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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended January 28, 2012 January 28, 2012
For the transition period from to
Commission file number: 000-25601
Brocade Communications Systems, Inc.
(Exact name of registrant as specified in its charter)
130 Holger Way
San Jose, CA 95134
(Address, including zip code, of principal
executive offices and registrants telephone
number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares outstanding of the registrants common stock as of February 24, 2012 was 459,267,665 shares.
QUARTER ENDED JANUARY 28, 2012
This Quarterly Report on Form 10-Q contains forward-looking statements regarding future events and future results. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including, but not limited to, statements regarding future revenue, margins, expenses, tax provisions, earnings, cash flows, benefit obligations, debt repayments, share repurchases or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning expected development, performance or market share relating to products or services; any statements regarding future economic conditions or performance; any statements regarding pending litigation, including claims or disputes; any statements of expectation or belief; and any statements of assumptions underlying any of the foregoing. Words such as expects, anticipates, assumes, targets, goals, projects, intends, plans, believes, seeks, estimates, continues, may, variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are based on current expectations, estimates, forecasts and projections about the industries in which Brocade operates, and the beliefs and assumptions of management. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to predict, including those identified below under Part II - Other Information, Item 1A. Risk Factors and elsewhere herein. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Further, Brocade undertakes no obligation to revise or update any forward-looking statements for any reason.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes to condensed consolidated financial statements.
CONDENSED CONSOLIDATED BALANCE SHEETS
See accompanying notes to condensed consolidated financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to condensed consolidated financial statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
Brocade Communications Systems, Inc. (Brocade or the Company) has prepared the accompanying Condensed Consolidated Financial Statements as of January 28, 2012 and for the three months ended January 28, 2012 and January 29, 2011, without audit, pursuant to the rules and regulations of the United States (U.S.) Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) have been condensed or omitted pursuant to such rules and regulations. The October 29, 2011 Condensed Consolidated Balance Sheet was derived from the Companys audited consolidated financial statements, but does not include all disclosures required by U.S. GAAP. These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the Companys Annual Report on Form 10-K for the fiscal year ended October 29, 2011.
In the opinion of management, all adjustments (which include only normal recurring adjustments, except as otherwise indicated) necessary to present a fair statement of financial position as of January 28, 2012, results of operations for the three months ended January 28, 2012 and January 29, 2011, and cash flows for the three months ended January 28, 2012 and January 29, 2011, have been made. The results of operations for the three months ended January 28, 2012 are not necessarily indicative of the operating results for the full fiscal year or any future period.
The Companys fiscal year is 52 or 53 weeks ending on the last Saturday in October. Fiscal year 2012 is a 52-week fiscal year, and the first quarter of 2012 was a 13-week quarter. Fiscal year 2011 was a 52-week year, and fiscal quarter of 2011 was a 13-week quarter.
The Condensed Consolidated Financial Statements include the accounts of Brocade and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Use of Estimates in Preparation of Condensed Consolidated Financial Statements
The preparation of condensed consolidated financial statements and related disclosures in conformity with U.S. GAAP requires management to make estimates and judgments that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Estimates are used for, but not limited to, revenue recognition, sales allowances and programs, allowance for doubtful accounts, stock-based compensation, purchase price allocations, warranty obligations, inventory valuation and purchase commitments, restructuring costs, commissions, facilities lease losses, impairment of goodwill and intangible assets, litigation, income taxes and investments. Actual results may differ materially from these estimates.
2. Summary of Significant Accounting Policies
There have been no material changes in the Companys significant accounting policies for the three months ended January 28, 2012 as compared to the significant accounting policies disclosed in Brocades Annual Report on Form 10-K for the fiscal year ended October 29, 2011.
Recent Accounting Pronouncements
There have been no accounting pronouncements issued during the three months ended January 28, 2012 that are expected to have a material impact on the Companys financial position, results of operations, cash flows or disclosure requirements.
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents, short-term investments and accounts receivable. The Companys cash, cash equivalents and short-term investments are primarily maintained at five major financial institutions. Deposits held with banks may be redeemed upon demand and may exceed the amount of insurance provided on such deposits.
A majority of the Companys accounts receivable balance is derived from sales to original equipment manufacturer (OEM) partners in the computer storage and server industry. As of January 28, 2012, two customers accounted for 15% and 11%, respectively, of total accounts receivable, for a combined total of 26% of total accounts receivable. As of October 29, 2011, two customers accounted for 16% and 14%, respectively, of total accounts receivable, for a combined total of 30% of total accounts receivable. The Company performs ongoing credit evaluations of its customers and generally does not require collateral on accounts receivable balances. The Company has established reserves for credit losses, sales allowances, and other allowances.
For the three months ended January 28, 2012, three customers accounted for 20%, 15% and 13%, respectively, of the Companys total net revenues for a combined total of 48% of total net revenues. For the three months ended January 29, 2011, three customers accounted for 18%, 17% and 12%, respectively, of the Companys total net revenues for a combined total of 47% of total net revenues.
The Company currently relies on single and limited sources for multiple key components used in the manufacture of its products. Additionally, the Company relies on multiple contract manufacturers (CMs) for the production of its products. Although the Company uses standard parts and components for its products where possible, the Companys CMs currently purchase, on the Companys behalf, several key components used in the manufacture of products from single or limited supplier sources.
3. Goodwill and Intangible Assets
The following table summarizes goodwill activity by reportable segment for the three months ended January 28, 2012 (in thousands):
The Company conducts its goodwill impairment test annually, as of the first day of the second fiscal quarter, or whenever events or changes in facts and circumstances indicate that the fair value of the reporting unit may be less than its carrying amount. Based on goodwill impairment analysis results during the second fiscal quarter of 2011, the Company determined that no impairment needed to be recorded. During the three months ended January 28, 2012, there were no facts and circumstances that indicated that the fair value of the reporting units may be less than their current carrying amount.
Intangible assets other than goodwill are amortized on a straight-line basis over the following estimated remaining useful lives, unless the Company has determined these lives to be indefinite. The following tables present details of the Companys intangible assets (in thousands, except for weighted-average remaining useful life):
The following table presents the amortization of intangible assets included on the Condensed Consolidated Statements of Income (in thousands):
The following table presents the estimated future amortization of intangible assets as of January 28, 2012 (in thousands):
4. Balance Sheet Details
The following table provides details of selected balance sheet items (in thousands):
5. Fair Value Measurements
The Company applies fair value measurements for both financial and nonfinancial assets and liabilities. The Company has no nonfinancial assets and liabilities that are required to be measured at fair value on a recurring basis as of January 28, 2012.
The Company did not elect to measure any eligible financial instruments at fair value and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date.
Fair Value Hierarchy
The Company utilizes a fair value hierarchy that maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. A financial instruments categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
Assets and liabilities measured and recorded at fair value on a recurring basis as of January 28, 2012 were as follows (in thousands):
Assets and liabilities measured and recorded at fair value on a recurring basis as of October 29, 2011 were as follows (in thousands):
During the three months ended January 28, 2012, the Company had no transfers between levels of the fair value hierarchy of its assets measured at fair value.
6. Liabilities Associated with Facilities Lease Losses
The Company reevaluates its estimates and assumptions on a quarterly basis and makes adjustments to the reserve balance if necessary. The following table summarizes the activity related to the facilities lease loss reserve, net of expected sublease income (in thousands):
Cash payments for facilities leases related to the above noted facilities lease losses are expected to be paid over the respective lease terms through fiscal year 2017.
The following table provides details of the Companys long-term debt (in thousands):
Senior Secured Notes
In January 2010, the Company issued $300 million in aggregate principal amount of senior secured notes due 2018 (the 2018 Notes) and $300 million in aggregate principal amount of senior secured notes due 2020 (the 2020 Notes and together with the 2018 Notes, the Senior Secured Notes). The senior secured notes bear interest payable semi-annually. No payments were made towards the principal of the senior secured notes during the three months ended January 28, 2012.
As of January 28, 2012 and October 29, 2011, the fair value of the Companys senior secured notes was approximately $645 million and $626 million, respectively, estimated based on broker trading prices.
On or after January 2013, the Company may redeem all or a part of the 2018 Notes at the redemption prices set forth in the Indenture governing the 2018 Notes (the 2018 Indenture), plus accrued and unpaid interest and special interest, if any, to the applicable redemption date. In addition, at any time prior to January 2013, the Company may, on one or more than one occasion, redeem some or all of the 2018 Notes at any time at a redemption price equal to 100% of the principal amount of the 2018 Notes redeemed, plus a make-whole premium as of, and accrued and unpaid interest and special interest, if any, to the applicable redemption date. On or after January 2015, the Company may redeem all or a part of the 2020 Notes at the redemption prices set forth in the Indenture governing the 2020 Notes (the 2020 Indenture), plus accrued and unpaid interest and special interest, if any, to the applicable redemption date. In addition, at any time prior to January 2015, the Company may, on one or more than one occasion, redeem some or all of the 2020 Notes at any time at a redemption price equal to 100% of the principal amount of the 2020 Notes redeemed, plus a make-whole premium as of, and accrued and unpaid interest and special interest, if any, to the applicable redemption date. At any time prior to January 2013, the Company may also redeem up to 35% of the aggregate principal amount of the 2018 Notes and 2020 Notes, using the proceeds of certain qualified equity offerings, at the redemption prices set forth in the 2018 Indenture and the 2020 Indenture, respectively.
If the Company experiences specified change of control triggering events, it must offer to repurchase the senior secured notes at a repurchase price equal to 101% of the principal amount of the senior secured notes repurchased, plus accrued and unpaid interest and special interest, if any, to the applicable repurchase date. If the Company or its subsidiaries sell assets under certain specified circumstances, the Company must offer to repurchase the senior secured notes at a repurchase price equal to 100% of the principal amount of the senior secured notes repurchased, plus accrued and unpaid interest and special interest, if any, to the applicable repurchase date.
Senior Secured Credit Facility
In October 2008, the Company entered into a credit facility agreement for (i) a five-year $1,100 million term loan facility and (ii) a five-year $125 million revolving credit facility, which includes a $25 million swing line loan sub-facility and a $25 million letter of credit sub-facility. The credit facility agreement was subsequently amended in January 2010 and June 2011.
The Company may draw additional proceeds from the revolving credit facility in the future for ongoing working capital and other general corporate purposes. The term loan facility and revolving credit facility are referred to together as the Senior Secured Credit Facility. There were no principal amounts outstanding under the revolving credit facility as of January 28, 2012 and October 29, 2011.
During the three months ended January 28, 2012, the Company paid $70 million towards the principal of the term loan, $62 million of which were voluntary prepayments.
The Company believes that the carrying value of its Senior Secured Credit Facility approximates its fair value as the interest rate is based on a floating market rate.
8. Commitments and Contingencies
The Companys accrued liability for estimated future warranty costs is included in Other accrued liabilities in the accompanying Condensed Consolidated Balance Sheets. The following table summarizes the activity related to the Companys accrued liability for estimated future warranty costs during the three months ended January 28, 2012 and January 29, 2011 (in thousands):
In addition, the Company has standard indemnification clauses contained within its various customer contracts. As such, the Company indemnifies the parties to whom it sells its products with respect to the Companys product, alone or potentially in combination with others, infringing upon any patents, trademarks, copyrights, or trade secrets, as well as against bodily injury or damage to real or tangible personal property caused by a defective Company product. As of January 28, 2012, there have been no known material events or circumstances that have resulted in a customer contract-related indemnification liability to the Company.
Manufacturing and Purchase Commitments
Brocade has manufacturing arrangements with CMs under which Brocade provides twelve-month product forecasts and places purchase orders in advance of the scheduled delivery of products to Brocades customers. The required lead time for placing orders with the CMs depends on the specific product. Brocade issues purchase orders and the CMs then generate invoices based on prices and payment terms mutually agreed upon and set forth in those purchase orders. Although the purchase orders Brocade places with its CMs are cancellable, the terms of the agreements require Brocade to purchase all inventory components not returnable, usable by, or sold to other customers of the CMs.
As of January 28, 2012, the Companys aggregate commitment to the CMs for inventory components used in the manufacture of Brocade products was $237.5 million, which the Company expects to utilize during future normal ongoing
operations, net of a purchase commitments reserve of $5.4 million. The Companys purchase commitments reserve reflects the Companys estimate of purchase commitments it does not expect to consume in normal ongoing operations within the next twelve months.
The Company has several ongoing income tax audits. For additional discussions, see Note 11, Income Taxes, of the Notes to Condensed Consolidated Financial Statements. The Company believes it has adequate reserves for all open tax years.
Initial Public Offering Litigation
On July 20, 2001, the first of a number of putative class actions for violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against Brocade, certain of its officers and directors, and certain of the underwriters for Brocades initial public offering (IPO) of securities. A consolidated amended class action captioned, In re Brocade Communications Systems, Inc. Initial Public Offering Securities Litigation, No. 01 Civ. 6613, was filed on April 19, 2002. The complaint generally alleged that various underwriters engaged in improper and undisclosed activities related to the allocation of shares in Brocades initial public offering and seeks unspecified damages for claims under the Exchange Act on behalf of a purported class of purchasers of common stock from May 24, 1999 to December 6, 2000. The lawsuit against Brocade was coordinated for pretrial proceedings with a number of other pending litigations challenging underwriter practices in over 300 cases as In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS), including actions against McDATA Corporation (McDATA), Inrange Technologies Corporation (Inrange) (which was first acquired by Computer Network Technology Corporation (CNT) and subsequently acquired by McDATA as part of the CNT acquisition), and Foundry Networks LLC (formerly Foundry Networks, Inc.) (Foundry, and collectively, the Brocade Entities), and certain of each entitys respective officers and directors, and initial public offering underwriters.
These actions have been resolved by a global settlement of the coordinated litigation in January 2012, under which the insurers pay the full amount of settlement share allocated to the Brocade Entities, and the Brocade Entities bear no financial liability.
Intellectual Property Litigation
On June 21, 2005, Enterasys Networks, Inc. (Enterasys) filed a lawsuit against Foundry (and Extreme Networks, Inc.) in the United States District Court for the District of Massachusetts alleging that certain of Foundrys products infringe six of Enterasys patents and seeking injunctive relief, as well as unspecified damages. Enterasys subsequently added Brocade as a defendant. On August 28, 2007, the Court granted Foundrys motion to stay the case based on petitions that Foundry had filed with the United States Patent and Trademark Office (USPTO) in 2007 for reexamination of five of the six Enterasys patents. Two of the patents received final rejections during their respective reexaminations, in which the USPTO held that the claims were invalid. Enterasys filed appeals of those rejections with the USPTOs Board of Patent Appeals and Interferences in 2009. The Board partially affirmed and partially reversed one of those rejections on January 24, 2011, and Enterasys did not appeal further, which ended the proceedings on those two patents. The USPTO has issued reexamination certificates for the remaining three patents undergoing reexamination indicating that the patents were valid over the submitted references. Meanwhile, on May 21, 2010, the Court lifted the stay of the litigation, and Enterasys subsequently dropped from the litigation the two patents it appealed at the USPTO. Accordingly, four patents remain at issue in the litigation. No trial date has been set.
On September 6, 2006, Chrimar Systems, Inc. (Chrimar) filed a lawsuit against Foundry (and D-Link Corporation and PowerDsine, Ltd.) in the United States District Court for the Eastern District of Michigan alleging that certain of Foundrys products infringe Chrimars U.S. Patent 5,406,260 and seeking injunctive relief, as well as unspecified damages. Discovery has been completed. No trial date has been set.
On August 4, 2010, Brocade and Foundry (Plaintiffs) filed a lawsuit against A10 Networks, Inc. (A10), A10s founder and other individuals in the United States District Court for the Northern District of California. On October 29, 2010, Plaintiffs filed an amended complaint. In the amended complaint, Brocade alleged that A10 and the individual defendants have misappropriated Plaintiffs trade secrets, infringed copyrighted works, interfered with existing contracts between the Plaintiffs and their employees, breached contracts, breached their fiduciary duties and duties of loyalty, and that certain of A10s products infringe 13 of Brocades patents. Brocade is seeking injunctive relief, as well as monetary damages. On May 16, 2011, A10 filed an answer and counterclaim alleging that certain of Brocades products infringe a patent recently acquired by A10 and seeking injunctive relief, as well as unspecified damages. On January 6, 2012 the Court granted Brocades summary judgment motion of non-infringement of the A10 patent. Trial is scheduled for July 16, 2012.
On September 9, 2011, A10 filed a lawsuit against Brocade in the United States District Court for the Northern District of California. A10 alleges that certain of Brocades products infringe two additional patents acquired by A10. After Brocade moved to dismiss the complaint, A10 dismissed one of its patents-in-suit. Brocade has filed a new motion to dismiss the sole remaining A10 patent. Trial is scheduled for May 2013.
From time to time, the Company is subject to other legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks, copyrights, patents and/or other intellectual property rights and commercial contract disputes. Third parties assert patent infringement claims against the Company from time to time in the form of letters, lawsuits and other forms of communication. In addition, from time to time, the Company receives notification from customers claiming that they are entitled to indemnification or other obligations from the Company related to infringement claims made against them by third parties. Litigation, even if the Company is ultimately successful, can be costly and divert managements attention away from the day-to-day operations of the Company.
On a quarterly basis, the Company reviews relevant information with respect to litigation contingencies and updates its accruals, disclosures and, when possible, estimates of reasonably possible losses or ranges of loss based on such reviews. However, litigation is inherently unpredictable, and outcomes are typically uncertain, and the Companys past experience does not provide any additional visibility or predictability to estimate the range of loss that may occur because the costs, outcome and status of these types of claims and proceedings have varied significantly in the past. The Company is not currently able to reasonably estimate the possible loss or range of loss from the above legal proceedings and, accordingly, the Company is unable to estimate the effects of the above on its financial condition, results of operations or cash flows.
The Company records a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated.
9. Derivative Instruments and Hedging Activities
In the normal course of business, the Company is exposed to fluctuations in interest rates and the exchange rates associated with foreign currencies. The Companys primary objective for holding derivative financial instruments is to manage foreign currency exchange rate risk. The Company currently does not enter into derivative instruments to manage credit risk. However, the Company manages its exposure to credit risk through its investment policies. The Company generally enters into derivative transactions with high-credit quality counterparties and, by policy, limits the amount of credit exposure to any one counterparty based on its analysis of that counterpartys relative credit standing. The amounts subject to credit risk related to derivative instruments are generally limited to the amounts, if any, by which counterpartys obligations exceed the Companys obligations with that counterparty.
Foreign Currency Exchange Rate Risk
A majority of the Companys revenue, expense and capital purchasing activities is transacted in U.S. dollars. However, the Company is exposed to foreign currency exchange rate risk inherent in conducting business globally in numerous currencies, of which the most significant to its operations for the three months ended January 28, 2012 were the Chinese yuan, the euro, the Japanese yen, the Indian rupee, the British pound, the Singapore dollar and the Swiss franc. The Company is primarily exposed to foreign currency fluctuations related to operating expenses denominated in currencies other than the U.S. dollar. The Company has established a foreign currency risk management program to protect against fluctuations in the volatility of future cash flows caused by changes in foreign currency exchange rates. This program reduces, but does not always entirely eliminate, the impact of foreign currency exchange rate movements. The Companys foreign currency risk management program includes foreign currency derivatives with cash flow hedge accounting designation that utilizes foreign currency forward contracts to hedge exposures to the variability in the U.S. dollar equivalent of anticipated non-U.S. dollar-denominated cash flows. These instruments generally have a maturity of less than one year. For these derivatives, the Company reports the after-tax gain or loss from the effective portion of the hedge as a component of accumulated other comprehensive loss in stockholders equity and reclassifies it into earnings in the same period in which the hedged transaction affects earnings. Net gains (losses) relating to the effective portion of foreign currency derivatives recorded in the condensed consolidated statements of income are as follows (in thousands):
The net foreign currency exchange gains and losses recorded as part of Interest and other income (loss), net were losses of $1.2 million for the three months ended January 28, 2012 and gains of $0.2 million for the three months ended January 29, 2011.
Gross unrealized loss positions are recorded within Other accrued liabilities, and gross unrealized gain positions are recorded within Prepaid expenses and other current assets. As of January 28, 2012, the Company had gross unrealized loss positions of $4.6 million and gross unrealized gain positions of $0.5 million included in Other accrued liabilities and Prepaid expenses and other current assets, respectively. Effective cash flow hedges are reported as a component of accumulated other comprehensive loss. Cash flow hedges ineffectiveness, which is included in the Companys net income as part of Interest and other income (loss), net, was not significant.
Volume of Derivative Activity
Total gross notional amounts, presented by currency, are as follows (in thousands):
The Company utilizes a rolling hedge strategy for the majority of its foreign currency derivative instruments with cash flow hedge accounting designation that hedges exposures to the variability in the U.S. dollar equivalent of anticipated non-U.S. dollar-denominated cash flows. All of the Companys foreign currency forward contracts are single delivery, which are settled at maturity involving one cash payment exchange.
10. Stock-Based Compensation
Stock-based compensation expense, net of estimated forfeitures, was included in the following line items on the Condensed Consolidated Statements of Income as follows (in thousands):
The following table presents stock-based compensation expense, net of estimated forfeitures, by grant type (in thousands):
The following table presents unrecognized compensation expense, net of estimated forfeitures, of the Companys equity compensation plans as of January 28, 2012, which is expected to be recognized over the following weighted-average periods, (in thousands, except for weighted-average period):
The following table presents details on grants made by the Company for the following periods:
The total intrinsic value of stock options exercised for the three months ended January 28, 2012 and January 29, 2011 was $8.8 million and $9.5 million, respectively.
11. Income Taxes
For the three months ended January 28, 2012, the Company recorded an income tax benefit of $3.2 million primarily due to a discrete benefit from net reserve releases of settling the Internal Revenue Service (IRS) audit for fiscal years 2004 through 2006, settling Foundrys 2006 and 2007 California franchise tax audit, and releases from expiring statutes of limitations, offset by a decrease to the federal research and development tax credit which expired on December 31, 2011.
For the three months ended January 29, 2011, the Company recorded an income tax benefit of $5.7 million primarily due to a discrete benefit from the retroactive reinstatement of the federal research and development tax credit for calendar year 2011, as a result of the Tax Relief Act enacted on December 17, 2010.
The total amount of unrecognized tax benefits of $114.4 million as of January 28, 2012 would affect the Companys effective tax rate, if recognized. Although the timing of the closure of audits is highly uncertain, it is reasonably possible that the balance of unrecognized tax benefits could significantly change during fiscal year 2012.
The IRS and other tax authorities regularly examine the Companys income tax returns. The IRS has commenced its audit for fiscal years 2009 and 2010. In addition, the Company is under negotiations with the Appeals division of the IRS on transfer pricing issues for fiscal years 2007 and 2008, and in discussion with foreign tax authorities to obtain correlative relief on transfer pricing adjustments settled with the IRS. We believe that our reserves for unrecognized tax benefits are adequate for all open tax years. The timing of the resolution of income tax examinations, as well as the amounts and timing of related settlements, is highly uncertain. The Company believes that before the end of fiscal year 2012, it is reasonably possible that either certain audits will conclude or the statutes of limitations relating to certain income tax examination periods will expire, or both. As such, after we reach settlement with the tax authorities, we expect to record a corresponding adjustment to our unrecognized tax benefits. Given the uncertainty as to settlement terms, the timing of payments and the impact of such settlements on other uncertain tax positions, the range of estimated potential decreases in underlying uncertain tax positions is between $0 and $10 million in the next twelve months.
The Company believes that sufficient positive evidence exists from historical operations and projections of taxable income in future years to conclude that it is more likely than not that the Company will realize its deferred tax assets. Accordingly, the Company applies a valuation allowance only on the deferred tax assets relating to capital loss carryforwards, due to limited carryforward periods and the character of such tax attributes. As part of the 2011-2012 budget, the Governor of the State of California has introduced tax proposals affecting future state income tax apportionment that may have a significant impact on the Companys ability to realize certain California deferred tax assets. The Company will reevaluate the realization of its California deferred tax assets if and when the current law changes.
12. Segment Information
Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker (CODM), or decision-making group, in deciding how to allocate resources and in assessing performance. Currently, the CODM is the Chief Executive Officer.
Brocade is organized into four operating segments. Two of the operating segments, Data Storage Products and Global Services are individually reportable segments. The other two operating segments, Ethernet Switching & Internet Protocol (IP) Routing and Application Delivery Products (ADP), combine to form a third reportable segment: Ethernet Products. These segments are organized principally by product category.
Financial decisions and the allocation of resources are based on the information from the Companys internal management reporting system. The Company does not track its assets by operating segments. The majority of the Companys assets as of January 28, 2012 were attributable to its United States operations.
Summarized financial information by reportable segment for the three months ended January 28, 2012 and January 29, 2011, based on the internal management reporting system, is as follows (in thousands):
13. Net Income per Share
The following table presents the calculation of basic and diluted net income per share (in thousands, except per share amounts):
14. Comprehensive Income
The components of comprehensive income, net of tax, are as follows (in thousands):
15. Guarantor and Non-Guarantor Subsidiaries
On January 20, 2010, the Company issued in total $600.0 million aggregate principal amount of its senior secured notes. The Companys obligations under the senior secured notes are guaranteed by certain of the Companys domestic subsidiaries (the Subsidiary Guarantors). Each of the Subsidiary Guarantors is fully owned by the Company and all guarantees are joint and several. The senior secured notes are not guaranteed by certain of the Companys domestic subsidiaries, the Companys Canadian and other foreign subsidiaries (the Non-Guarantor Subsidiaries).
Pursuant to the terms of the senior secured notes, the guarantees are full and unconditional, but are subject to release under the following circumstances:
Because the guarantees are subject to release under the above described circumstances, they would not be deemed full and unconditional for purposes of Rule 3-10 of Regulation S-X. However, as these circumstances are customary, the Company concluded that it may rely on Rule 3-10 of Regulation S-X, as the other requirements of Rule 3-10 have been met.
The following tables present condensed consolidated financial statements for the parent company, the Subsidiary Guarantors and the Non-Guarantor Subsidiaries, respectively.
The following is the condensed consolidated balance sheet as of January 28, 2012 (in thousands):
The following is the condensed consolidated balance sheet as of October 29, 2011 (in thousands):
The following is the condensed consolidated statement of income for the three months ended January 28, 2012 (in thousands):
The following is the condensed consolidated statement of income for the three months ended January 29, 2011 (in thousands):
The following is the condensed consolidated statement of cash flows for the three months ended January 28, 2012 (in thousands):
The following is the condensed consolidated statement of cash flows for the three months ended January 29, 2011 (in thousands):
You should read the following discussion and analysis in conjunction with the condensed consolidated financial statements and notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and with Managements Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report filed on Form 10-K with the Securities and Exchange Commission on December 20, 2011.
We are a leading supplier of end-to-end networking solutions and services for businesses and organizations of many types and sizes, including global enterprises, and service providers such as telecommunication firms, cable operators and mobile carriers. Our business model is driven by our two key markets, namely our Data Storage business, where we offer storage area network (SAN) backbones, directors, fabrics, switches, host bus adapters (HBAs), and server virtualization solutions, and our Ethernet business, where we offer modular and stackable solutions, Ethernet fabrics, converged network products, as well as application delivery, security and wireless solutions.
Growth opportunities in the Data Storage market are expected to be driven by key customer IT initiatives such as server virtualization, enterprise mobility, data center consolidation, migration to higher performance technologies and private cloud initiatives. Our Ethernet business strategies are intended to increase new Ethernet accounts, and expand our market share. Moreover, we plan to continue to support our Data Storage and Ethernet growth plans by enhancing our existing partnerships and forming new ones, through continuous innovation, new product introductions, and through investing in sales and marketing.
We continue to face multiple challenges, including aggressive price discounting from competitors, the pace at which customers adopt new technologies, and the uncertainty in the worldwide macroeconomic climate and its impact on IT spending patterns globally, as well as the federal government spending in the United States. We also continue to monitor the stability and health of other international markets, including China and Europe. We are cautious about the current global and country specific dynamics, including inflationary risks in China and the continuing sovereign debt risk in Europe, which may impact our business and that of our partners. While the diversification of our business model helps mitigate the effect of some of these challenges and we expect IT spending levels to generally rise in the long-term, it is generally difficult to offset short-term reductions of IT spending.
We expect the number of Data Storage and Ethernet products we ship to fluctuate depending on the demand for our existing and recently introduced products, sales support for our products from our new distribution and resale partners as well as the timing of product transitions by our original equipment manufacturer (OEM) partners. The average selling prices per port for our Data Storage and Ethernet products have typically declined in the past and will likely continue to decline in the future.
Our plans for our operating cash flows are to build our cash balance, reduce our existing term loan and opportunistically repurchase our stock.
Results of Operations
Our results of operations for the three months ended January 28, 2012 and January 29, 2011 are reported in this discussion and analysis as a percentage of total net revenues, except for gross margin for each segment, which is presented as a percentage of the respective segment net revenues.
Revenues. Our revenues are derived primarily from sales of our Data Storage Products, Ethernet products, and Global Services related to those products.
Our total net revenues are summarized as follows (in thousands, except percentages):
The increase in Data Storage Products revenues for the period was driven by an increase in both the number of ports shipped and our average selling price per port. The number of ports shipped for the three months ended January 28, 2012 increased by 4.0% compared to the three months ended January 29, 2011. Average selling price per port increased by 2.6% in the three months period ended January 28, 2012 compared to the three months period ended January 29, 2011 due to a favorable product mix shift to our high-end, higher bandwidth Director products in the three months ended January 28, 2012.
The decrease in Ethernet Products revenues for the period is due to lower revenues from enterprise customers, which offset growth in service provider customers. Lower revenues from enterprise customers are driven by a decrease in volume shipped to our enterprise customers and a decrease in average selling prices. The decrease in average selling prices is a result of higher discounting and to a lesser extent the customer mix having a higher percentage of our revenue coming from our channel partners. We believe that some customers may be postponing purchases in anticipation of our recently announced new enterprise products that will begin shipping later this year.
The decrease in Global Services revenues was primarily a result of lower Data Storage support and service revenues in the three months ended January 28, 2012, which was partially offset by an increase in Ethernet support revenues. The decline in the Data Storage service revenues is primarily attributed to the sale of Strategic Business Systems, Inc. (SBS), a wholly-owned subsidiary of the Company, which the Company sold during the fourth quarter of fiscal year 2011.
Our total net revenues by geographical area are summarized as follows (in thousands, except percentages):
International revenues decreased slightly as a percentage of total net revenues for the three months ended January 28, 2012 compared to the three months ended January 29, 2011 as a result of decreased product volumes in Europe, the Middle East and Africa. Revenues are attributed to geographic areas based on where our products are shipped. However, certain OEM partners take possession of our products domestically and then distribute these products to their international customers. Because we account for all of those OEM revenues as domestic revenues, we cannot be certain of the extent to which our domestic and international revenue mix is impacted by the practices of our OEM partners, but we believe that international revenues comprise a larger percentage of our total net revenues than the attributed revenues may indicate.
A significant portion of our revenues is concentrated among a relatively small number of OEM customers. For the three months ended January 28, 2012, three customers accounted for 20%, 15% and 13%, respectively, of the Companys total net revenues for a combined total of 48% of total net revenues. For the three months ended January 29, 2011, three customers accounted for 18%, 17% and 12%, respectively, of the Companys total net revenues for a combined total of 47% of total net revenues. We expect that a significant portion of our future revenues will continue to come from sales of products to a relatively small number of OEM partners and to the United States (U.S.) government and its individual agencies through our distributors. Therefore, the loss of, or a decrease in the level of sales to, or a change in the ordering pattern of any one of these customers could seriously harm our financial condition and results of operations.
Gross margin. Gross margin as stated below is indicated as a percentage of the respective segment net revenues, except for total gross margin, which is stated as a percentage of total net revenues. Gross margin is summarized as follows (in thousands, except percentages):
Total gross margin increased by $23.9 million or 2.7% for the three months ended January 28, 2012 compared to the three months ended January 29, 2011 primarily due to a higher percent of revenues from our Data Storage products, which have the highest gross margins of our segments.
Data Storage Products gross margins increased by 3.2% driven by revenue growth and a mix shift to our high-end, higher bandwidth Director products, as well as to other higher price per port products, and lower indirect manufacturing costs.
Ethernet Products gross margins decreased by 3.3% mainly due to lower Ethernet revenue, an increased percentage of sales going through the distribution sales channel at lower average selling prices, and an increase in indirect manufacturing costs. This was partially offset by lower product costs.
Global Services gross margins increased by 5.3% driven by the sale of SBS in the fourth quarter of fiscal year 2011, which operated with relatively lower gross margins, decreases in operating spending and intangible assets amortization expense, partially offset by an increase in indirect costs and stock-based compensation expense.
Stock-based compensation expense. Stock-based compensation expense is summarized as follows (in thousands, except percentages):
The increase in stock-based compensation expense for the three months ended January 28, 2012 compared to the three months ended January 29, 2011 was due to higher expense associated with restricted stock units due to new restricted stock units granted in the three months ended January 28, 2012 partially offset by lower ESPP expense and a decrease in Foundry Networks, LLC (formerly Foundry Networks, Inc.) (Foundry) acquisition related stock-based compensation expense.
Research and development expenses. Research and development (R&D) expenses consist primarily of salaries and related expenses for personnel engaged in engineering and R&D activities, fees paid to consultants and outside service providers, nonrecurring engineering charges, prototyping expenses related to the design, development, testing and enhancement of our products, depreciation related to engineering and test equipment, and related IT and facilities expenses.
R&D expenses are summarized as follows (in thousands, except percentages):
R&D expenses decreased for the three months ended January 28, 2012 compared to the three months ended January 29, 2011 due to the following (in thousands):
Engineering expenses decreased by $4.7 million primarily due to lower engineering spending related to chip design and lower prototype costs. In addition, expenses related to R&D equipment decreased by $1.2 million primarily due to the timing of R&D projects. This was partially offset by an increase in outside services of $1.5 million primarily due to projects related to our new Ethernet product offerings and new product certifications. In addition, sustaining engineering allocations to cost of goods sold decreased by $1.3 million, therefore increasing research and development expenses, primarily due to a decline in level of post sales support required.
Sales and marketing expenses. Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in sales, marketing and customer service functions, costs associated with promotional and marketing programs, travel expenses, and related IT and facilities expenses.
Sales and marketing expenses are summarized as follows (in thousands, except percentages):
Sales and marketing expenses increased for the three months ended January 28, 2012 compared with the three months ended January 29, 2011 due to the following (in thousands):
Marketing and advertising expenses increased primarily due to our marketing awareness campaign and various other marketing activities. Salaries and wages decreased primarily due to a reduction in variable compensation mainly attributable to lower sales commissions partially offset by an increase in bonuses. In addition, our sales and marketing headcount has decreased in the three months ended January 28, 2012 compared with the three months ended January 29, 2011. Travel and entertainment expenses decreased due to lower head count and cost control initiatives.
General and administrative expenses. General and administrative (G&A) expenses consist primarily of salaries and related expenses for corporate executives, finance, human resources, legal and investor relations, as well as recruiting expenses, professional fees, other corporate expenses, and related IT and facilities expenses.
G&A expenses are summarized as follows (in thousands, except percentages):
G&A expenses increased for the three months ended January 28, 2012 compared to the three months ended January 29, 2011 due to the following (in thousands):
Expenses associated with outside services increased by $1.7 million primarily driven by increased costs associated with our ongoing litigation. This increase was partially offset by a decrease in stock-based compensation expenses and various facility maintenance expenses.
Amortization of intangible assets. Amortization of intangible assets is summarized as follows (in thousands, except percentages):
During the three months ended January 28, 2012 and January 29, 2011, we recorded amortization of intangible assets related to our prior periods acquisitions. The decrease in amortization of intangible assets for the three months ended January 28, 2012 compared with the three months ended January 29, 2011 was primarily due to the full amortization of some of our intangible assets.
Interest expense. Interest expense primarily represents the interest cost associated with our term loan and senior secured notes (see Note 7, Borrowings, of the Notes to Condensed Consolidated Financial Statements). Interest expense is summarized as follows (in thousands, except percentages):
Interest expense decreased for the three months ended January 28, 2012 compared to the three months ended January 29, 2011 as a result of refinancing the term debt credit agreement in June 2011, as described further below in Liquidity and Capital Resources, and a reduction in the principal amount of the loan outstanding. During the three months ended January 28, 2012, we made net debt payments of $70.0 million toward the principal of the Senior Secured Credit Facility, $61.6 million of which were voluntary prepayments. We have repaid $191.2 million since the end of the first fiscal quarter of 2011.
Interest and other income (loss), net. Interest and other income (loss), net, are summarized as follows (in thousands, except percentages):
Other loss for the reporting period was primarily due to foreign exchange losses recognized during the three months ended January 28, 2012.
Income tax benefit. Income tax benefit and the effective tax rates are summarized as follows (in thousands, except effective tax rates):
We recorded a tax benefit for the three months ended January 28, 2012 primarily due to a discrete benefit from net reserve releases related to settling the Internal Revenue Service (IRS) audit for fiscal years 2004 through 2006, settling Foundrys 2006 and 2007 California franchise tax audit, and releases from expiring statutes of limitations, offset by a decrease to the federal research and development tax credit which expired on December 31, 2011 (see Note 11, Income Taxes, of the Notes to Condensed Consolidated Financial Statements).
We recorded a tax benefit for the three months ended January 27, 2011, primarily due to a discrete benefit from the retroactive reinstatement of the federal research and development tax credit for calendar year 2011, as a result of the Tax Relief Act enacted on December 17, 2010.
Based on our current forecasted results, we expect a lower tax expense for fiscal year 2012 compared to tax expense for fiscal year 2011 which was significantly impacted by the tax expense related to the nonrecurring cash distribution from our foreign subsidiaries. Our income tax provision could change from either effects of changing tax laws and regulations, or differences in international revenues and earnings from those historically achieved, a factor largely influenced by the buying behavior of our OEM and channel partners. Factors such as the mix of Ethernet versus Data Storage products and domestic versus international profits could also affect our tax expense. As estimates and judgments are used to project such international earnings, the impact to our tax provision could vary if current planning or assumptions change. In addition, we do not forecast discrete events, such as settlement of tax audits with governmental authorities due to their inherent uncertainty. Such settlements could materially impact our tax expense. Given that the tax rate is driven by several different factors, it is not possible to estimate our future tax rate with a high degree of certainty.
The IRS and other tax authorities regularly examine our income tax returns. We are currently under IRS audit for fiscal years 2007 through 2010. If we reach settlement with the IRS, we expect to record a corresponding adjustment to our unrecognized tax benefits. Due to availability of net operating losses and credits, the IRS audit settlement is not expected to result in a significant tax payment. Given the uncertainty as to settlement terms, the timing of payments and the impact of such settlements on other uncertain tax positions, the range of estimated potential decreases in underlying uncertain tax positions is between $0 and $10 million in the next twelve months.
We believe that sufficient positive evidence exists from historical operations and projections of taxable income in future years to conclude that it is more likely than not that we will realize our deferred tax assets. Accordingly, we apply a valuation allowance only on the deferred tax assets relating to capital loss carryforwards due to limited carryforward periods and the character of such tax attributes. The Governor of the State of California has introduced tax proposals affecting future state income tax apportionment that may have a significant impact on our ability to realize certain California deferred tax assets. We will reevaluate the realization of these California deferred tax assets if and when the current law changes.
Liquidity and Capital Resources
We use cash generated by operations as our primary source of liquidity. We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors, including fluctuations in our revenues, the rate at which products are shipped during the quarter, accounts receivable collections, inventory and supply chain management, and the timing and amount of tax and other payments. For additional discussion, see Part II - Other Information, Item 1A. Risk Factors.
During the third quarter of fiscal year 2011, we amended our term debt credit agreement to refinance all of the outstanding term loan with a replacement term loan that reduced interest rates on the term loan facility, and to amend certain other provisions of the Credit Agreement to provide us with greater flexibility, including extending the maturity date of the term loan facility to October 31, 2014.
Based on past performance and current expectations, we believe that internally generated cash flows are generally sufficient to support business operations, capital expenditures, contractual obligations, and other liquidity requirements associated with our operations for at least the next twelve months. Also, we have up to $125 million available under our revolving credit facility, and we can factor our trade receivables up to the maximum amount available at any time of our $50 million factoring facility to provide additional liquidity. There are no other transactions, arrangements, or other relationships with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity and the availability of and our requirements for capital resources.
Cash and cash equivalents and short-term investments as of January 28, 2012 increased by $70.0 million over the balance as of October 29, 2011 primarily due to cash from operating activities, partially offset by accelerated payments towards the principal of the term loan.
As of January 28, 2012, two customers accounted for 15% and 11%, respectively, of total accounts receivable, for a combined total of 26% of total accounts receivable. As of October 29, 2011, two customers accounted for 16% and 14%, respectively, of total accounts receivable, for a combined total of 30% of total accounts receivable. We perform ongoing credit evaluations of our customers and generally do not require collateral or security interests on accounts receivable balances. We have established reserves for credit losses, sales allowances, and other allowances. While we have not experienced material credit losses in any of the periods presented, there can be no assurance that we will not experience material credit losses in the future.
Net proceeds from the issuance of common stock in connection with employee participation in our equity compensation plans have historically been a significant component of our liquidity. The extent to which our employees participate in these programs generally increases or decreases based upon changes in the market price of our common stock. As a result, our cash flow resulting from the issuance of common stock in connection with employee participation in equity compensation plans will vary.
Three Months Ended January 28, 2012 Compared to Three Months Ended January 29, 2011
Operating Activities. Net cash provided by operating activities increased for the three months ended January 28, 2012 compared to the three months ended January 29, 2011 by $8.8 million. The increase was primarily due to higher net income in the reporting period and decreased payments with respect to accounts payable, partially offset by higher payments with respect to employee compensation and lower accounts receivables collections.
Investing Activities. Net cash used in investing activities decreased for the three months ended January 28, 2012 compared with the three months ended January 29, 2011 by $5.6 million. The decrease was due to lower purchases of property and equipment in the three months ended January 28, 2012.
Financing Activities. Net cash used in financing activities increased for the three months ended January 28, 2012, compared to the three months ended January 29, 2011 by $22.7 million. The increase was primarily due to higher net debt payments partially offset by increased proceeds from issuance of common stock during the three months ended January 28, 2012.
Manufacturing and Purchase Commitments. We have manufacturing arrangements with contract manufacturers under which we provide twelve-month product forecasts and place purchase orders in advance of the scheduled delivery of products to our customers. Our purchase commitments reserve reflects our estimate of purchase commitments we do not expect to consume in normal operations within the next twelve months, in accordance with our policy (see Note 8, Commitments and Contingencies, of the Notes to Condensed Consolidated Financial Statements).
Income Taxes. We accrue U.S. income taxes on the earnings of our foreign subsidiaries unless the earnings are considered indefinitely reinvested outside of the United States. We intend to reinvest current and accumulated earnings of our foreign subsidiaries for expansion of our business operations outside the United States for an indefinite period of time.
Our existing cash, cash equivalents and short-term investments totaled $485.0 million as of January 28, 2012. Of this amount, approximately 65% was held by our foreign subsidiaries. Under current tax laws and regulations, if these funds are distributed to the United States in the form of dividends or otherwise, we may be subject to additional U.S. income taxes and foreign withholding taxes.
The IRS and other tax authorities regularly examine our income tax returns (see Note 11, Income Taxes, of the Notes to Condensed Consolidated Financial Statements). We believe we have adequate reserves for all open tax years.
Senior Secured Credit Facility. A portion of our outstanding debt is related to the financing of the Foundry acquisition, the costs and expenses related to the merger, and the ongoing working capital and other general corporate purposes of the combined organization after consummation of the merger (see Note 7, Borrowings, of the Notes to Condensed Consolidated Financial Statements). During the third quarter of fiscal year 2011, we amended our term debt credit agreement to refinance all of the outstanding term loan with a replacement term loan that reduced interest rates on the term loan facility, and to amend certain other provisions of the Credit Agreement to provide us with greater operating flexibility, including extending the maturity date of the term loan facility to October 31, 2014 and removing certain restrictions on the repurchase of the Companys shares, provided the consolidated senior secured leverage ratio is under 2.00. During the three months ended January 28, 2012, we paid $70.0 million towards the principal of the Senior Secured Credit Facility, $61.6 million of which were voluntary prepayments. We have the following resources available to obtain short-term or long-term financing, if we need additional liquidity, as of January 28, 2012 (in thousands):
Senior Secured Notes. In January 2010, we issued $300 million in aggregate principal amount of senior secured notes due 2018 (the 2018 Notes) and $300 million in aggregate principal amount of senior secured notes due 2020 (the 2020 Notes and together with the 2018 Notes, the senior secured notes).The proceeds from the senior secured notes were used to pay down debt and retire convertible subordinated debt at maturity.
Trade Receivables Factoring Facility. We have an agreement with a financial institution to sell certain of our trade receivables from customers with limited, non-credit related, recourse provisions. The sale of receivables eliminates our credit exposure in relation to these receivables. Total trade receivables sold under our factoring facility are summarized as follows (in thousands):
Under the terms of the factoring agreement, the remaining available amount of the factoring facility as of January 28, 2012 is $50.0 million.
The senior secured notes were issued pursuant to two separate indentures (together, the Indentures), among the Company, the Subsidiary Guarantors and Wells Fargo Bank, National Association, as trustee. Each of the Indentures contains covenants that, among other things, restrict the ability of the Company and its restricted subsidiaries to:
These covenants are subject to a number of other limitations and exceptions set forth in the Indentures. The Company was in compliance with all applicable Indentures covenants as of January 28, 2012 and October 29, 2011.
Each of the Indentures provides for customary events of default, including, but not limited to, cross defaults to specified other debt of the Company and its subsidiaries. In the case of an event of default arising from specified events of bankruptcy or insolvency, all outstanding senior secured notes will become due and payable immediately without further action or notice. If any other event of default under either Indenture occurs or is continuing, the applicable trustee or holders of at least 25% in aggregate principal amount of the then outstanding 2018 Notes or 2020 Notes, as applicable, may declare all of the 2018 Notes or 2020 Notes, respectively, to be due and payable immediately.
The Senior Secured Credit Facility agreement contains customary representations and warranties and customary affirmative and negative covenants applicable to the Company and its subsidiaries, including, among other things, restrictions on liens, indebtedness, investments, fundamental changes, dispositions, capital expenditures, prepayment of other indebtedness, redemption or repurchase of subordinated indebtedness, share repurchases, dividends and other distributions. The credit agreement contains financial covenants that require the Company to maintain a minimum consolidated fixed charge coverage ratio, a maximum consolidated leverage ratio and a maximum consolidated senior secured leverage ratio, each as defined in the credit agreement and described further below. The credit agreement also includes customary events of default, including cross-defaults on the Companys material indebtedness and change of control. The Company was in compliance with all applicable covenants as of January 28, 2012 and October 29, 2011.
Consolidated Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), as defined in the credit agreement, is used to determine the Companys compliance with certain covenants in the Senior Secured Credit Facility. Consolidated EBITDA is defined as:
The Senior Secured Credit Facility financial covenants are defined as below:
Consolidated Fixed Charge Coverage Ratio
Consolidated fixed charge coverage ratio means, at any date of determination, the ratio of (a) (i) consolidated EBITDA (excluding interest expense, if any, attributable to the campus sale-leaseback), plus (ii) rentals payable under leases of real property, less (iii) the aggregate amount of all capital expenditures to (b) consolidated fixed charges; provided that, for purposes of calculating the consolidated fixed charge coverage ratio for any period ending prior to the first anniversary of the closing date, consolidated interest charges shall be an amount equal to actual consolidated interest charges from the closing date through the date of determination multiplied by a fraction the numerator of which is 365 and the denominator of which is the number of days from the closing date through the date of determination.
In accordance with the amendment and waiver to the credit agreement, the Company has agreed that it will not permit the consolidated fixed charge coverage ratio as of the end of any fiscal quarter during any period set forth below to be less than the ratio set forth below opposite such period:
Consolidated Leverage Ratio
Consolidated leverage ratio means, as of any date of determination, the ratio of (a) consolidated funded indebtedness as of such date to (b) consolidated EBITDA for the measurement period ending on such date.
In accordance with the amendment and waiver to the credit agreement, the Company has agreed that it will not permit the consolidated leverage ratio at any time during any period set forth below to be greater than the ratio set forth below opposite such period:
Consolidated Senior Secured Leverage Ratio
Consolidated senior secured leverage ratio means, as of any date of determination, the ratio of (a) consolidated funded indebtedness as of such date, minus, without duplication, all unsecured senior subordinated or subordinated indebtedness of Brocade or its subsidiaries on a consolidated basis as of such date (including the McDATA Corporation (McDATA) convertible subordinated debt prior to being retired on February 16, 2010), to (b) consolidated EBITDA for the measurement period ending on such date.
In accordance with the amendment and waiver to the credit agreement, the Company has agreed that it will not permit the consolidated senior secured leverage ratio at any time during any period set forth below to be greater than the ratio set forth below opposite such period:
The following table summarizes our contractual obligations, including interest expense, and commitments as of January 28, 2012 (in thousands):
Share Repurchase Program. As of November 29, 2007, our Board of Directors authorized a total of $800.0 million for the repurchase of our common stock. The purchases may be made, from time to time, in the open market or by privately negotiated transactions and will be funded from available working capital. The number of shares to be purchased and the timing of purchases will be based on the level of our cash balances, general business and market conditions, our debt covenants and other factors, including alternative investment opportunities. Approximately $178.4 million remains authorized for future repurchases under this program as of January 28, 2012. We are subject to certain covenants relating to our borrowings that restrict the amount of our Companys shares that we can repurchase. There is no restriction on the repurchase of our Companys shares under the terms of our Senior Secured Credit Facility, provided our consolidated senior secured leverage ratio as defined in the credit agreement is under 2.00. We made no repurchases for the three months ended January 28, 2012 due to prioritizing our use of cash for debt repayment.
Off-Balance Sheet Arrangements
As part of our ongoing business, we do not participate in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As of January 28, 2012, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Securities and Exchange Commission (SEC) Regulation S-K.
Critical Accounting Estimates
There have been no material changes in the matters for which we make critical accounting estimates in the preparation of our condensed consolidated financial statements during the three months ended January 28, 2012 as compared to those disclosed in our Annual Report on Form 10-K for the fiscal year ended October 29, 2011.
Impairment of goodwill and intangible assets. Goodwill is generated as a result of business combinations. We conduct our goodwill impairment test annually, as of the first day of the second fiscal quarter, or whenever events or changes in facts and circumstances indicate that the fair value of the reporting unit may be less than its carrying amount. Events which might indicate impairment include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on our customer base, material negative changes in relationships with significant customers, and/or a significant decline in our stock price for a sustained period. Consistent with prior years, we will perform our annual goodwill impairment test using measurement data as of the first day of the second fiscal quarter of 2012.
Our last annual goodwill impairment test was performed as of the first day of the second quarter of 2011. We applied a two-step approach in testing goodwill for impairment for each reporting unit, which we have determined to be at the operating segment level. The reporting units are determined by the components of our operating segments that constitute a business for which both (i) discrete financial information is available and (ii) segment management regularly reviews the operating results of that component. Our four reporting units are: Data Storage Products; Ethernet Switching & Internet Protocol (IP) Routing, which includes Open Systems Interconnection Reference Model (OSI) Layer 2-3 products; Application Delivery Products (ADP), which includes OSI Layer 4-7 products; and Global Services.
Based on our most recent testing results all of our reporting units passed the step one test and step two was not required to be performed. However, because some of the inherent assumptions and estimates used in determining the fair value of these reportable segments are outside the control of management, changes in these underlying assumptions can adversely impact fair value. The sensitivity analysis below quantifies the impact of key assumptions on certain reporting units fair value estimates. The principal key assumptions impacting our estimates were (i) discount rates and (ii) DCF terminal value multipliers. As the discount rates, ultimately, reflect the risk of achieving reporting units revenue and cash flow projections, we do not believe that a separate sensitivity analysis for changes in revenue and cash flow projections is meaningful or useful.
The estimated fair value of the Ethernet Switching & IP Routing reporting unit exceeded its carrying value by approximately $176 million and the ADP reporting unit exceeded its carrying value by approximately $34 million. The respective fair values of our remaining reporting units exceeded carrying value by significant amounts and were not subject to the sensitivity analysis presented below.
The following table summarizes the approximate impact that a change in principal key assumptions would have on the estimated fair value of Ethernet Switching & IP Routing reporting unit, leaving all other assumptions unchanged:
The following table summarizes the approximate impact that a change in principal key assumptions would have on the estimated fair value of ADP reporting unit, leaving all other assumptions unchanged:
Recent Accounting Pronouncements
For a description of recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on our condensed consolidated financial statements, see Note 2, Summary of Significant Accounting Policies, of the Notes to Condensed Consolidated Financial Statements.
In the normal course of business, we are exposed to market risks related to changes in interest rates, foreign currency exchange rates and equity prices that could impact our financial position and results of operations. Our risk management
strategy with respect to these three market risks may include the use of derivative financial instruments. We use derivative contracts only to manage existing underlying exposures of the Company. Accordingly, we do not use derivative contracts for speculative purposes. Our risks and risk management strategy are outlined below. Actual gains and losses in the future may differ materially from the sensitivity analyses presented below based on changes in the timing and amount of interest rates and our actual exposures and hedges.
Interest Rate Risk
Our exposure to market risk due to changes in the general level of United States interest rates relates primarily to our term loan and cash equivalents.
We are exposed to changes in interest rates as a result of our borrowings under our term loan. As of January 28, 2012, the weighted-average annualized interest rate on the term loan was 3.0%. Based on outstanding principal indebtedness of $120.0 million under our term loan as of January 28, 2012, if market rates average 1% above the current interest rate, our annual interest expense would increase by approximately $1.2 million.
Our cash and cash equivalents are primarily maintained at five major financial institutions. The primary objective of our investment activities is the preservation of principal while maximizing investment income and minimizing risk.
The Company did not have any material investments as of January 28, 2012 that are sensitive to changes in interest rates.
Foreign Currency Exchange Rate Risk
We are exposed to foreign currency exchange rate risk inherent in conducting business globally in numerous currencies, of which the most significant to our operations for the three months ended January 28, 2012 were the Chinese yuan, the euro, the Japanese yen, the Indian rupee, the British pound, the Singapore dollar and the Swiss franc. We are primarily exposed to foreign currency fluctuations related to operating expenses denominated in currencies other than the U.S. dollar. As such, we benefit from a stronger U.S. dollar and may be adversely affected by a weaker U.S. dollar relative to the foreign currency. We use foreign currency forward contracts designated as cash flow hedges to protect against the foreign currency exchange rate risks inherent in our forecasted operating expenses denominated in currencies other than the U.S. dollar. We recognize the gains and losses on foreign currency forward contracts in the same period as the remeasurement losses and gains of the related foreign currency denominated exposures.
We also may enter into other non-designated derivatives that consist primarily of forward contracts to minimize the risk associated with the foreign exchange effects of revaluing monetary assets and liabilities. Monetary assets and liabilities denominated in foreign currencies and any associated outstanding forward contracts are marked-to-market with realized and unrealized gains and losses included in earnings.
Alternatively, we may choose not to hedge the foreign currency risk associated with our foreign currency exposures if we believe such exposure acts as a natural foreign currency hedge for other offsetting amounts denominated in the same currency or if the currency is difficult or too expensive to hedge. As of January 28, 2012, we held $107.0 million in cash flow derivative instruments. The maximum length of time over which we are hedged as of January 28, 2012 is through October 3, 2012.
We have performed a sensitivity analysis as of January 28, 2012, using a modeling technique that measures the change in the fair values arising from a hypothetical 10% adverse movement in the levels of foreign currency exchange rates relative to the U.S. dollar, with all other variables held constant. The analysis covers all of our foreign currency contracts offset by the underlying exposures. The foreign currency exchange rates we used were based on market rates in effect at January 28, 2012. The sensitivity analysis indicated that a hypothetical 10% adverse movement in foreign currency exchange rates would not result in a material foreign exchange loss as of January 28, 2012.
Equity Price Risk
We had no investments in publicly traded equity securities as of January 28, 2012. The aggregate cost of our equity investments in non-publicly traded companies was $7.0 million as of January 28, 2012. We monitor our equity investments for impairment on a periodic basis. In the event that the carrying value of the equity investment exceeds its fair value, and we determine the decline in value to be other-than-temporary, we reduce the carrying value to its current fair value. Generally, we do not attempt to reduce or eliminate our market exposure on these equity securities. We do not purchase our equity securities with the intent to use them for speculative purposes.
Our common stock is quoted on the NASDAQ Global Select Market under the symbol BRCD. On January 27, 2012, the last business day of our first fiscal quarter of 2012, the last reported sale price of our common stock on the NASDAQ Global Select Market was $5.62 per share.
(a) Evaluation of Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this Quarterly Report on Form 10-Q (the Evaluation Date).
The purpose of this evaluation is to determine if, as of the Evaluation Date, our disclosure controls and procedures are effective such that the information required to be disclosed in our SEC reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective.
(b) Changes in Internal Control over Financial Reporting. There were no changes in our internal control over financial reporting that occurred during the quarter ended January 28, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Limitations on the Effectiveness of Disclosure Controls and Procedures.
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and implemented, can provide only reasonable, not absolute, assurance that the control systems objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within a company are detected. The inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple errors or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls.
Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.
Information set forth in the Legal Proceedings portion of Note 8, Commitments and Contingencies, of the Notes to Condensed Consolidated Financial Statements in Part 1, Item 1 of this Form 10-Q is incorporated herein by reference.
Uncertainty about or a slowdown in the domestic and global economies may increasingly adversely affect Brocades operating results and financial condition.
There is ongoing uncertainty about the domestic and global economies and there may be a prolonged period of significant slowdown. Such uncertainty or slowdown may result in lower growth in the networking industry and reduced demand for information technology, including high-performance data networking solutions. Information technology spending has historically declined as federal spending decreases and general economic and market conditions have worsened. If the domestic and/or global economy undergoes a prolonged period of uncertainty or a significant downturn, such as the debt crisis occurring in the Eurozone economy, or if Brocades customers believe such a period of uncertainty or a downturn will continue for a sustained period, they will likely reduce their information technology spending and future budgets. Brocade is particularly susceptible to reductions in information technology spending because the purchase of Brocades products is often discretionary and may involve a significant commitment of capital and other resources. Future delays or reductions in information technology spending, domestically and/or internationally, could harm Brocades business, results of operations and financial condition in a number of ways, including longer sales cycles, increased inventory provisions, increased production costs, lowered prices for products and reduced sales volumes. Similarly, as Brocades suppliers face challenges in obtaining credit or otherwise in operating their businesses, they may become unable to continue to offer the materials Brocade uses to manufacture its products. These events have caused, and may cause further, reductions in Brocades revenue, profitability and cash flows, increased price competition, increased operating costs and longer fulfillment cycles and exacerbate many other risks noted in this Form 10-Q, which adversely affect Brocades business, results of operations and financial condition.
Given the current uncertainty about the extent and duration of the global financial recovery, it is increasingly difficult for Brocade, Brocades customers and Brocades suppliers to accurately forecast future product demand trends, which could cause Brocade to produce excess products that would increase Brocades inventory carrying costs and result in obsolete inventory. Alternatively, this forecasting difficulty could cause a shortage of products or materials used in Brocades products that would result in an inability to satisfy demand for Brocades products and a loss of market share.
A period of uncertainty or economic downturn may also significantly affect financing markets, the availability of capital and the terms and conditions of financing arrangements, including the overall cost of financing. Circumstances may arise in which Brocade needs, or desires, to raise additional capital. Such capital may not be available on commercially reasonable terms, or at all, which in turn could adversely affect Brocades financial condition.
Intense competition in the market for networking solutions could prevent Brocade from increasing or maintaining revenue, profitability and cash flows with respect to its networking solutions.
The networking market is increasingly competitive. While Cisco Systems, Inc. (Cisco) maintains a dominant position in the Ethernet networking market, other companies have strengthened their networking portfolios through acquisitions, including the acquisition of Force10 Networks by Dell Inc. (Dell), the acquisition of 3Com Corporation by Hewlett-Packard Company (HP), and the acquisition of Blade Network Technologies by International Business Machines Corporation (IBM). These acquisitions will significantly limit Brocades ability to sell Ethernet products through these companies and may also indirectly impact the Fibre Channel business. HP, IBM and Dell are important OEM partners for Brocade in the Fibre Channel switching market, yet also are competitive with Brocade in other respects. Other competitors in the Ethernet networking market include Arista Networks, Alcatel-Lucent, Avaya Inc., A10 Networks, Inc. (A10), Enterasys Networks, Inc., Extreme Networks, Inc., F5 Networks, Inc., Huawei Technologies Co. Ltd., and Juniper Networks, Inc.
Brocade also competes with Cisco and QLogic Corporation in the Fibre Channel switching market and with QLogic Corporation and Emulex Corporation in the server connectivity or HBA market. In addition, EMC Corporation, one of Brocades top OEM customers in terms of Fibre Channel sales and a go-to-market and technology partner since 1997, has formed a separate venture with Cisco and VMware called Virtual Computing Environment that enables the new company to sell packaged cloud computing and data center virtualization solutions.
The above-referenced acquisitions and business partnerships demonstrate the increasingly complex nature of relationships within the networking industry, especially as the IT industry migrates to cloud computing models. This trend has led the networking industry to introduce new solutions and technology architectures to support cloud computing. Brocade calls this category Ethernet fabrics and has introduced a new portfolio through the Brocade VDX family of Data Center Switches and the Brocade VCS software. Brocades competitors also recently introduced and have begun shipping new products focused on cloud computing and delivering alternative flat network solutions such as Juniper Networks, Inc. with its QFabric architecture and Cisco with its FabricPath. Other competitors in cloud solutions include Arista Networks, Avaya Inc., Alcatel-Lucent and Dell/Force10 Networks who have all recently introduced roadmaps and solutions targeted at cloud computing users.
Some of Brocades competitors have greater market leverage, longer operating histories, greater financial, technical, sales, marketing and other resources, more name recognition and larger installed customer bases. Brocades competitors could also adopt more aggressive pricing policies than Brocade. Brocade believes that competition based on price may become more aggressive than it has traditionally experienced. As a result of these factors, Brocades competitors could devote more resources to develop, promote and sell their own products rather than Brocades, and, therefore, those competitors could respond more quickly to changes in customer or market requirements. Brocades failure to successfully compete in the market would harm Brocades business and financial results.
The prices of Brocades products have declined in the past and Brocade expects the prices of Brocades products to continue to decline, which could reduce Brocades revenues, gross margins and profitability.
The average selling price for Brocades products has typically declined in the past and will likely continue to decline in the future as a result of changes in competitive pricing pressure, broader macroeconomic factors, product mix, enhanced marketing programs, increased sales discounts, new product introductions by Brocade or Brocades competitors, the entrance of new competitors and other factors. Price declines may also increase as competitors ramp up product releases that compete with Brocades products. Furthermore, particularly as economic conditions deteriorate and drive a more cautious capital spending environment in the technology sector, Brocade and its competitors could pursue more aggressive pricing strategies in an effort to maintain or seek to increase sales levels. If Brocade is unable to offset the negative impact from the above factors on the average selling price of Brocades products by increasing the volume of products shipped or reducing product manufacturing costs, Brocades total revenues and gross margins will be negatively impacted.
In addition, to maintain Brocades gross margins, Brocade must maintain or increase the number of existing products shipped and develop and introduce new products and product enhancements with improved costs, and continue to reduce the overall manufacturing costs of Brocades products. While Brocade has successfully reduced the cost of manufacturing Brocades products in the past, Brocade may not be able to continue to reduce cost of production at historical rates or at all. Moreover, most of Brocades expenses are fixed in the short-term or incurred in advance of receipt of corresponding revenue. As a result, Brocade may not be able to decrease its spending quickly enough or in sufficient amounts to offset any unexpected shortfall in revenues. If this occurs, Brocade could incur losses and Brocades operating results and gross margins could be below expectations. Additionally, Brocades gross margins may be negatively affected by fluctuations in manufacturing volumes, component costs, foreign currency exchange rates, the mix of product configurations sold and the mix of distribution channels through which its products are sold. In addition, if product or related warranty costs associated with Brocades products are greater than previously experienced, Brocades gross margins may also be adversely affected. Brocade has also announced its plans to increase gross margins for its Ethernet products by a combination of initiatives, including new product introductions with improved gross margins, normalized pricing, inventory management and increased product volumes. If Brocade is not able to successfully execute on one or more of these on-going initiatives, gross margin improvements may not be realized.
The loss of any of Brocades major OEM customers, the failure to successfully grow a direct and channel model or any other significant failure to execute on Brocades overall sales strategy could significantly reduce Brocades revenues and negatively affect Brocades financial results.
Brocades SAN business depends on recurring purchases from a limited number of large OEM partners for a substantial portion of its revenues. As a result, these large OEM partners have a significant influence on Brocades quarterly and annual financial results. For fiscal years 2011, 2010 and 2009, the same three customers each represented 10% or more of Brocades total net revenues. Brocades agreements with its OEM partners are typically cancelable, non-exclusive, have no minimum purchase requirements and have no specific timing requirements for purchases. Brocades OEM partners could also elect to eliminate, reduce, or rebalance the amount they purchase from Brocade and/or increase the amount purchased from Brocades competitors or introduce their own technology. Changes to inventory levels at one or multiple partners can impact Brocades revenue and earnings results and may mask underlying changes in end-user demand. Also, one or more of Brocades OEM partners could elect to consolidate or enter into a strategic partnership with one of Brocades competitors, which could reduce or eliminate Brocades future revenue opportunities with that OEM partner. Brocade anticipates that a significant portion of its
revenues and operating results from its SAN business will continue to depend on sales to a relatively small number of OEM partners. The loss of any one significant OEM partner, or a decrease in the level of sales to any one significant OEM partner, or unsuccessful quarterly negotiation on key terms, conditions or timing of purchase orders placed during a quarter, would likely cause serious harm to Brocades business and financial results.
Brocades OEM partners evaluate and qualify Brocades SAN products for a limited time period before they begin to market and sell them. Assisting Brocades OEM partners through the evaluation process requires significant sales, marketing and engineering management efforts on Brocades part, particularly if Brocades SAN products are being qualified with multiple distribution partners at the same time. In addition, once Brocades SAN products have been qualified, its customer agreements have no minimum purchase commitments. Brocade may not be able to effectively maintain or expand its distribution channels, manage distribution relationships successfully, or market its products through distribution partners.
Brocade offers its Ethernet products through a multipath distribution strategy, including through resellers, distributors, and the Brocade direct sales force, and through OEMs that have historically offered Brocade SAN products. However, Brocades efforts to increase sales through both these new and expanded channels may not generate much, if any, incremental Ethernet revenue opportunities for Brocade. This is further compounded by the fact that several major OEMs, including Dell, IBM and HP, have acquired companies who offer Ethernet products competitive to Brocades offerings. A loss of or significant reduction in revenue through one of Brocades paths to market would impact Brocades financial results.
Additionally, Brocade has focused substantial resources to emphasize the Ethernet networking market and grow revenues through a multi-tier channel strategy. This focus towards the Ethernet networking market may negatively impact Brocades other businesses such as its Data Storage networking products because managements attention and limited resources such as employees may be reallocated away from Brocades Data Storage products and towards Ethernet products. Brocade must continually anticipate and respond to the needs of its distribution partners and their customers, and ensure that its products integrate with their solutions. Brocades failure to successfully manage and grow its distribution relationships or the failure of its distribution partners to sell Brocades products could reduce Brocades revenues significantly. In addition, Brocades ability to respond to the needs of its distribution partners in the future may depend on third parties producing complementary products and applications for Brocades products. There can be no assurance that Brocade will be successful in expanding its go-to-market objectives. If Brocade fails to respond successfully to the needs of these distribution partners, its business and financial results could be harmed.
The loss or delay of continued orders from any of Brocades more significant customers, such as the U.S. government or individual agencies within the U.S. government such as the Department of Defense or certain intelligence agencies where Brocades revenue is highly concentrated, or companies within the financial services, education and health sectors, could also cause its revenue and profitability to suffer. For example, if Brocade is unable to offer qualified products to such government customers due to regulations and requirements with respect to country of origin designation, or if Brocade experiences governmental procurement delays due to the timing of approval of the federal budget, budget reductions that target specific agencies where Brocades revenue is concentrated, including reductions resulting from the recently failed efforts by the Congressional Super Committee, or other reasons, Brocades revenue and operating results could be negatively impacted. In addition, a change in the mix of Brocades customers, or a change in the mix of direct and indirect sales, could adversely affect its revenue and gross margins. Also, such governmental delays or budget reductions could negatively impact IT spending across the broader economy and therefore negatively impact Brocades revenue and operating results.
Brocades future revenue growth depends on its ability to introduce new products and services on a timely basis and achieve market acceptance of these new products and services.
Developing new offerings requires significant upfront investments that may not result in revenue for an extended period of time, if at all. Brocade must achieve widespread market acceptance of Brocades new product and service offerings on a timely basis in order to realize the benefits of Brocades investments. The market for networking solutions, however, is characterized by rapidly changing technology, accelerating product introduction cycles, changes in customer requirements and evolving industry standards. Brocades future success depends largely upon its ability to address the rapidly changing needs of its customers by developing and supplying high-quality, cost-effective products, product enhancements and services on a timely basis and by keeping pace with technological developments and emerging industry standards. This risk will likely become more pronounced if the networking market become more competitive and if demand for new and improved technologies increases.
Examples of such technological developments include adoption of network attached storage and internet small computer system interface in storage networks, which may displace existing products in customer IT implementations and may erode the total addressable market for Fibre Channel products. Brocade recently introduced a number of Fibre Channel switching products that support the new 16 gigabits per second technology standards. The transition to this new Fibre Channel technology may be negatively impacted if customers accelerate their adoption of alternative storage networking technologies.
Brocade is also an early developer of, and the vendor who was first-to-market for, Ethernet fabrics based on the Brocade VDX 6720 and Brocade VCS software, which were built to provide the features necessary to support server virtualization and cloud based architectures. The success of Ethernet fabrics will depend on customers recognizing the benefits of upgrading their data center local area networks to fabric-based architectures. Although Brocade plans to continue to invest in this area with new and enhanced Ethernet fabric solutions, Brocades future success would be negatively impacted if this technological transition does not occur at the anticipated rate or at all.
Other factors that may affect Brocades successful introduction of new product and service offerings include Brocades ability to:
Various factors impacting market acceptance are outside of Brocades control, including the following:
If Brocade is not able to successfully develop and market new and enhanced products and services on a timely basis, its business and results of operations will likely be harmed.
As Brocade introduces new or enhanced products, Brocade must also successfully manage the transition from older products to minimize disruption in customers ordering patterns, avoid excessive levels of older product inventories and provide sufficient supplies of new products to meet customer demands. When Brocade introduces new or enhanced products, Brocade faces numerous risks relating to product transitions, including the inability to accurately forecast demand, manage excess and obsolete inventories, address new or higher product cost structures, and manage different sales and support requirements due to the type or complexity of the new products. In addition, any customer uncertainty regarding the timeline for rolling out new products or Brocades plans for future support of existing products may negatively impact customer purchase decisions.
If Brocade loses key talent or is unable to hire additional qualified talent, Brocades business may be harmed.
Brocades success depends, to a significant degree, upon the continued contributions of key management, engineering, sales and other talent, many of whom would be difficult to replace. Brocade believes its future success depends, in large part, upon Brocades ability to effectively attract highly skilled sales talent in addition to managerial, engineering and other talent, and on the ability of management to operate effectively, both individually and as a group, in geographically diverse locations. There is limited qualified talent in each applicable market and competition for such talent has become much more aggressive. Other companies in Brocades industry and geographic regions are recruiting from the same limited talent pool which creates further
compression on the availability of qualified talent. In particular, Brocade operates in various locations with highly competitive labor markets including Bangalore, India and San Jose, California, as well as certain emerging labor markets, such as the Eastern European and Latin American markets. Brocade may experience difficulty in hiring qualified talent with skills in areas such as sales, application-specific integrated circuits (ASICs), software, system and test, product management, marketing, service, customer support and key management.
In addition, future declines in Brocades stock price would reduce the value of equity awards granted to its employees. If such a decline in Brocades stock price were to occur, Brocades ability to incentivize, retain or attract qualified talent could be negatively impacted. Additionally, such declines in stock price may result in additional underwater stock options held by certain employees. Brocades ability to retain qualified talent may also be affected by future acquisitions, which may cause uncertainty and loss of key talent. The loss of the services of any of Brocades key employees, the inability to attract or retain qualified talent in the future, or delays in hiring required talent, particularly sales and engineering talent, could delay the development and introduction of Brocades products or services, and negatively affect Brocades ability to sell its products or services.
In addition, companies in the computer storage, networking and server industries whose employees accept positions with competitors may claim that their competitors have engaged in unfair hiring practices or that there will be inappropriate disclosure of confidential or proprietary information. Brocade may be subject to such claims in the future as Brocade seeks to hire additional qualified talent. Such claims could result in litigation. As a result, Brocade could incur substantial costs in defending against these claims, regardless of their merits, and be subject to additional restrictions if any such litigation is resolved against Brocade.
The failure to accurately forecast demand for Brocades products or the failure to successfully manage the production of Brocades products could negatively affect Brocades product cost or Brocades ability to manufacture and sell Brocades products.
Brocade provides product forecasts to its contract manufacturers and places purchase orders with them in advance of the scheduled delivery of products to Brocades customers. In preparing sales and demand forecasts, Brocade relies largely on input from its sales force, partners, resellers and end-user customers. Therefore, if Brocade or its partners are unable to accurately forecast demand, or if Brocade fails to effectively communicate with its distribution partners about end-user demand or other time-sensitive information, the sales and demand forecasts may not reflect the most accurate, up-to-date information. If these forecasts are inaccurate, Brocade may be unable to obtain adequate manufacturing capacity from its contract manufacturers to meet customers delivery requirements or Brocade may accumulate excess inventories. Furthermore, Brocade may not be able to identify forecast discrepancies until late in its fiscal quarter. Consequently, Brocade may not be able to make timely adjustments to its business model. If Brocade is unable to obtain adequate manufacturing capacity from its contract manufacturers, or if Brocade is unable to make necessary adjustments to Brocades business model to offset forecast discrepancies, revenue may be delayed or even lost to Brocades competitors and Brocades business and financial results may be harmed. If excess inventories accumulate, Brocades gross margins may be negatively impacted by write-downs for excess and/or obsolete inventory. In addition, Brocade may experience higher fixed costs as it expands its contract manufacturer capabilities, which could negatively affect Brocades ability to react quickly if demand suddenly decreases.
Brocades ability to accurately forecast demand also may become increasingly more difficult as Brocade introduces new or enhanced products, begins phasing out certain products, or acquires other companies or businesses. Forecasting demand for products that are nearing end of life or are being replaced by new versions, and decreasing production on these older products, while at the same time ramping up production on the new products, may be difficult. Brocade may be unable to obtain adequate supply of new product components and/or manufacturing capacity from its contract manufacturers to meet customers delivery requirements and such a situation may negatively impact revenues. Brocade may also accumulate excess inventories that may negatively impact gross margins due to write-downs for excess and/or obsolete inventory.
In addition, although the purchase orders placed with Brocades contract manufacturers are cancelable in certain circumstances, if Brocade cancels any of its contract manufacturer (CM) purchase orders, Brocade could be required to purchase certain unused material of the CM if that material is not returnable, usable by, or sold to other customers. This purchase commitment exposure is particularly high in periods of new product introductions and product transitions. If Brocade is required to purchase unused material from Brocades contract manufacturers, Brocade could incur unanticipated expenses, including write-downs for excess and/or obsolete inventory, and Brocades business and financial results could be negatively affected. In the past, Brocade has experienced delays in shipments of its Ethernet products from its contract manufacturers and OEMs, which in turn delayed product shipments to its customers. Brocade may in the future experience similar delays or other problems, such as insufficient quantity of product, acquisition by a competitor or loss of business from one or more of its OEMs, any of which could harm Brocades business and operating results.
Brocade has a substantial amount of acquired intangible assets, goodwill and deferred tax assets on its balance sheet, and Brocade could be required to record impairment charges for these assets; Any impairment of the carrying value of those assets could adversely affect Brocades business and financial results.
Brocade has a substantial amount of acquired intangible assets, goodwill and deferred tax assets on its balance sheet. The goodwill and acquired intangibles relate to Brocades prior strategic acquisitions. In response to changes in industry and market conditions, Brocade may elect to realign its resources strategically and consider restructuring, selling, disposing of, or otherwise exiting businesses. Any decision to limit investment in, sell, dispose of or otherwise exit businesses may result in the recording of special charges, such as inventory and technology-related write-offs, goodwill impairment charges, intangible asset write-offs, workforce reduction costs, charges relating to consolidation of excess facilities, or claims from third parties who were resellers or users of discontinued products.
As a result of Brocades acquisition of Foundry in December 2008, Brocade reorganized into four operating segments, of which two are individually reportable segments: Data Storage Products and Global Services; and the two other operating segments, Ethernet Switching & IP Routing and ADP, combine to form a third reportable segment: Ethernet Products. Brocades determination of fair value of long-lived assets relies on managements assumptions of future revenues, operating costs, and other relevant factors. If managements estimates of future operating results change or if there are changes to other assumptions, such as the discount rate applied to future cash flows, the estimate of the fair value of Brocades reporting units could change significantly, which could result in goodwill impairment charges. Brocades estimates with respect to the useful life or ultimate recoverability of Brocades carrying basis of assets, including purchased intangible assets, could change as a result of such assessments and decisions. Brocade is required to perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances, and future goodwill impairment tests may result in a charge to earnings. Brocade conducted its annual goodwill impairment test during the second fiscal quarter of 2011, and determined that no impairment needed to be recorded (see Note 3, Goodwill and Intangible Assets, of the Notes to Condensed Consolidated Financial Statements, and sensitivity analysis performed in Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations). If future goodwill impairment tests result in a charge to earnings, Brocades financial results would be adversely affected.
Brocade has determined that more-likely-than-not it will realize its deferred tax assets based on positive evidence of its historical operations and projections of future income. Accordingly, the Company only applies a valuation allowance on the deferred tax assets relating to capital loss carryforwards. In the event future income by jurisdiction is less than what is currently projected, Brocade may be required to apply a valuation allowance to these deferred tax assets in jurisdictions where realization of such assets are no longer more-likely-than-not (see discussion in Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations, and also Note 15, Income Taxes, of the Notes to Consolidated Financial Statements in Part II, Item 8 of the Form 10-K).
Brocades estimates relating to the liabilities for excess facilities are also affected by changes in real estate market conditions. In addition, Brocade has made investments in certain private companies which could become impaired if the operating results of those companies change adversely.
Brocades revenues and operating results and financial position may fluctuate in future periods due to a number of factors, which make predicting results of operations difficult and could adversely affect the trading price of Brocades stock.
Information technology spending is subject to cyclical and uneven fluctuations. It can be difficult to predict the degree to which the seasonality and uneven sales patterns of Brocades OEM partners or other customers will affect Brocades business in the future, particularly as Brocade releases new products. While Brocades first and fourth fiscal quarters have typically been seasonally stronger quarters than its second and third fiscal quarters, particularly for storage networking products, future buying patterns may differ from historical seasonality. In addition, the United States federal budget for government IT spending can be subject to delay, reductions and uncertainty from time to time due to political and legislative volatility, which can cause Brocades financial results to fluctuate unevenly and unpredictably.
Uneven sales patterns are not only difficult to predict, but also can result in irregular shipment patterns that can cause shortages or underutilized capacity, increase costs due to higher inventory levels, and otherwise adversely impact inventory planning. For example, Brocades Ethernet networking business has experienced significantly higher levels of sales towards the end of a period. Orders received towards the end of the period may not ship within the period due to Brocades manufacturing lead times. This exposes Brocade to additional inventory risk because Brocade must order products in anticipation of expected future orders and additional sales risk if Brocade is unable to fulfill unanticipated demand.
Brocades quarterly and annual revenues and operating results and financial position may vary significantly in the future due to the factors noted above as well as other factors, including but not limited to, the following:
Accordingly, Brocades quarterly and annual revenues and operating results may vary significantly in the future. The results of any prior periods should not be relied upon as an indication of future performance. Brocade cannot assure you that in some future quarter Brocades revenues or operating results will not be below Brocades projections or the expectations of stock market analysts or investors, which could cause Brocades stock price to decline.
Brocade has extensive international operations, which subjects it to additional business risks.
A significant portion of Brocades sales occur in international jurisdictions. In addition, Brocades contract manufacturers have significant operations in China. Brocade plans to continue to expand its international operations and sales activities. Brocades international sales of its Ethernet networking products have primarily depended on a variety of its resellers, including Tech Data Corporation and Avnet Inc. in Europe and Net One Systems in Japan. The failure by international resellers to sell Brocades products could limit its ability to sustain and grow revenue. Maintenance or expansion of international sales or international operations involves inherent risks that Brocade may not be able to control, including:
Failure to manage expansion effectively could seriously harm Brocades business, financial condition and prospects. In addition, international political instability may halt or hinder Brocades ability to do business and may increase Brocades costs. Various events, including the occurrence or threat of terrorist attacks, increased national security measures in the United States and other countries, and military action and armed conflicts, may suddenly increase international tensions. Such events may have an adverse effect on the world economy and could adversely affect Brocades business operations or the operations of Brocades OEM partners, end-user customers and channels, contract manufacturers and suppliers.
To date, no material amount of Brocades international revenues and cost of revenues have been denominated in foreign currencies. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could make Brocades products more expensive and, thus, not competitively priced in foreign markets. Additionally, a decrease in the value of the U.S. dollar relative to foreign currencies could increase Brocades product and operating costs in foreign locations (e.g., appreciation of the European Unions euro and Chinese yuan). In the future, a larger portion of Brocades international revenues may be denominated in foreign currencies, which will subject Brocade to additional risks associated with fluctuations in those foreign currencies. In addition, Brocade may be unable to successfully hedge against any such fluctuations.
Brocade is subject to, and may in the future be subject to other, intellectual property infringement claims and litigation that are costly to defend and/or settle, and that could result in significant damage and cost awards against Brocade and limit Brocades ability to use certain technologies in the future.
Brocade competes in markets that are frequently subject to claims and related litigation regarding patent and other intellectual property rights. From time to time, third parties have asserted patent, copyright, trade secret, and/or other intellectual property related claims against Brocade and/or employees of Brocade. These claims may be, and have been in the past, made against Brocades products and services, subcomponents of its products, methods performed by its products, or a combination of products, including third party products, methods used in its operations or uses of its products by its customers, or may concern Brocades hiring of a former employee of the third party claimant. Brocade and companies acquired by Brocade, such as Foundry, have in the past incurred, are currently incurring, and will in the future incur, substantial expenses to defend against such third-party claims. For instance, Brocade currently is defending patent-related lawsuits, including lawsuits filed by A10, Enterasys Networks, Inc. and Chrimar Systems, Inc. Brocades suppliers and customers also may be subject to third party intellectual property claims, which could negatively impact their ability to supply Brocade or their willingness to purchase from Brocade, respectively. In addition, Brocade may be subject to claims and indemnification obligations with respect to third-party intellectual property rights pursuant to Brocade agreements with suppliers, OEM and channel partners, or customers. The third party asserters of such intellectual property claims may be unreasonable in their demands, or may simply refuse to settle, which could lead to expensive settlement payments, prolonged periods of litigation expenses, additional burden on employees or other resources, distraction from Brocades business initiatives and operations, component supply stoppages and lost sales. In the event of an adverse determination, Brocade could incur substantial monetary liability and be prohibited from utilizing certain intellectual property or technology, hiring certain people, selling, shipping, importing or servicing certain products or incorporating necessary components into Brocades products. Suppliers of components or OEM systems to Brocade may be unwilling to, or not be able to, defend or indemnify Brocade against third party assertions directed at, or based in part on, the components or systems they supply to Brocade, and may