year 2011. The increase is primarily attributable to an increase in worldwide income, change in the jurisdictional mix of income and expense and the expiration of the research and development tax credit in the U.S. on December 31, 2011. The provision for income taxes in 2011 is net of a $3 million tax benefit for the increase in deferred tax assets from U.S. legislation retroactively reinstating the research and development tax credit and a $3 million tax benefit from a change in estimate related to research and development tax credits. Year Ended October 30, 2011 Compared to Year Ended October 31, 2010 The following tables set forth our results of operations for the years ended October 30, 2011 and October 31, 2010. Year Ended October 30, 2011 October 31, 2010 October 30, 2011 October 31, 2010 (In millions) (As a percentage of net revenue) Statement of Operations Data: Net revenue $ 2,336 $ 2,093 100 % 100 % Cost of products sold: Cost of products sold 1,133 1,068 49 51 Amortization of intangible assets 56 58 2 3 Restructuring charges - 1 - - Total cost of products sold 1,189 1,127 51 54 Gross margin 1,147 966 49 46 Research and development 317 280 14 14 Selling, general and administrative 220 196 9 9 Amortization of intangible assets 22 21 1 1 Restructuring charges 4 3 - - Total operating expenses 563 500 24 24 Income from operations 584 466 25 22 Interest expense (4 ) (34 ) - (2 ) Loss on extinguishment of debt (20 ) (24 ) (1 ) (1 ) Other income (expense), net 1 (2 ) - - Income before income taxes 561 406 24 19 Provision for income taxes 9 (9 ) - (1 ) Net income $ 552 $ 415 24 % 20 % Net revenue. Net revenue was $2,336 million for fiscal year 2011, compared to $2,093 million for fiscal year 2010, an increase of $243 million or 12%. Net revenue increased during fiscal year 2011 primarily due to strength in our wired infrastructure target market, as well as strength in our wireless communications and industrial and automotive electronics target markets. The year over year increase in net revenue was partially due to improved general economic conditions during the year, compared to fiscal year 2010 and also due to our introduction of a number of new, proprietary products, which helped us to grow net revenues substantially over the period. 44-------------------------------------------------------------------------------- Table of Contents Net revenue by target market data is derived from our understanding of our end customers' primary markets, and was as follows: Year Ended October 30, October 31, % of Net Revenue 2011 2010 Change Wireless communications 38 % 38 % - % Industrial and automotive electronics 29 29 - Wired infrastructure 28 24 4 Consumer and computing peripherals 5 9 (4 ) Total net revenue 100 % 100 % Year Ended October 30, October 31, Net Revenue 2011 2010 Change (In millions) Wireless communications $ 887 $ 796 $ 91 Industrial and automotive electronics 672 605 67 Wired infrastructure 659 509 150 Consumer and computing peripherals 118 183 (65 ) Total net revenue $ 2,336 $ 2,093 $ 243 Net revenue from wireless communications products, increased in absolute dollars in fiscal year 2011, compared with fiscal year 2010, while remaining flat as a percentage of net revenue. The launch of next-generation smartphones at leading new and existing OEM customers, which incorporate many of our proprietary products such as 3G and 4G radio frequency filters and power amplifiers drove revenue growth during fiscal year 2011. Net revenue from our industrial and automotive electronics products increased in absolute dollars in fiscal year 2011, compared with fiscal year 2010, while remaining flat as a percentage of net revenue. The increase in the fiscal year 2011 was due to particular strength in sales of optocouplers, industrial fiber optic transceivers and industrial motion encoders. We continued to benefit from strong demand in renewable energy, smart power grid installations and transportation applications, in both developed economies and emerging economies such as China. Demand in our industrial market slowed towards the end of fiscal year 2011 as a result of slower economic growth in China and a slow-down in the renewable energy sector. We believe this has caused some ongoing inventory corrections in the supply chain in this target market. The effects of this were particularly noticeable in demand for servo drives and inverters for renewable energy applications in Europe and Asia-Pacific towards the end of fiscal year 2011. Net revenue from our wired infrastructure target market increased substantially, in absolute dollars and also increased as a percentage of net revenue, in fiscal year 2011, compared with fiscal year 2010. Spending on enterprise networking data centers, storage systems and core routing grew during the year. In addition, we introduced a number of new fiber optic transceivers and ASICs in fiscal year 2011, compared with fiscal year 2010, which contributed to the increase in revenue. The strong growth in sales of our ASIC products compared to fiscal year 2010 was due primarily to strength in next-generation data center switching. Increase in revenue recognized on development contracts for future ASIC products in fiscal year 2011, compared with fiscal year 2010, also contributed to the increase in revenue. Net revenue from our consumer and computing peripheral target market decreased in absolute dollars and as a percentage of net revenue in fiscal year 2011, compared with fiscal year 2010. This reflected a decline in sales of optical sensors used in optical mice and sales of motion encoders used in applications such as optical disc drives and printers in fiscal year 2011. Net revenue from this target market during this period was also affected by ongoing softness in the personal computer and printer market. Gross margin. Gross margin was $1,147 million for fiscal year 2011 compared to $966 million for fiscal year 2010, an increase of $181 million or 19%. As a percentage of net revenue, gross margin increased to 49% for fiscal year 2011 from 46% for fiscal year 2010. The increase in gross margin percentage was primarily attributable to continuing improvements in product mix. During fiscal year 2011, compared fiscal year 2010, a higher proportion of our net revenues were from products sold into the wired infrastructure target market and from sales of our proprietary products, which generally earn higher gross margins than our other products, partially offset by continued strong sales of our wireless products and changes in the mix of our wireless products. Gross margin benefited from a reduction in depreciation expense of $3 million in fiscal year 2011 resulting from a change in the duration of the useful lives of certain of our assembly and test equipment. We also released charges of 45-------------------------------------------------------------------------------- Table of Contents $7 million during fiscal year 2011 for warranty costs compared to charges of $12 million recorded in fiscal year 2010. See Note 15. "Commitments and Contingencies" to the Consolidated Financial Statements. Research and development. Research and development expense was $317 million for fiscal year 2011, compared to $280 million for fiscal year 2010, an increase of $37 million or 13%. As a percentage of net revenue, research and development expenses remained flat at 14% for fiscal year 2011 compared to fiscal year 2010. The increase in absolute dollars was primarily attributable to $13 million in additional research and development project materials and supplies, an $8 million increase in compensation expense resulting from annual salary adjustment, a $6 million increase in share-based compensation expense due to grants of share-based awards at higher fair market values, a $5 million increase in depreciation expense and a $2 million increase in hardware test services in fiscal year 2011 as compared to fiscal year 2010. These increases were partially offset by $1 million in accrued reimbursements pursuant to research and development grants. Selling, general and administrative. Selling, general and administrative expense was $220 million for the year ended October 30, 2011 compared to $196 million for the year ended October 31, 2010, an increase of $24 million or 12%. As a percentage of net revenue, selling, general and administrative expense remained flat at 9% for the year ended October 30, 2011 compared to the year ended October 31, 2010. The increase in absolute dollars was attributable to an $8 million increase in legal expenses related to offensive litigation matters initiated in fiscal year 2010, a $7 million increase in compensation expense resulting from annual salary adjustments, a $6 million increase in share-based compensation expense due to grants of share-based awards at higher fair market values, a $2 million increase in sales commissions expense paid to our sales employees, and a $2 million increase in third party IT fees, partially offset by a $5 million decrease in incentive compensation expense related to our employee bonus program, which is a variable expense related to our overall profitability in fiscal year 2011 as compared to fiscal year 2010. Amortization of intangible assets. Total amortization of intangible assets incurred was $78 million and $79 million, respectively, for fiscal years 2011 and 2010. Restructuring charges. During fiscal year 2011, we incurred total restructuring charges of $4 million, compared to $4 million for fiscal year 2010, both predominantly representing employee termination costs. Interest expense. Interest expense was $4 million for fiscal year 2011, compared to $34 million for fiscal year 2010, which represents a decrease of $30 million. The decrease is primarily due to the redemption of the remaining $230 million aggregate principal amount of our senior subordinated rate notes on December 1, 2010. Loss on extinguishment of debt. During fiscal year 2011, we redeemed $230 million aggregate principal amount of our senior subordinated notes. The redemption of the senior subordinated notes resulted in a loss on extinguishment of debt of $19 million. During fiscal year 2011, we also terminated our senior secured revolving credit facility. There were no outstanding loan borrowings under this facility at the time of termination. This termination resulted in a loss on extinguishment of debt of $1 million, related to the write-off of debt amortization costs and other related expenses. During fiscal year 2010, we redeemed $318 million aggregate principal amount of our senior fixed rate notes and the remaining $46 million aggregate principal amount of our senior floating rate notes. The redemption of the senior fixed rate notes and senior floating rate notes in fiscal year 2010 resulted in a loss on extinguishment of debt of $24 million. See Note 7. "Borrowings" to the Consolidated Financial Statements. Other income (expense), net. Other income (expense), net includes interest income, foreign currency gain (loss), loss on other-than-temporary impairment of investment and other miscellaneous items. Other income, net was $1 million for fiscal year 2011 compared to other expense, net was $2 million for fiscal year 2010. The increase to other income, net for fiscal year 2011, compared to other expense, net for fiscal year 2010 is primarily attributable to a decrease in foreign currency losses, and an increase in interest income due primarily to higher cash balances compared to the same period in prior year. Provision for (benefit from) income taxes. We recorded an income tax expense totaling $9 million for fiscal year 2011 compared to an income tax benefit of $9 million for fiscal year 2010. The provision for income taxes in 2011 included a $3 million tax benefit for the increase in deferred tax assets from U.S. legislation retroactively reinstating the research and development tax credit and a $3 million tax benefit from a change in estimate related to research and development tax credits. The benefit from income taxes in 2010 included a $29 million benefit from the release of deferred tax asset valuation allowances, mainly associated with irrevocably calling our senior subordinated notes for redemption in October 2010, partially offset by a write-off of $6 million of deferred tax assets resulting from the grant of a new tax incentive in Malaysia. Liquidity and Capital Resources The following section discusses our principal liquidity and capital resources as well as our principal liquidity requirements and sources and uses of cash. Our cash and cash equivalents are maintained in highly liquid investments with remaining maturities of 90 days or less at the time of purchase. We believe our cash equivalents are liquid and accessible. The majority of our cash and cash equivalents are held in financial institutions in Singapore. 46-------------------------------------------------------------------------------- Table of Contents Our primary sources of liquidity as at October 28, 2012 consisted of: (1) approximately $1,084 million in cash and cash equivalents, (2) cash we expect to generate from operations and (3) our $300 million revolving credit facility, which is committed until March 31, 2015, all of which is available to be drawn. Our short-term and long-term liquidity requirements primarily arise from: (i) working capital requirements, (ii) research and development and capital expenditure needs, including acquisitions from time to time and (iii) quarterly dividend payments (if and when declared by our Board) and any share repurchases we may choose to make under our share repurchase program. Our ability to fund these requirements will depend on our future cash flows, which are determined by future operating performance and are, therefore, subject to prevailing global macroeconomic conditions and financial, business and other factors, some of which are beyond our control. In June 2011, our board of directors authorized the repurchase of up to 15 million of the Company's outstanding ordinary shares, not to exceed $500 million, in the aggregate, referred to as the 2011 share repurchase program, in open market transactions prior to our 2012 Annual General Meeting of the Company, which was held on April 4, 2012. During the year ended October 28, 2012, we repurchased an aggregate of 2.8 million shares for an aggregate purchase price of $85 million, under the 2011 share repurchase program. On April 4, 2012, our Board of Directors authorized the Company to repurchase up to 15 million of its ordinary shares, referred to as the 2012 share repurchase program. For the fiscal year ended October 28, 2012, the Company repurchased 0.7 million shares for an aggregate of purchase price of $25 million in cash under the 2012 share repurchase program. Share repurchases under our share repurchase programs are made in the open market at such times and in such amounts as the Company deems appropriate. The timing and actual number of shares repurchased depend on a variety of factors including price, market conditions and applicable legal requirements. The 2012 share repurchase program does not obligate the Company to repurchase any specific number of shares and may be suspended or terminated at any time without prior notice. The 2012 share repurchase program will expire at the Company's 2013 AGM, unless earlier terminated. Our cash and cash equivalents increased by $255 million to $1,084 million at October 28, 2012 from $829 million at October 30, 2011 primarily as a result of $693 million in cash provided by operating activities and $44 million in cash received from the issuance of ordinary shares pursuant to the exercise of options under our employee share option plans and purchase rights under our employee share purchase plan. Partially offsetting this increase were $241 million cash paid for capital expenditures, $110 million of cash paid to repurchase 3.5 million of our ordinary shares, and $137 million in dividends paid to our shareholders. We believe that our cash and cash equivalents on hand, and cash flows from operations, combined with availability under our revolving credit facility, will provide sufficient liquidity to fund our current obligations, projected working capital requirements, capital spending, quarterly dividends (if and when declared by our Board) and any share repurchases we may choose to make under our share repurchase program for at least the next 12 months. We anticipate that our capital expenditures for fiscal year 2013 may be incrementally higher than for fiscal year 2012, due primarily to increased spending on capacity expansion in our Fort Collins internal fabrication facility, as well as spending on equipment to support various research and development projects. If we do not have sufficient cash to fund our operations or finance growth opportunities, including acquisitions, or unanticipated capital expenditures, our business and financial condition could suffer. We could also reduce certain expenditures such as repurchases of our ordinary shares and payment of our quarterly dividend. In such circumstances we may seek to obtain debt or equity financing in the future. However, we cannot assure that such additional financing will be available on terms acceptable to us or at all. Our ability to service any indebtedness we may incur, including under our revolving credit facility, will depend on our ability to generate cash in the future. In addition, even though we may not need additional funds, we may still elect to sell additional debt or equity securities or increase our current credit facility for other reasons. The following table summarizes our cash flows for the periods indicated (in millions): Year Ended October 28, 2012 October 30, 2011 October 31, 2010 Net cash provided by operating activities $ 693 $ 726 $ 510 Net cash used in investing activities (244 ) (122 ) (86 ) Net cash used in financing activities (194 ) (336 ) (335 ) Net increase in cash and cash equivalents $ 255 $ 268 $ 89 Cash Flows for the Years Ended October 28, 2012 and October 30, 2011 Operating Activities Net cash provided by operating activities during the year ended October 28, 2012 was $693 million. The net cash provided by operating activities was principally due to net income of $563 million and non-cash charges of $217 million, offset by changes in operating assets and liabilities of $87 million. 47-------------------------------------------------------------------------------- Table of Contents Accounts receivable increased to $341 million at the end of fiscal year 2012 from $328 million at the end of fiscal year 2011. Accounts receivable days sales outstanding increased to 51 days at October 28, 2012 from 48 days at October 30, 2011 primarily due to linearity of shipments in the last three months of fiscal year 2012 as compared to the last three months of fiscal year 2011. We use the current quarter revenue in our calculation of number of days sales outstanding. Inventory was $194 million at both October 28, 2012 and October 30, 2011. Inventory days on hand remained flat at 58 days as of both October 28, 2012 and October 30, 2011. We use the current quarter cost of products sold in our calculation of days on hand of inventory. Other current assets increased to $72 million at October 28, 2012 from $42 million at the end of fiscal year 2011 primarily due to a $16 million increase in cash advances made to certain of our existing distributors for anticipated distributor price adjustments, a $5 million increase in receivables from our contract manufacturers for materials purchased by us on their behalf to secure pricing, a $5 million increase in receivables from intellectual property-related revenue, a $3 million increase in receivables from government grants, a $3 million increase in assets related to the employee deferred compensation plan and a $1 million increase in deposits paid for fixed assets, partially offset by a $4 million decrease in current deferred taxes, net of valuation allowances. During the second quarter of fiscal year 2012, we entered into agreements with certain distributors whereby we agreed to advance cash to them to fund estimated price adjustments. These advances are estimated based on an agreed percentage of the rolling previous three months average ending inventory, as reported by the distributor, multiplied by the rolling previous three months price adjustment credits as a percentage of the distributor's reported rolling previous three months resales. The terms of these advances are set forth in binding legal agreements and are unsecured, bear no interest on unsettled balances, and are due upon demand. The agreements governing these advances can be cancelled by us at any time. Such advances have no impact on revenue recognition or our consolidated statements of operations and are recorded in other current assets on our consolidated balance sheets. Current liabilities decreased to $346 million at the end of fiscal year 2012 from $350 million at the end of fiscal year 2011 mainly due to a decrease in employee compensation and benefits accruals and other current liabilities, partially offset by an increase in accounts payable. Employee compensation and benefits decreased to $61 million at the end of fiscal year 2012 from $89 million at the end of fiscal year 2011 mainly due to performance levels under our employee bonus program related to our overall profitability and other performance metrics. Other current liabilities decreased to $36 million at the end of fiscal year 2012 from $38 million at the end of fiscal year 2011 primarily due to a $3 million release from and $1 million utilization of warranty accruals, a $2 million decrease in supplier inventory liabilities and $2 million recognition of previously deferred revenue, offset by a $6 million increase in income tax and sales and use tax payables. Accounts payable increased to $248 million as at October 28, 2012 from $221 million at the end of fiscal year 2011 due to timing of disbursements and a higher volume of purchases to support the increase in revenue over the year. Other long-term assets increased to $66 million at the end of fiscal year 2012 from $61 million at the end of fiscal year 2011 mainly due to the increase in long-term deferred tax assets. Other long-term liabilities increased to $95 million at the end of fiscal year 2012 from $86 million at the end of fiscal year 2011 mainly due to the change in actuarial assumptions used in the valuation of our post-retirement benefit and defined benefit pension plans liabilities and the net periodic pension expenses recorded during the year for our post-retirement benefit and defined benefit pension plans. Net cash provided by operating activities during the year ended October 30, 2011 was $726 million. The net cash provided by operating activities was principally due to net income of $552 million and non-cash charges of $209 million, offset by changes in operating assets and liabilities of $35 million. Investing Activities Net cash used in investing activities for the year ended October 28, 2012 was $244 million. The net cash used in investing activities principally related to purchases of property, plant and equipment of $241 million, in connection with the expansion of our internal manufacturing facilities in Fort Collins, Colorado and $4 million related to immaterial business acquisitions completed in fiscal year 2012. Net cash used in investing activities for the year ended October 30, 2011 was $122 million. The net cash used in investing activities principally related to purchases of property, plant and equipment of $112 million and $8 million related to a business acquisition completed in fiscal year 2011. Financing Activities Net cash used in financing activities for the year ended October 28, 2012 was $194 million. The net cash used in financing activities was principally due to an aggregate of $137 million in payments of cash dividends to shareholders and the payment of an aggregate of $110 million to repurchase and cancel 3.5 million shares of our ordinary shares under our share repurchase program. This was partially offset by $44 million in net proceeds provided by the exercises of options, and purchases of our ordinary shares by employees under our ESPP. 48-------------------------------------------------------------------------------- Table of Contents Net cash used in financing activities for the year ended October 30, 2011 was $336 million. The net cash used in financing activities was principally due to the redemption of the remaining $230 million in principal amount of senior subordinated notes, an aggregate of $86 million in payments of cash dividends to shareholders and the payment of an aggregate of $93 million to repurchase and cancel 2.6 million shares of our ordinary shares under our share repurchase program. This was partially offset by $70 million in net proceeds provided by the exercises of options and purchases of our ordinary shares by employees under our ESPP. Cash Flows for the Years Ended October 30, 2011 and October 31, 2010 Operating Activities Net cash provided by operating activities during the year ended October 30, 2011 was $726 million. The net cash provided by operating activities was principally due to net income of $552 million and non-cash charges of $209 million, offset by changes in operating assets and liabilities of $35 million. Accounts receivable increased to $328 million at the end of fiscal year 2011 from $285 million at the end of fiscal year 2010. Accounts receivable days sales outstanding increased to 48 days at October 30, 2011 from 45 days at October 31, 2010 primarily due to linearity of shipments in the last three months of fiscal year 2011 as compared to the last three months of fiscal year 2010. We use the current quarter revenue in our calculation of number of days sales outstanding. Inventory increased to $194 million at October 30, 2011 from $189 million at October 31, 2010. The increase in inventory dollar amount is attributable to anticipated increased demand. Inventory days on hand decreased slightly from 61 days at October 31, 2010 to 58 days at October 30, 2011. We use the current quarter cost of products sold in our calculation of days on hand of inventory. Current liabilities decreased to $350 million at the end of fiscal year 2011 from $565 million at the end of fiscal year 2010 mainly due to the redemption in December 2010 of $230 million of long-term debt that was classified as current at October 31, 2010 (as it had been irrevocably called for redemption before the fiscal year end) and decreases in accrued interest and other current liabilities, offset by increases in accounts payable and employee compensation and benefits accruals. Accrued interest decreased to less than $1 million at October 30, 2011 from $12 million at the end of fiscal year 2010 mainly due to the debt redemption and semi-annual interest payments made during fiscal year 2011. Other current liabilities decreased to $38 million at the end of fiscal year 2011 from $41 million at the end of fiscal year 2010 primarily due to an $11 million decrease in accrued warranty related to settlement payments and reassessment of replacement parts exposure, partially offset by a $4 million increase in current income tax payable and a $3 million increase in deferred revenue. Accounts payable increased to $221 million as at October 30, 2011 from $198 million at the end of fiscal year 2010 due to timing of disbursements and higher volume of purchases to support the increase in revenue over the year. Employee compensation and benefits increased to $89 million at the end of fiscal year 2011 from $82 million at the end of fiscal year 2010 mainly due to salary increases and our employee bonus program related to our overall profitability. Other long-term assets increased to $61 million at the end of fiscal year 2011 from $44 million at the end of fiscal year 2010 mainly due to the increase in long-term deferred tax assets. Other long-term liabilities increased to $86 million at the end of fiscal year 2011 from $83 million at the end of fiscal year 2010 mainly due to the change in actuarial assumptions used in the valuation of our U.S. post-retirement benefit plan liabilities and the net periodic pension expenses recorded during the year for our U.S. post-retirement benefit plan. Net cash provided by operating activities during the year ended October 31, 2010 was $510 million. The net cash provided by operating activities was principally due to net income of $415 million and non-cash charges of $194 million, offset by changes in operating assets and liabilities of $99 million. Investing Activities Net cash used in investing activities for the year ended October 30, 2011 was $122 million. The net cash used in investing activities principally related to purchases of property, plant and equipment of $112 million, in connection with the expansion of our internal manufacturing facilities in Fort Collins, Colorado, and in Singapore and $8 million related to a business acquisition completed in fiscal year 2011. Net cash used in investing activities for the year ended October 31, 2010 was $86 million. The net cash used in investing activities principally related to purchases of property, plant and equipment of $79 million and acquisitions and investments of $9 million. 49-------------------------------------------------------------------------------- Table of Contents Financing Activities Net cash used in financing activities for the year ended October 30, 2011 was $336 million. The net cash used in financing activities was principally due to the redemption of the remaining $230 million in principal amount of our senior subordinated notes, an aggregate of $86 million in payments of cash dividends to shareholders and the payment of an aggregate of $93 million to repurchase and cancel 2.6 million shares of our ordinary shares under our share repurchase program. This was partially offset by $70 million in net proceeds provided by the exercises of options and purchases of our ordinary shares by employees under our ESPP. Net cash used in financing activities for the year ended October 31, 2010 was $335 million, comprised mainly of the redemption of $318 million in principal amount of senior fixed rate notes and $46 million principal amount of senior floating rate notes, offset by $28 million provided by the issuance of ordinary shares, upon the exercise of options. Indebtedness As of October 28, 2012, we had $3 million of capital lease obligations. At such date, we also had $300 million of borrowing capacity available under our revolving credit facility. Revolving Credit Facility Our current credit agreement provides for a $200 million senior unsecured revolving credit facility with a term of four years, ending on March 31, 2015. The revolving credit facility is available for cash borrowings and for the issuance of letters of credit up to a sub-limit of $40 million. The credit agreement contains financial covenants requiring Avago Finance to maintain a maximum leverage ratio and a minimum interest coverage ratio and customary restrictive covenants, including certain restrictions on the ability of our subsidiaries (including Avago Finance) to pay dividends, and customary events of default. In addition, the credit agreement permits Avago Finance to increase the aggregate commitments under the credit agreement from $200 million to $300 million, at any time, subject to certain conditions and the receipt of sufficient commitments for such increase from the lenders. Compliance with financial covenants is required for the term of the credit agreement irrespective of the amount of borrowing outstanding. On August 6, 2012, Avago Finance exercised the accordion feature under its credit agreement to increase the aggregate commitments for its unsecured revolving credit facility from $200 million to $300 million. This increase in the revolving credit facility commitment result in a corresponding increase in commitment fees payable under the credit agreement. Certain subsidiaries of the Company guarantee the revolving credit facility. Borrowings under our senior unsecured revolving credit facility are subject to floating rates of interest and will bear interest at a rate per annum equal to: Base Rate Advances: the highest of (x) Citibank's publicly announced base rate from time to time, (y) the U.S. Federal funds rate plus 0.5% and (z) the British Bankers Association Interest Settlement Rate, or BBA LIBOR Rate applicable to Dollars for a period of one month plus 1.00%; or Eurocurrency Advances: the rate per annum obtained by dividing (x) the BBA LIBOR Rate for deposits in Dollars for the applicable interest period by (y) a percentage equal to 100% minus the Eurocurrency liabilities reserve percentage specified by the U.S. Federal Reserve System for such interest period, plus, in each case, a margin based on the credit rating of Avago Finance's long-term unsecured debt or Avago Finance's corporate credit rating, as applicable, or the Avago Public Debt Rating. Avago Finance is also required to pay the lenders a commitment fee at a rate per annum that varies based on the Public Debt Rating and the aggregate amount of the outstanding commitments under the credit agreement. As of October 28, 2012, we had no borrowings outstanding under the revolving credit facility and were in compliance with the financial covenants under our credit agreement. We did not draw on our revolving credit facility during fiscal year 2012. Contractual Commitments Our cash flows from operations are dependent on a number of factors, including fluctuations in our operating results, accounts receivable collections, inventory management, and timing of payments. As a result, the impact of contractual obligations on our liquidity and capital resources in future periods should be analyzed in conjunction with such factors. 50-------------------------------------------------------------------------------- Table of Contents The following table sets forth our contractual obligations and commitments as of October 28, 2012 for the fiscal periods noted (in millions): 2014 to 2016 to Total 2013 2015 2017 Thereafter Operating leases(1) $ 97 $ 10 $ 20 $ 9 $ 58 Capital leases(2) 3 1 2 - - Purchase Commitments (3) 121 121 - - - Revolving credit facility commitments(4) 3 1 2 - - Other Contractual Commitments(5) 53 21 20 12 - _______________________________________ (1) Includes operating lease commitments for facilities and equipment that we have entered into with third parties. (2) Includes capital lease commitments for equipment that we have entered into with third parties. (3) We purchase components from a variety of suppliers and use several contract manufacturers to provide manufacturing services for our products. During the normal course of business, we issue purchase orders with estimates of our requirements several months ahead of the delivery dates. However, our agreements with these suppliers usually allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. Typically purchase orders outstanding with delivery dates within 30 days are non-cancelable. We also make purchases from a variety of vendors in connection with the expansion of our Fort Collins internal fabrication facility. These purchases are typically conducted on a purchase order basis and the amount shown in the table includes $33 million in cancelable and non-cancelable outstanding purchase obligations under such purchase orders as of October 28, 2012. In addition to the above non-cancelable purchase commitments, we record a liability for firm, non-cancelable, and unconditional purchase commitments for quantities in excess of our future demand forecasts in conjunction with our write-down of inventory. As of October 28, 2012, the liability for our firm, non-cancelable and unconditional purchase commitments related to inventory suppliers was $2 million. This amount is included in other current liabilities in our balance sheets at October 28, 2012, and are excluded from the preceding table. (4) Represents commitment fees and letter of credit fees. (5) Represents amounts payable pursuant to agreements related to outsourced IT, human resources, financial infrastructure outsourcing services and other services agreements. Due to the inherent uncertainty with respect to the timing of future cash outflows associated with our unrecognized tax benefits at October 28, 2012, we are unable to reliably estimate the timing of cash settlement with the respective taxing authority. Therefore, $22 million of unrecognized tax benefits classified as long-term income tax payable in the consolidated balance sheet as of October 28, 2012 have been excluded from the contractual obligations table above. Off-Balance Sheet Arrangements We had no material off-balance sheet arrangements at October 28, 2012 as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. Indemnifications to Hewlett-Packard and Agilent Agilent Technologies, Inc. has given multiple indemnities to Hewlett-Packard Company in connection with its activities prior to its spin-off from Hewlett-Packard Company in June 1999 for the businesses that constituted Agilent prior to the spin-off. As the successor to the SPG business of Agilent, we may acquire responsibility for indemnifications related to assigned intellectual property agreements. Additionally, when we completed the SPG Acquisition in December 2005, we provided indemnities to Agilent with regard to Agilent's conduct of the SPG business prior to the SPG Acquisition. In our opinion, the fair value of these indemnifications is not material and no amount has been accrued in the accompanying consolidated financial statements with respect to these indemnification obligations. Other Indemnifications As is customary in our industry and as provided for in local law in the United States and other jurisdictions, many of our standard contracts provide remedies to our customers and others with whom we enter into contracts, such as defense, settlement, or payment of judgment for intellectual property claims related to the use of our products. From time to time, we indemnify customers, as well as our suppliers, contractors, lessors, lessees, companies that purchase our businesses or assets 51-------------------------------------------------------------------------------- Table of Contents and others with whom we enter into contracts, against combinations of loss, expense, or liability arising from various triggering events related to the sale and the use of our products, the use of their goods and services, the use of facilities and state of our owned facilities, the state of the assets and businesses that we sell and other matters covered by such contracts, usually up to a specified maximum amount. In addition, from time to time we also provide protection to these parties against claims related to undiscovered liabilities, additional product liability or environmental obligations. In our experience, claims made under such indemnifications are rare and the associated estimated fair value of the liability is not material. Accounting Changes and Recent Accounting Standards For a description of accounting changes and recent accounting standards, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements, see Note 2. "Summary of Significant Accounting Policies" to Consolidated Financial Statements of this Annual Report on Form 10-K. |