10-Q 1 d246506d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED OCTOBER 31, 2011

OCTOBER 31, 2011

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM                      TO                     

COMMISSION FILE NUMBER 000-28139

BLUE COAT SYSTEMS, INC.

(Exact Name of Registrant as Specified In Its Charter)

 

 

 

DELAWARE   91-1715963

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

420 NORTH MARY AVENUE

SUNNYVALE, CALIFORNIA 94085

(Address of Principal Executive Offices and Zip Code)

Registrant’s Telephone Number, Including Area Code: (408) 220-2200

 

 

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.

 

Large accelerated filer  x       Accelerated filer  ¨   Non-accelerated filer  ¨     Smaller reporting company  ¨
    (Do not check if a smaller

reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)    YES  ¨    NO  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

There were 42,802,885 shares of the registrant’s Common Stock issued and outstanding as of November 22, 2011.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page  

PART I. FINANCIAL INFORMATION

     4   

Item 1.

   Financial Statements      4   
   Condensed Consolidated Balance Sheets as of October 31, 2011 and April 30, 2011      4   
   Condensed Consolidated Statements of Operations for the Three and Six Months Ended October 31, 2011 and 2010      5   
   Condensed Consolidated Statements of Cash Flows for the Six Months Ended October 31, 2011 and 2010      6   
   Notes to Condensed Consolidated Financial Statements      7   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      24   

Item 3.

   Quantitative and Qualitative Disclosures about Market Risk      41   

Item 4.

   Controls and Procedures      41   

PART II. OTHER INFORMATION

     43   

Item 1.

   Legal Proceedings      43   

Item 1A.

   Risk Factors      43   

Item 6.

   Exhibits      57   
  

Signatures

     58   

 

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FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements include, but are not limited to, statements concerning the following: plans to develop and offer new products and services and enter new markets; expectations with respect to future market growth opportunities; changes in and expectations with respect to revenues, gross margins and income tax provisions; future operating expense levels and operating margins; the impact of quarterly fluctuations of revenue and operating results; the success of our business strategy and changes in our business model, management, organizational structure and operations; the impact of macroeconomic conditions on our business; the adequacy of our capital resources to fund operations and growth; investments or potential investments in acquired businesses and technologies, as well as internally developed technologies; the effectiveness of our sales force, distribution channel, and marketing activities; the impact of recent changes in accounting standards; and assumptions underlying any of the foregoing. In some cases, forward-looking statements are identified by the use of terminology such as “anticipate,” “expect,” “intend,” “plan,” “predict,” “believe,” “estimate,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” or negatives or derivatives of the foregoing, or other comparable terminology.

The forward-looking statements in this Quarterly Report on Form 10-Q involve known and unknown risks, uncertainties and other factors that may cause industry and market trends, or our actual results, level of activity, performance or achievements, to be materially different from any future trends, results, level of activity, performance or achievements expressed or implied by these statements. For a detailed discussion of these risks, uncertainties and other factors, see the “Risk Factors” section under Part II, Item 1A of this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update forward-looking statements to reflect new information or events or circumstances occurring after the date of this Quarterly Report on Form 10-Q, except as may be required by applicable law.

 

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

BLUE COAT SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value)

 

    October 31,
2011
    April 30,
2011
 
    (Unaudited)        

ASSETS

   

Current assets:

   

Cash and cash equivalents

  $ 361,393      $ 375,939   

Accounts receivable, net of allowance of $0 as of October 31, 2011 and April 30, 2011, respectively

    70,737        67,626   

Inventory

    9,934        10,134   

Prepaid expenses and other current assets

    11,706        14,091   

Current portion of deferred income tax assets

    10,582        10,399   
 

 

 

   

 

 

 

Total current assets

    464,352        478,189   

Property and equipment, net

    29,565        31,745   

Restricted cash

    1,066        1,031   

Goodwill

    242,611        242,611   

Identifiable intangible assets, net

    18,965        24,970   

Non-current portion of deferred income tax assets

    35,517        34,650   

Other assets

    5,760        6,212   
 

 

 

   

 

 

 

Total assets

  $ 797,836      $ 819,408   
 

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

   

Current liabilities:

   

Accounts payable

  $ 18,420      $ 20,806   

Accrued payroll and related benefits

    17,745        15,947   

Deferred revenue

    116,995        121,526   

Other current liabilities

    11,184        10,758   
 

 

 

   

 

 

 

Total current liabilities

    164,344        169,037   

Deferred revenue, less current portion

    57,928        56,546   

Deferred rent, less current portion

    4,940        5,501   

Long-term income taxes payable

    38,953        35,152   

Other non-current liabilities

    791        688   

Convertible senior notes

    78,583        78,136   

Commitments and contingencies

   

Stockholders’ equity:

   

Preferred stock: $0.0001 par value; issuable in series; 9,958 shares authorized; none issued and outstanding

    —          —     

Common stock: $0.0001 par value; 200,000 shares authorized; 42,703 and 44,527 shares issued and 42,703 and 44,064 shares outstanding at October 31, 2011 and April 30, 2011, respectively

    4        4   

Additional paid-in capital

        1,239,979            1,269,311   

Accumulated deficit

    (787,686     (794,967
 

 

 

   

 

 

 

Total stockholders’ equity

    452,297        474,348   
 

 

 

   

 

 

 

Total liabilities and stockholders’ equity

  $ 797,836      $ 819,408   
 

 

 

   

 

 

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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BLUE COAT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2011     2010     2011     2010  

Net revenue:

        

Product

   $ 62,289      $ 73,127      $   120,845      $   148,695   

Service

     51,792        47,920        102,745        94,832   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net revenue

     114,081        121,047        223,590        243,527   

Cost of net revenue:

        

Product

     14,883        15,284        28,647        31,248   

Service

     12,089        10,723        24,357        21,111   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total cost of net revenue

     26,972        26,007        53,004        52,359   

Gross profit

     87,109        95,040        170,586        191,168   

Operating expenses:

        

Sales and marketing

     46,781        44,821        94,338        89,476   

Research and development

     19,618        20,948        38,827        40,803   

General and administrative

     11,447        10,715        21,620        21,058   

Amortization of intangible assets

     1,826        1,843        3,669        3,686   

Restructuring

     —          38        —          178   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     79,672        78,365        158,454        155,201   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating income

     7,437        16,675        12,132        35,967   

Interest income

     137        126        250        290   

Interest expense

     (227     (223     (462     (447

Other income (expense), net

     (473     158        (819     (165
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     6,874        16,736        11,101        35,645   

Provision for income taxes

     2,288        4,703        3,820        9,687   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 4,586      $ 12,033      $ 7,281      $ 25,958   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income per share:

        

Basic

   $ 0.10      $ 0.26      $ 0.16      $ 0.56   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

   $ 0.10      $ 0.25      $ 0.15      $ 0.55   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average shares used in computing net income per share:

        

Basic

     46,362        46,712        46,517        46,520   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

     46,699        47,638        47,124        47,594   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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BLUE COAT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

     Six Months Ended
October 31,
 
     2011     2010  

Operating Activities

  

Net income

   $ 7,281      $ 25,958   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation

     7,126        6,953   

Amortization

     6,798        6,836   

Stock-based compensation

     8,201        8,985   

Deferred income taxes

     (1,050     3,686   

Tax benefit of stock option deduction

     41        523   

Excess tax benefit from stock-based compensation

     (334     (521

Loss on disposition of equipment

     —          18   

Changes in operating assets and liabilities:

    

Accounts receivable, net

     (3,111     (17,976

Inventory

     200        (4,788

Prepaid expenses and other assets

     2,491        4,029   

Accounts payable

     (2,386     4,079   

Accrued expenses and other liabilities

     5,567        4,989   

Deferred revenue

     (3,149     8,666   
  

 

 

   

 

 

 

Net cash provided by operating activities

     27,675        51,437   

Investing Activities

  

Purchases of property and equipment, and technology licenses

     (4,946     (5,953

Restricted cash

     (35     (45
  

 

 

   

 

 

 

Net cash used in investing activities

     (4,981     (5,998

Financing Activities

  

Net proceeds from issuance of common stock

     5,446        6,894   

Payments for repurchases of common stock

     (43,020     —     

Excess tax benefit from stock-based compensation

     334        521   

Acquisition of noncontrolling interest

     —          (427
  

 

 

   

 

 

 

Net cash (used in) provided by financing activities

     (37,240     6,988   
  

 

 

   

 

 

 

Net (decrease) increase in cash and cash equivalents

     (14,546     52,427   

Cash and cash equivalents at beginning of period

     375,939        236,347   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $   361,393      $   288,774   
  

 

 

   

 

 

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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Notes to Condensed Consolidated Financial Statements

Note 1. Basis of Presentation and Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The unaudited condensed consolidated financial statements include the accounts of Blue Coat Systems, Inc. and our subsidiaries, which are each wholly owned. All inter-company balances and transactions have been eliminated. We record all acquisitions using the purchase method of accounting and, accordingly, include the acquired company’s results of operations in our consolidated results from the date of acquisition.

In management’s opinion, the accompanying condensed consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of the results for the interim periods presented. The condensed consolidated balance sheet as of April 30, 2011 is derived from the April 30, 2011 audited consolidated financial statements. Certain prior fiscal year amounts have been reclassified to conform to the current period’s presentation. Such reclassifications were not material and did not affect net revenue, operating income or net income. Interim financial results are not necessarily indicative of results anticipated for the full year. These unaudited financial statements should be read in conjunction with our fiscal 2011 audited financial statements and footnotes included in our Annual Report on Form 10-K for the year ended April 30, 2011, as filed with the Securities and Exchange Commission (“SEC”) on June 8, 2011.

The preparation of condensed consolidated financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities, at the dates of the condensed consolidated financial statements, and the reported amounts of net revenue and expenses during the reporting period. Actual results may differ from these estimates, and such differences could be material to our consolidated financial condition and results of operations.

The functional currency of our domestic and foreign operations is the U.S. dollar. Accordingly, the effects of foreign currency transactions, and of remeasuring the financial condition and results of operations from local currencies into the functional currency, are included in other income (expense), net, in the accompanying condensed consolidated statements of operations.

There have been no material changes to our significant accounting policies, as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended April 30, 2011.

Revenue Recognition

We design, develop and sell products and services that secure and optimize the delivery of business applications and other information to distributed users over a Wide Area Network (“WAN”), or across an enterprise’s gateway to the public Internet (also known as the Web). Our products provide our end user customers with information about the applications and Web traffic running on their networks, including the ability to discover, classify, manage and control communications between users and applications across internal networks, the WAN and the Internet. Our products are also designed to optimize the performance of our end users’ business applications and content, whether used internally or hosted by external providers. In addition to optimizing the performance and delivery of applications, our products enable our end user customers to secure their Internet gateways and remote computer systems by providing protection from malicious code, or malware, and objectionable content.

We operate a multiple tier channel distribution model that includes both distributors and value-added resellers. In most cases, we sell our products to distributors, who in turn sell to value-added resellers and

 

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ultimately end users. In these cases, we generally ship our products from our fulfillment centers to value-added resellers who provide configuration services for end users. In some cases, we sell directly to value-added resellers, who in turn sell to end users. In these cases, we generally ship our products from our fulfillment centers directly to end users. We generally do not accept orders from distributors or value-added resellers when we are aware that they do not have an order from an end user. Additionally, we provide unspecified software upgrades for most of our products, on a when-and-if available basis, through post contract customer support (“maintenance”) contracts.

We recognize revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery or performance has occurred; the sales price is fixed or determinable; and collection is probable. We define each of those four criteria as follows:

Persuasive evidence of an arrangement exists. Evidence of an arrangement generally consists of a purchase order issued pursuant to the terms and conditions of a distributor or value-added reseller agreement and, in limited cases, an end user agreement.

Delivery or performance has occurred. We use shipping and related documents, or written evidence of customer acceptance, when applicable, to verify delivery or performance. We do not recognize product revenue until transfer of title and risk of loss, which generally is upon shipment to distributors, value-added resellers or end users as our customers do not carry stock and therefore do not have stock rotation rights. We generally do not have significant obligations for future performance, such as rights of return or pricing credits, associated with our sales.

The sales price is fixed or determinable. We assess whether the sales price is fixed or determinable based on payment terms and whether the sales price is subject to refund or adjustment.

Collection is probable. We assess probability of collection on a customer-by-customer basis. We subject our customers to a credit review process that evaluates their financial condition and ability to pay for our products and services. If we conclude that collection is not probable based upon our initial review, we do not recognize revenue until cash is received.

The majority of our products are hardware appliances containing software components that operate together to provide the essential functionality of the product. Revenue is recognized for these products in accordance with general revenue recognition accounting guidance. Our product revenue also includes stand-alone software products that operate on our hardware appliances but are not considered essential to their functionality. Revenue is recognized for these products in accordance with industry-specific software revenue recognition guidance. Certain of our stand-alone software, when sold with our appliances, is considered essential to its functionality and accordingly is recognized in accordance with general revenue recognition accounting guidance; however, this same software, when sold separately is accounted for under industry-specific software revenue recognition guidance.

We enter into multiple element revenue arrangements in which a customer may purchase a combination of hardware, software, hardware and software upgrades, hardware and software maintenance, and professional services. The revenue recognition guidance for multiple deliverable arrangements requires an entity to allocate arrangement consideration to each element based on a selling price hierarchy, where the selling price for an element is based on vendor-specific objective evidence (“VSOE”), if available; third-party evidence (“TPE”), if available and VSOE is not available; or the best estimate of selling price (“BESP”), if neither VSOE or TPE is available. Under the guidance, we allocate the arrangement fee to each element based upon the relative selling price of such element and, if software and software-related (e.g. maintenance for the software element) elements are also included in the arrangement, we allocate the arrangement fee to each of those software and software-related elements as a group based upon our BESP for those elements. After such allocation is made, the amount of the arrangement fee allocated to the software and software-related elements is accounted for using the residual method. When applying the relative selling price method, we determine the selling price for each element using VSOE of selling price, if it exists, or if not, TPE of selling price, if it exists. If neither VSOE nor TPE of selling

 

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price exist for an element, we use our BESP for that element. The revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for that element. We account for multiple element arrangements that contain only software and software-related elements under the software revenue recognition guidance.

We determine VSOE for each element based on historical stand-alone sales to third parties. VSOE of fair value is based on the price charged when the element is sold separately. We analyze our stand-alone hardware and software maintenance renewals by stratification of sales channel and service offering. We determine the VSOE of fair value for hardware and software maintenance by analyzing our stand-alone maintenance renewals and noting that a substantial majority of transactions fall within a narrow range for each stratum. In limited cases, VSOE of fair value has been based on management determined prices.

We typically are not able to determine TPE for our products, maintenance or professional services. TPE is determined based on competitor prices for similar elements when sold separately. Generally, our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, our go-to-market strategy differs from that of our peers and we are unable to reliably determine what similar competitor products’ selling prices are on a stand-alone basis.

When we are unable to establish the selling price of an element using VSOE or TPE, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine BESP for a product or service by considering multiple factors including, but not limited to, historical pricing practices by geography, current market trends, customer class and distribution channel, and gross margin objectives.

For our hardware and software elements, we allocate the arrangement consideration based on the relative selling price of the element. For these elements, we use BESP as our selling price. For our hardware and software maintenance and professional services, we generally use VSOE as our selling price. When we are unable to establish selling price using VSOE for our hardware and software maintenance and professional services, we use BESP in our allocation of arrangement consideration.

We regularly review VSOE and BESP and maintain internal controls over the establishment and updates of these estimates. There was no material impact during the quarter from changes in either VSOE or BESP.

Maintenance and subscription revenue is initially deferred and recognized ratably over the life of the contract, with the related expenses recognized as incurred. Maintenance and subscription contracts usually have a term of one to three years. Unearned maintenance and subscription revenue is included in deferred revenue.

We recognize revenue from the sale of third party anti-virus software net of royalties paid and classify this revenue as net service revenue in our condensed consolidated statements of operations.

When we bill customers for shipping, we record shipping costs in both net revenue and cost of net revenue. If we do not charge customers for shipping, the costs incurred for shipping are reflected in cost of net revenue.

Recent Accounting Pronouncements

Presentation of Comprehensive Income: In June 2011, the FASB issued Accounting Standards Update No. 2011-05, Comprehensive Income (Topic 220)—Presentation of Comprehensive Income (“ASU 2011-05”), to require an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of stockholders’ equity. ASU 2011-05 will be effective for us in our first quarter of fiscal 2013 and will be applied retrospectively. This standard will only affect how, and in what specific financial statements, we present the components of comprehensive income. Accordingly, the adoption of ASU 2011-05 will not affect our financial position, results of operations or cash flows.

 

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Goodwill Impairment Assessments: In September 2011, the FASB issued Accounting Standards Update No. 2011-08, Intangibles—Goodwill and Other (Topic 350): Testing Goodwill for Impairment (“ASU 2011-08”) which provides companies with the option to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing updated qualitative factors, a company determines that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it would not have to perform the current two-step goodwill impairment test. ASU 2011-08 will be effective for us in the first quarter of fiscal 2013 and will be applied retrospectively. The adoption of ASU 2011-08 is not expected to have a material impact on our consolidated financial statements.

Note 2. Per Share Amounts

Our convertible senior notes, discussed in Note 5, are participating securities whereby the holder would participate equally in any future dividends and in undistributed earnings with common stockholders; therefore, we calculated basic and diluted net income per share using the two-class method. Certain of our unvested restricted stock awards and the warrants, discussed in Note 5, are also considered participating securities; however, the number of unvested restricted stock awards and the number of shares covered by the warrants are immaterial and, therefore, not included in our calculation under the two-class method. See Note 5 for further information regarding the convertible senior notes and warrants.

Under the two-class method, basic net income per share is computed by dividing the net income available to common stockholders by the weighted-average number of common shares outstanding for the period. Net income available to common stockholders is determined after allocating undistributed earnings to convertible senior note holders. Diluted net income per share is computed using the weighted-average number of shares of common stock outstanding, including dilutive common shares subject to repurchase and potential shares issuable assuming the (i) dilutive effect of outstanding stock options, restricted stock awards and restricted stock units, warrants and shares issuable under our employee stock purchase plan using the treasury stock method, and (ii) conversion of convertible senior notes.

 

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The following table presents the calculation of weighted average common shares used in the computations of basic and diluted per share amounts presented in the accompanying condensed consolidated statements of operations reconciled to basic and diluted per share amounts available to common stockholders:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
         2011             2010             2011             2010      
    

    (in thousands, except per share amounts)    

 

Basic net income per share

        

Numerator:

        

Net income

   $     4,586      $     12,033      $     7,281      $     25,958   

Less: undistributed earnings allocated to convertible senior note holders

     (381     (992     (603     (2,159
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income available to common stockholders

   $ 4,205      $ 11,041      $ 6,678      $ 23,799   

Denominator:

        

Basic weighted average common shares used in computing basic net income per share

     46,362        46,712        46,517        46,520   

Effect of participating convertible senior notes

     (3,854     (3,854     (3,854     (3,854
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average common shares outstanding using the two-class method

     42,508        42,858        42,663        42,666   
  

 

 

   

 

 

   

 

 

   

 

 

 

Basic income per share available to common stockholders

   $ 0.10      $ 0.26      $ 0.16      $ 0.56   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted net income per share

        

Numerator:

        

Net income

   $ 4,586      $ 12,033      $ 7,281      $ 25,958   

Less: undistributed earnings allocated to convertible senior note holders

     (378     (973     (595     (2,102
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income available to common stockholders

   $ 4,208      $ 11,060      $ 6,686      $ 23,856   

Denominator:

        

Basic weighted average common shares used in computing basic net income per share

     46,362        46,712        46,517        46,520   

Add: Weighted average employee stock options

     242        705        426        780   

Add: Other weighted average dilutive potential common stock

     95        221        181        294   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average common shares used in computing diluted net income per share

     46,699        47,638        47,124        47,594   

Effect of participating convertible senior notes

     (3,854     (3,854     (3,854     (3,854
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average common shares outstanding using the two-class method

     42,845        43,784        43,270        43,740   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted income per share available to common stockholders

   $ 0.10      $ 0.25      $ 0.15      $ 0.55   
  

 

 

   

 

 

   

 

 

   

 

 

 

For the three and six months ended October 31, 2011, outstanding stock options, restricted stock awards and restricted stock units covering an aggregate of 4.5 million shares and 3.5 million shares, respectively, were excluded from the calculation of diluted net income per share as their inclusion would have been anti-dilutive under the treasury stock method.

For the three and six months ended October 31, 2010, outstanding stock options, restricted stock awards and restricted stock units covering an aggregate of 2.6 million shares and 2.2 million shares, respectively, were excluded from the calculation of diluted net income per share as their inclusion would have been anti-dilutive under the treasury stock method.

 

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Warrants to purchase 385,356 shares of our common stock were outstanding at October 31, 2011 and 2010. The warrants were not included in the computation of diluted net income per share for the three and six months ended October 31, 2011 because the exercise price of the warrants was greater than the average market price of our common stock during the period; therefore, their effect was anti-dilutive. The warrants were included in the computation of the diluted net income per share for the three and six months ended October 31, 2010 because the exercise price of the warrants was less than the average market price of our common stock during the period.

Note 3. Acquisitions

Fiscal 2011 Acquisition

S7 Software Solutions Pvt. Ltd.

On January 25, 2010, we acquired 84.5% of the outstanding shares of S7 Software Solutions Pvt. Ltd. (“S7”), an IT research and development outsourcing firm based in Bangalore, India. We acquired an additional 15.5% of the outstanding shares of S7 in fiscal 2011. We acquired S7 to serve as our new development center in India and to provide expertise in software development, code migration and network security. We have included the operating results of S7 in our consolidated financial results since the January 25, 2010 acquisition date.

The total purchase price was $6.4 million in cash, consisting of $4.3 million for the initial shares acquired and $0.8 million for the noncontrolling interest subsequently acquired (which amounts include an allocation of $1.1 million for excess working capital remaining as of the closing date), and $1.3 million payable over the 30 months subsequent to the initial closing date. Under the stock purchase agreement, the selling shareholders will indemnify us for up to $1.3 million for damages caused by inaccuracies in, breaches or violations of or defaults under representations, warranties, covenants or agreements. Any such amounts may be withheld from the $1.3 million in remaining payments due under the purchase agreement. In allocating the purchase price based on estimated fair values, we recorded approximately $4.5 million of goodwill, $0.7 million of identifiable intangible assets for customer relationships and $1.2 million of net tangible assets. In connection with the acquisition, we recognized $0.1 million of transaction costs which were included in general and administrative expenses in our condensed consolidated statement of operations. In addition, we agreed to pay potential retention bonuses up to an aggregate amount of $2.0 million to certain S7 shareholders who were also employees. Payment of these bonuses is contingent upon the performance of post-acquisition services by those shareholders over the 30 months subsequent to the initial closing date. Accordingly, the potential bonus amounts are accrued as compensation expense over the assumed retention period. Our acquisition of S7 did not result in the creation of a new business segment.

The fair value of the acquisition-related intangible assets was calculated considering market participant expectations and using an income approach with estimates and assumptions provided by S7 and our management. We used a discount rate reflective of the risk of the respective cash flows. The acquisition-related intangible assets consist of assumed customer contracts, which represent S7’s underlying relationships with its customers at the time of the acquisition of the initial shares. The fair value assigned to customer relationships was $0.7 million, which is amortized on a straight-line basis over the expected useful life of 4 years, consistent with the number of periods of prospective cash flow and other benefits utilized to estimate the fair values of the assets.

Note 4. Goodwill and Identifiable Acquisition-Related Intangible Assets

Goodwill

There were no changes in the carrying amount of goodwill, which generally is not deductible for tax purposes, for the six months ended October 31, 2011.

 

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Identifiable Acquisition-Related Intangible Assets

Our identifiable acquisition-related intangible assets are as follows (in thousands):

 

October 31, 2011

  Amortization
period
    Gross
Amount
    Accumulated
Amortization
    Net Carrying
Value
 

Developed technology and patents

    3-7 years      $     26,031      $     (18,737   $     7,294   

Core technology

    5 years        2,929        (2,929     —     

Customer relationships

    4-7 years        37,723        (26,052     11,671   

Trade names

    2 years        400        (400     —     
   

 

 

   

 

 

   

 

 

 

Total

    $ 67,083      $ (48,118   $ 18,965   
   

 

 

   

 

 

   

 

 

 

 

April 30, 2011

  Amortization
period
    Gross
Amount
    Accumulated
Amortization
    Net Carrying
Value
 

Developed technology and patents

    3-7 years      $     26,031      $     (16,401   $     9,630   

Core technology

    5 years        2,929        (2,929     —     

Customer relationships

    4-7 years        37,723        (22,383     15,340   

Trade names

    2 years        400        (400     —     
   

 

 

   

 

 

   

 

 

 

Total

    $ 67,083      $ (42,113   $ 24,970   
   

 

 

   

 

 

   

 

 

 

Amortization expense for our identifiable acquisition-related intangible assets for the three and six months ended October 31, 2011 and 2010 was allocated as follows:

 

     Three Months Ended
October 31,
     Six Months Ended
October 31,
 
     2011      2010      2011      2010  
    

    (in thousands)    

 

Included in cost of net revenue

   $     1,168       $     1,168       $     2,336       $     2,356   

Included in operating expenses

     1,826         1,843         3,669         3,686   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,994       $ 3,011       $ 6,005       $ 6,042   
  

 

 

    

 

 

    

 

 

    

 

 

 

As of October 31, 2011, we had no identifiable acquisition-related intangible assets with indefinite lives. The weighted average remaining life of identifiable acquisition-related intangible assets was 1.6 years and 2.1 years as of October 31, 2011 and April 30, 2011, respectively.

Estimated amortization expense related to our identifiable acquisition-related intangible assets in future periods is as follows:

 

Year Ended April 30,

   Amortization  
     (in thousands)  

Remainder of 2012

   $     5,952   

2013

     11,782   

2014

     1,231   
  

 

 

 
   $ 18,965   
  

 

 

 

Note 5. Convertible Senior Notes

On June 2, 2008, we issued $80.0 million aggregate principal amount of Zero Coupon Convertible Senior Notes due June 2, 2013 (the “Convertible Senior Notes”) and warrants (the “Warrants”) to purchase an aggregate of 385,356 shares of our common stock at an exercise price of $20.76 to Manchester Securities Corp., an affiliate of Elliott Associates, L.L.P. (“Manchester”) and Francisco Partners II, L.P. and Francisco Partners Parallel Fund

 

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II, L.P. (together, the “FP Entities”) in a private placement. As of October 31, 2011, the Convertible Senior Notes were reported on our condensed consolidated balance sheet at $78.6 million, net of a discount of $1.4 million primarily related to the value assigned to the Warrants, which is being amortized to interest expense over the life of the Convertible Senior Notes.

The Convertible Senior Notes rank equal in right of payment to any of our other existing and future senior unsecured indebtedness. The Convertible Senior Notes are initially convertible into 3,853,564 shares of our common stock at the holders’ option at any time prior to maturity at the initial conversion price of $20.76. The Convertible Senior Notes do not bear interest. The conversion price of the Convertible Senior Notes and the exercise price of the Warrants are subject to adjustment, if we:

 

   

issue shares of our common stock as a dividend or distribution on our shares of common stock;

 

   

effect a stock split or stock combination;

 

   

issue shares of capital stock in the event of a reclassification; or

 

   

purchase shares of our common stock pursuant to a tender offer or exchange offer at a premium to market.

If we issue rights, options, warrants or pay a cash dividend or otherwise make a distribution of cash or other assets to all holders of our common stock, such right, option, warrant, dividend or distribution shall also be issued to the holders of the Convertible Senior Notes and the Warrants on an as-converted or as-exercised basis.

Subject to certain exceptions, the holders of the Convertible Senior Notes, at their option, may require us to repurchase for cash all or a portion of the Convertible Senior Notes at a purchase price equal to 100% of the outstanding principal amount of the Convertible Senior Notes if our common stock is suspended from trading or ceases to be listed on an eligible market for a period of 5 consecutive trading days or for more than 15 trading days in any 365-day period.

On June 2, 2008, we and the FP Entities entered into a Registration Rights Agreement, (the “Registration Rights Agreement”) containing customary terms and conditions providing for the registration of our common stock underlying the Convertible Senior Notes and the Warrants issued to the FP Entities. Pursuant to the Registration Rights Agreement, we filed an automatically effective resale shelf registration statement on August 4, 2008. We filed amendments to that registration statement on June 23, 2009 and October 2, 2009.

Keith Geeslin, a partner of Francisco Partners II, L.P., has served as a member of our Board of Directors since June 2006.

Note 6. Consolidated Balance Sheet Data

Inventory

Inventory consisted of the following:

 

     October 31,
2011
     April 30,
2011
 
     (in thousands)  

Raw materials

   $     3,568       $     4,048   

Finished goods

     6,366         6,086   
  

 

 

    

 

 

 

Total

   $ 9,934       $ 10,134   
  

 

 

    

 

 

 

 

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Deferred Revenue

Deferred revenue consisted of the following:

 

     As of  
     October 31,
2011
     April 30,
2011
 
     (in thousands)  

Deferred product revenue, current

   $ 991       $ 2,286   

Deferred service revenue, current

     116,004         119,240   
  

 

 

    

 

 

 

Total deferred revenue, current

     116,995         121,526   

Deferred service revenue, non-current

     57,928         56,546   
  

 

 

    

 

 

 

Total deferred revenue

   $     174,923       $     178,072   
  

 

 

    

 

 

 

Note 7. Fair Value of Assets and Liabilities

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Cash Equivalents and Restricted Cash

Our cash historically has been invested in highly liquid investments such as time deposits held at major banks, commercial paper, U.S. government agency discount notes, money market mutual funds and other money market securities with maturities at the date of purchase of 90 days or less. Our restricted cash is invested in time deposits with maturity dates consistent with the maturity dates of the letters of credit they collateralize. At October 31, 2011, our cash was invested in money market mutual funds and a money market savings account. The carrying amount of cash and cash equivalents and restricted cash reported on the balance sheet approximates its fair value. The fair values of cash equivalents are based upon quoted market prices.

Convertible Senior Notes

The carrying amount of the Convertible Senior Notes is net of discounts, primarily related to the associated Warrants. The fair value of the Convertible Senior Notes as of October 31, 2011 was determined based on an internal valuation model that utilized quoted market prices and interest rates for similar instruments, and is approximately $79.4 million. See Note 5 for further information regarding the Convertible Senior Notes and Warrants.

The estimated fair values of our financial instruments are as follows:

 

     As of  
     October 31, 2011      April 30, 2011  
     Amortized
Cost
     Estimated
Fair Value
     Amortized
Cost
     Estimated
Fair Value
 

Assets:

           

Cash

   $ 42,403       $ 42,403       $ 61,133       $ 61,133   

Money market funds

     320,056         320,056         315,837         315,837   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $     362,459       $     362,459       $     376,970       $     376,970   
  

 

 

    

 

 

    

 

 

    

 

 

 

Reported as:

           

Assets:

           

Cash and cash equivalents

      $ 361,393          $ 375,939   

Long-term restricted cash

        1,066            1,031   
     

 

 

       

 

 

 
      $ 362,459          $ 376,970   
     

 

 

       

 

 

 

 

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Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts business. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy is based on three levels of inputs that may be used to measure fair value, of which the first two are considered observable and the last is considered unobservable. These levels of inputs are the following:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Fair Value Measurements

Our financial instruments are valued using quoted prices in active markets. The following table sets forth the fair value of our financial assets and liabilities that were measured on a recurring basis as of October 31, 2011 and April 30, 2011 (in thousands):

 

     Level 1      Level 2      Level 3      Total  

October 31, 2011:

           

Money market funds (1)

   $     320,056       $     —         $     —         $     320,056   

April 30, 2011:

           

Money market funds (1)

   $ 315,837       $ —         $ —         $ 315,837   

 

(1) Included in cash and cash equivalents on our condensed consolidated balance sheets as of October 31, 2011 and April 30, 2011.

Our investments in money market funds are measured at fair value on a recurring basis. Our money market funds are targeted to be priced and have a value of $1 net asset value per share. These money market funds are actively traded and reported daily through a variety of sources. The fair value of the money market fund investments are classified as Level 1.

During the quarter ended October 31, 2011, we did not remeasure any nonfinancial assets and liabilities measured at fair value on a nonrecurring basis, such as goodwill, intangible assets, property and equipment and nonfinancial assets and liabilities initially measured at fair value in a business combination.

Note 8. Stockholders’ Equity

Stock Repurchases

On November 16, 2010, our Board of Directors approved a program to repurchase up to $50 million of our common stock. Under the program, repurchases may be made from time to time in the open market or in negotiated transactions and are expected to comply with Rule 10b-18 under the Securities Exchange Act of 1934 and other legal requirements. The timing and amount of the repurchase transactions are determined by management and may depend on a variety of factors, including the trading price of the stock, market conditions, alternative investment opportunities, and other corporate and regulatory considerations. The program does not obligate us to acquire any particular amount of common stock and it may be modified or discontinued at any time. During the six months ended October 31, 2011, we repurchased 1.9 million shares of common stock for $43.0 million under the program.

 

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Stock-based Compensation

The following table summarizes the stock-based compensation expense for stock options, our Employee Stock Purchase Plan (“ESPP”), restricted stock awards and restricted stock unit awards that we recorded in our condensed consolidated statements of operations for the three and six months ended October 31, 2011 and 2010:

 

     Three Months Ended
October 31,
     Six Months Ended
October 31,
 
     2011      2010      2011      2010  
    

    (in thousands)    

 

Stock-based compensation expense:

           

Cost of net revenue: product

   $ 162       $ 153       $ 355       $ 287   

Cost of net revenue: service

     289         269         536         489   

Sales and marketing

     1,257         1,462         2,727         2,794   

Research and development

     1,478         1,579         2,873         2,810   

General and administrative

     537         1,450         1,710         2,605   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $     3,723       $       4,913       $     8,201       $     8,985   
  

 

 

    

 

 

    

 

 

    

 

 

 

We use the Black-Scholes option valuation model to calculate compensation expense. We estimate the expected term based on our historical experience of grants, exercise pattern and post-vesting cancellations. We considered our historical volatility over the expected term and implied volatility of traded stock options in developing our estimate of volatility.

For the three and six months ended October 31, 2011 and 2010, we used the following assumptions to estimate the fair value of options granted:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2011     2010     2011     2010  

Risk-free interest rate

     0.7     1.1     0.9     1.4

Dividend yield

     —          —          —          —     

Expected term (in years)

     3.7        4.3        3.7        4.3   

Volatility

     65     59     59     56

Expected forfeitures

     17.3     18.0     17.3     18.0

For the three and six months ended October 31, 2011 and 2010, we used the following assumptions to estimate the fair value of shares purchased under our ESPP:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2011     2010     2011     2010  

Risk-free interest rate

     0.1     0.2     0.1     0.2

Dividend yield

     —          —          —          —     

Expected term (in years)

     0.5        0.5        0.5        0.5   

Volatility

     62     58     54     52

During the three and six months ended October 31, 2011, options to purchase 41,544 shares and 202,586 shares were exercised. As of October 31, 2011, there was approximately $11.8 million and $1.2 million of unrecognized stock-based compensation expense related to stock option grants and ESPP awards, respectively, which will be recognized over the remaining weighted average vesting period of approximately 2.8 years and 0.3 years, respectively.

The cost of awards of restricted stock and restricted stock units is determined using the fair value of our common stock on the date of the grant, and compensation expense is recognized over the vesting period, which

 

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generally is four years. During the second quarter of fiscal 2012, we awarded 543,685 restricted stock units and canceled 10,570 shares of restricted stock and 324,933 restricted stock units. As of October 31, 2011, we had approximately $0.5 million and $20.4 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to restricted stock awards and restricted stock unit awards, respectively, which we will recognize over the remaining weighted average vesting period of approximately 1.0 years and 3.3 years, respectively.

Note 9. Income Taxes

The provision for income taxes for the three and six months ended October 31, 2011 was $2.3 million and $3.8 million compared with $4.7 million and $9.7 million the three and six months ended October 31, 2010. The provision primarily reflects current and deferred U.S. federal and state taxes and foreign income taxes in taxable foreign jurisdictions. The primary difference between the effective tax rate and the federal statutory tax rate relates to taxes in foreign jurisdictions with a tax rate different than the U.S. federal statutory rate and non-deductible stock-based compensation expense.

Our total gross unrecognized tax benefits as of October 31, 2011 and April 30, 2011 were $47.0 million and $43.3 million, respectively. The increase was primarily related to uncertainties with respect to the taxation of cross-border arrangements within the consolidated company that were recorded in the period. Included in our gross unrecognized tax benefits as of October 31, 2011 are approximately $44.4 million of tax benefits that, if recognized, would result in an adjustment to our effective tax rate.

Our policy is to classify interest and penalties related to uncertain tax positions as a component of our provision for income taxes. Accrued interest and penalties relating to our unrecognized tax benefits was approximately $3.0 million as of October 31, 2011, including approximately $0.4 million and $0.7 million charged to provision for income taxes for the three and six months ended October 31, 2011, respectively.

Due to our taxable loss position from inception through fiscal year 2010, all tax years are subject to examination in U.S. federal and state jurisdictions. We are also subject to examination in various foreign jurisdictions for tax years 2005 forward, none of which are individually material. We are unable to anticipate the change to the balance of our unrecognized tax benefits in the next twelve months due to the possibility of tax examinations and our continued assessment of potential contingencies.

Note 10. Commitments and Contingencies

Guarantees, Indemnifications and Warranty Obligations

Our customer agreements generally include certain provisions for indemnifying such customers against certain liabilities, including if our products infringe a third party’s intellectual property rights. We have also agreed in certain circumstances to indemnify for customer costs that would be incurred in connection with a product recall and to indemnify certain suppliers in connection with liabilities they may incur in connection with the provision of services to us. To date, we have not incurred any material costs as a result of such indemnification provisions and we have not accrued any liabilities related to such obligations in the accompanying condensed consolidated financial statements.

Our Bylaws provide that we shall indemnify our directors and officers to the fullest extent permitted by Delaware law, including in circumstances in which indemnification is otherwise discretionary under Delaware law. We have also entered into indemnification agreements or other contractual arrangements with current and former executive officers and directors of our company and of certain of our subsidiaries, which contain provisions that may require us, among other things, to indemnify such officers and directors against certain liabilities that may arise by reason of their status or service as directors or officers and to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified. We were required to

 

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indemnify certain current and former officers and directors and other employees for their attorneys’ fees and related expenses incurred in connection with the internal investigations, regulatory investigations and derivative litigation relating to our historical stock option grant practices, and may be required to indemnify certain current and former officers in connection with the recently filed class action and derivative lawsuits.

We maintain a warranty accrual for estimated future warranty obligations based on the historical warranty costs and revenue volumes together with anticipated future warranty costs. We generally provide a one-year warranty on hardware products.

Changes in our warranty obligations, which are included in other current liabilities in our condensed consolidated balance sheets for the six months ended October 31, 2011, were as follows (in thousands):

 

Warranty obligation at April 30, 2011

   $ 521   

Warranties issued during the period

     845   

Warranty costs incurred during the period

     (835

Change in estimate of warranty obligation during the period

     (218
  

 

 

 

Warranty obligation at October 31, 2011

   $ 313   
  

 

 

 

Leases

We lease certain office equipment and office facilities and office equipment under non-cancelable operating leases that expire at various dates through fiscal 2020. The facility leases generally require us to pay operating costs, including property taxes, insurance and maintenance, and may contain scheduled rent increases and certain other rent escalation clauses. Rent expense is recognized in our condensed consolidated financial statements on a straight-line basis over the terms of the respective leases after consideration of rent increases, rent holidays and improvement allowances, if applicable, with any assets purchased using a lessee improvement allowance capitalized as fixed assets and depreciated over the shorter of their useful lives or the lease term.

Rent expense was $2.6 million and $5.1 million for the three and six months ended October 31, 2011, respectively, and $2.4 million and $4.8 million for the three and six months ended October 31, 2010, respectively.

As of October 31, 2011, future minimum lease payments under non-cancelable operating leases with initial or remaining terms in excess of one year are as follows:

 

Year ending April 30,

   Total  
     (in thousands)  

Remainder of 2012

   $ 5,453   

2013

     10,469   

2014

     8,868   

2015

     8,014   

2016

     4,456   

Thereafter

     1,445   
  

 

 

 

Total future minimum lease payments, net

   $ 38,705   
  

 

 

 

Purchase Commitments and Other

We purchase components from a variety of suppliers and use several contract manufacturers to provide manufacturing services for our products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, we enter into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by us or

 

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that establish the parameters defining our requirements. A significant portion of our reported purchase commitments arising from these agreements consists of firm, noncancelable, and unconditional commitments. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. These agreements are enforceable and legally binding against us in the short term and all amounts under these arrangements are due to be paid by the end of fiscal 2012. As of October 31, 2011 our total purchase commitments for inventory were $6.7 million.

Note 11. Litigation

Litigation Relating to IPOs

IPO Allocation Litigation

Beginning on May 16, 2001, a series of putative securities class actions were filed in the United States District Court for the Southern District of New York against the firms that underwrote our initial public offering, us, and some of our officers and directors. These cases have been consolidated under the case captioned In re CacheFlow, Inc. Initial Public Offering Securities Litigation, Civil Action No. 1-01-CV-5143. In November 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against the firms that underwrote Packeteer’s initial public offering, Packeteer, and some of its officers and directors. An amended complaint, captioned In re Packeteer, Inc. Initial Public Offering Securities Litigation, Civil Action No. 01-CV-10185, was filed on April 20, 2002.

These are two of a number of actions coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, 21 MC 92. Plaintiffs in the coordinated proceeding brought claims under the federal securities laws against numerous underwriters, companies, and individuals, alleging generally that defendant underwriters engaged in improper and undisclosed activities concerning the allocation of shares in the IPOs of more than 300 companies during late 1998 through 2000. Among other things, the plaintiffs allege that the underwriters’ customers had to pay excessive brokerage commissions and purchase additional shares of stock in the aftermarket in order to receive favorable allocations of shares in an IPO.

The consolidated amended complaint in our case sought unspecified damages on behalf of a purported class of purchasers of our common stock between December 9, 1999 and December 6, 2000.

The amended complaint in the Packeteer case seeks unspecified damages on behalf of a purported class of purchasers of Packeteer’s common stock between July 27, 1999 and December 6, 2000.

The parties reached a global settlement of the litigation under which, the insurers will pay the full amount of settlement share allocated to the Company and Packeteer, and the Company and Packeteer will not bear any financial liability. On October 5, 2009, the district court entered an order granting final approval of the settlement. Certain objectors appealed that order to the Court of Appeals for the Second Circuit. Several of the appeals were dismissed. In May 2011, the Second Circuit issued an order granting the motion to dismiss as to one set of the remaining appeals and remanding the other set of appeals to the district court for further action. On August 25, 2011, the district court ruled that the objector that submitted the remaining set of appeals is not a class member, and therefore does not have standing to object to the settlement. That objector is now appealing the district court’s August 2011 order.

Derivative Litigation Against Packeteer

On or about October 10, 2007, Vanessa Simmonds, a purported shareholder of Packeteer, filed a complaint in the United States District Court, Western District of Washington, against the underwriters of Packeteer’s 1999 initial public offering of its common stock, seeking recovery in the name of Packeteer for alleged violation by those underwriters of Section 16(b) of the Securities Exchange Act of 1934, as amended. The complaint seeks to recover from the underwriters any “short-swing profits” obtained by them in violation of Section 16(b).

 

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Packeteer is named as a nominal defendant. On February 28, 2008, the plaintiff filed an amended complaint asserting substantially similar claims as those set forth in the initial complaint and naming three additional underwriters as defendants.

This is one of 54 actions that were coordinated for pretrial purposes as In re Section 16(b) Litigation, Master Case No. 07-1549 JLR, with the first action filed on October 2, 2007. In July 2008, Packeteer and 29 other nominal defendants moved to dismiss the amended complaint. Packeteer also separately moved to dismiss the action brought against it on the ground that the plaintiff lacks standing to pursue the action because her interest was extinguished when Packeteer merged into our wholly-owned subsidiary on June 6, 2008. The Court heard the motions to dismiss in January 2009. On March 12, 2009, as a consequence of those motions, the court issued an Order Dismissing Cases and entered judgment dismissing the actions, including the action brought against Packeteer. The court denied as moot, Packeteer’s separate motion to dismiss.

On March 31, 2009, Simmonds appealed the judgment to the Court of Appeals for the Ninth Circuit, and thereafter filed an amended notice of appeal on April 10, 2009 at the appellate court’s request. The underwriter defendants filed a cross-appeal in each of the cases wherein the issuers moved for dismissal (including the appeal relating to Packeteer’s IPO). The appellate court heard oral argument on October 5, 2010 and, on December 2, 2010, issued an order dismissing with prejudice the amended complaint against the moving defendants, including Packeteer, but reversed and remanded the district court’s decision on the underwriter defendants’ motion to dismiss the claims arising from the non-moving issuers’ IPOs.

On December 16, 2010, the underwriter defendants filed a petition for panel rehearing and petition for rehearing en banc. Appellant Simmonds also filed a petition for rehearing en banc. On January 18, 2011, the court denied the petition for rehearing and petitions for rehearing en banc. It further ordered that no further petitions for rehearing may be filed.

On April 5, 2011, Simmonds filed a Petition for Writ of Certiorari with the U.S. Supreme Court seeking reversal of the Ninth Circuit’s December 2, 2010 decision. That petition was docketed by the Supreme Court on April 7, 2011, and Packeteer’s opposition to the petition was filed on May 26, 2011. On June 27, 2011, the Supreme Court denied Simmonds’ petition and granted the petition of the underwriter defendants. The Ninth Circuit mandate for all cases continues to be stayed pending final disposition of the underwriters’ petition. The underwriters’ brief on the merits was submitted on August 18, 2011, and Simmonds’ brief was submitted on September 26, 2011. Oral argument in that case is scheduled for November 29, 2011.

Litigation Relating to Certain Statements Made in 2009-2010

Class Action

On August 30, 2011, a purported securities class action complaint was filed in the United States District Court for the Northern District of California against us and certain of our current and former officers by an individual on behalf of a putative class of persons who purchased our common stock between November 24, 2009 and May 27, 2010. The complaint alleges that the defendants made false or misleading statements about our business and prospects in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint seeks compensatory damages, attorneys’ fees and costs, and such other relief as the court deems proper. A response to the complaint is not yet due and the court has not yet appointed lead plaintiffs.

Derivative Actions

On September 28, 2011, a purported shareholder derivative complaint was filed in the Superior Court of the State of California, County of Santa Clara, against certain of our officers and directors and against us as nominal defendant. Plaintiff alleges that the individual defendants breached their fiduciary duties between November 24, 2009 and May 27, 2010 by causing or allowing the company to disseminate materially misleading statements

 

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about our business and prospects; willfully ignoring alleged problems with our internal controls and procedures; failing to properly oversee and manage the company; unjustly enriching themselves to the detriment of the company; and wasting corporate assets. The complaint seeks an order directing us to take certain actions to improve our corporate governance and internal procedures, disgorgement of certain profits obtained by the individual defendants, attorneys’ fees and costs, and such other relief as the court deems proper. A response to the complaint is not yet due.

On November 3, 2011, a purported shareholder derivative action was filed in the United States District Court for the Northern District of California, against certain of our current and former officers and directors and against us as nominal defendant. Plaintiff alleges that the individual defendants breached their fiduciary duties between November 24, 2009 and May 27, 2010 by failing to establish and maintain internal controls which would have prevented the company from disseminating materially false, misleading, and inaccurate statements and information to shareholders; failing to require the Company to provide materially adverse information to shareholders; failing to properly oversee and manage the company; and unjustly enriching themselves to the detriment of the company. The complaint seeks an order directing us to take certain actions to improve our corporate governance and internal procedures, disgorgement of certain profits obtained by the individual defendants, attorneys’ fees and costs, and such other relief as the court deems proper. A response to the complaint is not yet due.

We do not believe that any of the above mentioned legal matters will have a material effect on our consolidated financial position, results of operations or cash flows.

Note 12. Geographic and Product Category Information Reporting

We conduct business in one operating segment that designs, develops and sells products and services that optimize, accelerate and secure the delivery of business applications and other information to distributed users over a WAN or across an enterprise’s Internet gateway. Our chief operating decision maker, our chief executive officer, allocates resources and makes operating decisions based on financial data consistent with the presentation in the accompanying condensed consolidated financial statements. Our revenue consists of two categories: product and service.

Net revenue is attributed to three geographic areas based on the location of the customers. The following is a summary of net revenue by geographic area:

 

     Three Months Ended October 31,  
     2011     2010  
     (dollars in thousands)  

Americas (1)

   $ 57,649         50.5   $ 56,937         47.0

EMEA (2)

     35,349         31.0        40,889         33.8   

APAC (3)

     21,083         18.5        23,221         19.2   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total net revenue

   $     114,081             100.0   $     121,047             100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

     Six Months Ended October 31,  
     2011     2010  
     (dollars in thousands)  

Americas (1)

   $ 105,501         47.2   $ 111,549         45.8

EMEA (2)

     73,506         32.9        83,096         34.1   

APAC (3)

     44,583         19.9        48,882         20.1   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total net revenue

   $     223,590             100.0   $     243,527             100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

(1) North America, Central America and Latin America (“Americas”)
(2) Europe, Middle East and Africa (“EMEA”)
(3) Asia and Pacific regions (“APAC”)

 

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The following is a summary of net revenue by product category:

 

     Three Months Ended October 31,  
     2011     2010  
     (dollars in thousands)  

Product

   $ 62,289         54.6   $ 73,127         60.4

Service

     51,792         45.4        47,920         39.6   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total net revenue

   $     114,081             100.0   $     121,047             100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

     Six Months Ended October 31,  
     2011     2010  
     (dollars in thousands)  

Product

   $ 120,845         54.0   $ 148,695         61.1

Service

     102,745         46.0        94,832         38.9   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total net revenue

   $     223,590             100.0   $     243,527             100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

At October 31, 2011, substantially all of our long-lived assets were located in the United States.

Certain of our global distributors, including their various affiliates, may account for more than 10% of our net revenue in certain periods. In the second quarter of fiscal 2012, ComputerLinks, Westcon Group, Inc. and Arrow Enterprise Computing Solutions, Inc. accounted for 22.9%, 15.0% and 16.6% of our total net revenue, respectively. In the second quarter of fiscal 2011, ComputerLinks, Westcon Group, Inc. and Arrow Enterprise Computing Solutions, Inc. accounted for 27.4%, 14.1% and 18.0% of our total net revenue, respectively. In the first six months of fiscal 2012, ComputerLinks, Westcon Group, Inc. and Arrow Enterprise Computing Solutions, Inc. accounted for 23.2%, 14.8% and 15.2% of our total net revenue, respectively. In the first six months of fiscal 2011, ComputerLinks, Westcon Group, Inc. and Arrow Enterprise Computing Solutions, Inc. accounted for 25.3%, 16.0% and 14.9% of our total net revenue, respectively.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements include, but are not limited to, statements concerning the following: plans to develop and offer new products and services and enter new markets; expectations with respect to future market growth opportunities; changes in and expectations with respect to revenues, gross margins and income tax provisions; future operating expense levels and operating margins; the impact of quarterly fluctuations of revenue and operating results; the success of our business strategy and changes in our business model, management, organizational structure and operations; the impact of macroeconomic conditions on our business; the adequacy of our capital resources to fund operations and growth; investments or potential investments in acquired businesses and technologies, as well as internally developed technologies; the effectiveness of our sales force, distribution channel, and marketing activities; the impact of recent changes in accounting standards; and assumptions underlying any of the foregoing. In some cases, forward-looking statements are identified by the use of terminology such as “anticipate,” “expect,” “intend,” “plan,” “predict,” “believe,” “estimate,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” or negatives or derivatives of the foregoing, or other comparable terminology.

The forward-looking statements in this Quarterly Report on Form 10-Q involve known and unknown risks, uncertainties and other factors that may cause industry and market trends, or our actual results, level of activity, performance or achievements, to be materially different from any future trends, results, level of activity, performance or achievements expressed or implied by these statements. For a detailed discussion of these risks, uncertainties and other factors, see the “Risk Factors” section under Part II, Item 1A of this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update forward-looking statements to reflect new information or events or circumstances occurring after the date of this Quarterly Report on Form 10-Q, except as required by applicable law.

Overview

We design, develop and sell a family of proxy and other appliances, and related software and services that secure, accelerate and optimize the delivery of business applications, Web content and other information to distributed users over a Wide Area Network (“WAN”) or across an enterprise’s gateway to the public Internet (also known as the Web). Our products are based on three core functionalities: 1) security of the delivery of applications and content; 2) acceleration and optimization of the delivery of applications and content; and 3) visibility of the applications, content and users on the network. Our business strategy includes offering the core functionality of our products to new markets and through new delivery models and strategic relationships.

During the second quarter of fiscal 2012, Gregory S. Clark was appointed as President and Chief Executive Officer. Under his leadership, we made further refinements to our business strategy and have taken steps to implement that strategy. We streamlined our research and development organization and realigned our product-oriented and development resources into two groups, Web Security and WAN Optimization. Similarly, we took steps to simplify our sales organization and reallocated much of the management of our sales resources, which previously had been centralized at corporate headquarters, to our geographic regions. In addition, as described in previous filings with the Securities and Exchange Commission, several management changes occurred during the first and second quarters of fiscal 2012 and certain executive and other positions were eliminated. As a result of these changes, we incurred severance costs of $3.0 million during the second quarter of fiscal 2012.

We continue to focus on strengthening our go-to-market strategy and better engaging our channel partners; addressing increased competition in our core markets with respect to both pricing and products; and addressing the need to improving productivity and execution; improving operational efficiency, cost structure and profitability; and to retain our best personnel. These structural changes and our improvement initiatives present

 

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risk and uncertainty; however, we believe that, if they are successfully implemented, they will promote greater and faster innovation, improved accountability and closer alignment with the needs of our channel partners and end user customers.

In the second half of fiscal 2012, we intend to make investments designed to drive increased product revenue and market penetration, including continued expenditures on sales and marketing initiatives and research and development activities. As well, we intend to continue to invest in our Cloud Security Service, although revenue from this subscription based service will be recognized ratably over a period of a year or more and accordingly will have a lessened impact on current revenue and profitability, even as our sales of that service increase. We anticipate that these expenditures will continue to put pressure on our operating margins until we can increase our product revenue.

We track many financial metrics as key measures of our business performance, including consolidated net revenue, operating margin, deferred revenue, cash flow from operations and cash position.

Net Revenue

Net revenue, which includes product and service revenue, decreased to $114.1 million in the second quarter of fiscal 2012 from $121.0 million in the second quarter of fiscal 2011. Net product revenue in the second quarter of fiscal 2012 was $62.3 million, a $10.8 million decrease compared with the second quarter of fiscal 2011. Net product revenue primarily consists of revenue from sales of our Web Security and WAN Optimization products. We experienced a 15% decline in product revenue in the second quarter of fiscal 2012 compared with the second quarter fiscal 2011, which primarily related to decreased sales of our Web Security and WAN optimization products. We recognized $51.8 million in service revenue in the second quarter of fiscal 2012, a $3.9 million increase compared with the second quarter of fiscal 2011. Net service revenue primarily consists of revenue related to support and maintenance contracts. The increase in service revenue was primarily a result of increased revenue from the sales of renewal services contracts, partially offset by a decrease in service revenue from the sales of new service contracts.

Operating Margin

Our operating income decreased to $7.4 million in the second quarter of fiscal 2012 from $16.7 million in the second quarter of fiscal 2011. This decrease primarily resulted from a decrease in gross profit driven by a decrease in net revenue and an increase in operating expenses during the quarter. The quarter-over-quarter increase in operating expenses was primarily driven by increased severance expenses, including those associated with the departure of certain executives, as well as increases in our marketing expenses due to incremental investments made to increase market penetration and the expansion of existing marketing programs.

Operating expenses consist of sales and marketing expenses, research and development expenses, general and administrative expenses, amortization of acquisition-related intangible assets and restructuring charges. Personnel-related costs, including stock-based compensation, are the primary driver of our operating expenses in each functional area. As of October 31, 2011 and 2010 we had 1,321 and 1,294 full-time equivalent employees, respectively.

Deferred Revenue

Total deferred revenue was $174.9 million at October 31, 2011 compared with $178.1 million at April 30, 2011. The decrease was primarily due to a decrease in the sales of new service contracts and the recognition of deferred product revenue in the first half of fiscal 2012, partially offset by an increase in the sales of renewal service contracts.

 

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Cash Flow from Operations and Cash Position

During the first six months of fiscal 2012, we generated cash flow from operations of $27.7 million compared with $51.4 million generated in the same period in fiscal 2011. The decrease in operating cash flow in fiscal 2012 compared with fiscal 2011 was primarily driven by lower net income, after excluding the impact of non-cash charges such as stock-based compensation, depreciation and amortization expense, as well as working capital uses of cash from lower accounts payable and deferred revenue balances, partially offset by a decrease in working capital uses of cash related to increased accounts receivable. Our cash and cash equivalents and restricted cash were $362.5 million at October 31, 2011 compared with $377.0 million at April 30, 2011. The overall decrease in our cash and cash equivalents balance was primarily due to the expenditure of $43.0 million to repurchase our shares of common stock in the first six months of fiscal 2012.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, net revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to Revenue Recognition, Stock-Based Compensation, Supply Chain Liabilities and Valuation of Inventory, Acquisitions, Goodwill and Identifiable Intangible Assets, Income Taxes, and Legal and Other Contingencies. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and such differences could be material.

We have discussed the development and selection of critical accounting policies and estimates with the audit committee of our board of directors. We believe the accounting policies described below are those that most frequently require us to make estimates and judgments that materially affect our financial statements and that are critical to the understanding of our financial condition and results of operations:

 

   

Revenue Recognition

 

   

Stock-Based Compensation

 

   

Supply Chain Liabilities and Valuation of Inventory

 

   

Acquisitions, Goodwill and Identifiable Intangible Assets

 

   

Income Taxes

 

   

Legal and Other Contingencies

Revenue Recognition

We design, develop and sell products and services that secure and optimize the delivery of business applications and other information to distributed users over a Wide Area Network (“WAN”), or across an enterprise’s gateway to the public Internet (also known as the Web). Our products provide our end user customers with information about the applications and Web traffic running on their networks, including the ability to discover, classify, manage and control communications between users and applications across internal networks, the WAN and the Internet. Our products are also designed to optimize the performance of our end users’ business applications and content, whether used internally or hosted by external providers. In addition to optimizing the performance and delivery of applications, our products enable our end user customers to secure their Internet gateways and remote computer systems by providing protection from malicious code, or malware, and objectionable content.

 

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We operate a multiple tier channel distribution model that includes both distributors and value-added resellers. In most cases, we sell our products to distributors, who in turn sell to value-added resellers and ultimately end users. In these cases, we generally ship our products from our fulfillment centers to value-added resellers who provide configuration services for end users. In some cases, we sell directly to value-added resellers, who in turn sell to end users. In these cases, we generally ship our products from our fulfillment centers directly to end users. We generally do not accept orders from distributors or value-added resellers when we are aware that they do not have an order from an end user. Additionally, we provide unspecified software upgrades for most of our products, on a when-and-if available basis, through post contract customer support (“maintenance”) contracts.

We recognize revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery or performance has occurred; the sales price is fixed or determinable; and collection is probable. We define each of those four criteria as follows:

Persuasive evidence of an arrangement exists. Evidence of an arrangement generally consists of a purchase order issued pursuant to the terms and conditions of a distributor or value-added reseller agreement and, in limited cases, an end user agreement.

Delivery or performance has occurred. We use shipping and related documents, or written evidence of customer acceptance, when applicable, to verify delivery or performance. We do not recognize product revenue until transfer of title and risk of loss, which generally is upon shipment to distributors, value-added resellers or end users as our customers do not carry stock and therefore do not have stock rotation rights. We generally do not have significant obligations for future performance, such as rights of return or pricing credits, associated with our sales.

The sales price is fixed or determinable. We assess whether the sales price is fixed or determinable based on payment terms and whether the sales price is subject to refund or adjustment.

Collection is probable. We assess probability of collection on a customer-by-customer basis. We subject our customers to a credit review process that evaluates their financial condition and ability to pay for our products and services. If we conclude that collection is not probable based upon our initial review, we do not recognize revenue until cash is received.

The majority of our products are hardware appliances containing software components that operate together to provide the essential functionality of the product. Revenue is recognized for these products in accordance with general revenue recognition accounting guidance. Our product revenue also includes stand-alone software products that operate on our hardware appliances but are not considered essential to their functionality. Revenue is recognized for these products in accordance with industry-specific software revenue recognition guidance. Certain of our stand-alone software, when sold with our appliances, is considered essential to its functionality and accordingly is recognized in accordance with general revenue recognition accounting guidance; however, this same software, when sold separately, is accounted for under industry-specific software revenue recognition guidance.

We enter into multiple element revenue arrangements in which a customer may purchase a combination of hardware, software, hardware and software upgrades, hardware and software maintenance, and professional services. The revenue recognition guidance for multiple deliverable arrangements requires an entity to allocate arrangement consideration to each element based on a selling price hierarchy, where the selling price for an element is based on vendor-specific objective evidence (“VSOE”), if available; third-party evidence (“TPE”), if available and VSOE is not available; or the best estimate of selling price (“BESP”), if neither VSOE or TPE is available. Under the guidance, we allocate the arrangement fee to each element based upon the relative selling price of such element and, if software and software-related (e.g. maintenance for the software element) elements are also included in the arrangement, we allocate the arrangement fee to each of those software and software-related elements as a group based upon our BESP for those elements. After such allocation is made, the amount of the arrangement fee allocated to the software and software-related elements is accounted for using the residual

 

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method. When applying the relative selling price method, we determine the selling price for each element using VSOE of selling price, if it exists, or if not, TPE of selling price, if it exists. If neither VSOE nor TPE of selling price exist for an element, we use our BESP for that element. The revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for that element. We account for multiple element arrangements that contain only software and software-related elements under the software revenue recognition guidance.

We determine VSOE for each element based on historical stand-alone sales to third parties. VSOE of fair value is based on the price charged when the element is sold separately. We analyze our stand-alone hardware and software maintenance renewals by stratification of sales channel and service offering. We determine the VSOE of fair value for hardware and software maintenance by analyzing our stand-alone maintenance renewals and noting that a substantial majority of transactions fall within a narrow range for each stratum. In limited cases, VSOE of fair value has been based on management determined prices.

We typically are not able to determine TPE for our products maintenance or professional services. TPE is determined based on competitor prices for similar elements when sold separately. Generally, our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, our go-to-market strategy differs from that of our peers and we are unable to reliably determine what similar competitor products’ selling prices are on a stand-alone basis.

When we are unable to establish the selling price of an element using VSOE or TPE, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine BESP for a product or service by considering multiple factors including, but not limited to, historical pricing practices by geography, current market trends, customer class and distribution channel, and gross margin objectives.

For our hardware and software elements, we allocate the arrangement consideration based on the relative selling price of the element. For these elements, we use BESP as our selling price. For our hardware and software maintenance and professional services, we generally use VSOE as our selling price. When we are unable to establish selling price using VSOE for our hardware and software maintenance and professional services, we use BESP in our allocation of arrangement consideration.

We regularly review VSOE and BESP and maintain internal controls over the establishment and updates of these estimates. There was no material impact during the quarter from changes in either VSOE or BESP.

Maintenance and subscription revenue is initially deferred and recognized ratably over the life of the contract, with the related expenses recognized as incurred. Maintenance and subscription contracts usually have a term of one to three years. Unearned maintenance and subscription revenue is included in deferred revenue.

We recognize revenue from the sale of third party anti-virus software net of royalties paid and classify this revenue as net service revenue in our condensed consolidated statements of operations.

When we bill customers for shipping, we record shipping costs in both net revenue and cost of net revenue. If we do not charge customers for shipping, the costs incurred for shipping are reflected in cost of net revenue.

Stock-Based Compensation

We utilize the Black-Scholes option valuation model to calculate compensation expense. The Black-Scholes option valuation model requires the input of highly subjective assumptions, including the expected term of options, the expected price volatility of the stock underlying such options, the risk-free interest rate, and the expected dividend yield. We are required to estimate the stock awards that we ultimately expect to vest and to reduce compensation expense for the effects of estimated forfeitures of awards over the expense recognition period. To the extent our actual forfeitures are different than our estimates, we record a true-up for the difference in the period that the awards vest.

 

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Supply Chain Liabilities and Valuation of Inventory

We outsource our manufacturing, product fulfillment and repair operations to contract manufacturers and third party logistics providers, and a significant portion of our cost of net revenue results from these activities. We currently purchase several key parts and components used in the manufacture of our products from a limited number of suppliers. Our contract manufacturers procure components and manufacture our products based on demand forecasts that we prepare. These forecasts are based on estimates of future product demand and are adjusted for overall market conditions. If the actual product demand is significantly lower than forecasted, we may be required to write down our inventory or accrue for excess supply chain liability, which could have an adverse impact on our gross margins and profitability.

Inventory consists of raw materials and finished goods. Inventory is recorded at the lower of cost (using the first-in, first-out method) or market, after obsolescence and inventory in excess of anticipated future demand is considered. In assessing the ultimate recoverability of inventory, we are required to make estimates regarding future customer demand, last time buy decisions, the timing of new product introductions, economic trends and market conditions.

Acquisitions, Goodwill and Identifiable Intangible Assets

We account for acquired businesses using the purchase method of accounting, which requires that the assets acquired, liabilities assumed, contractual contingencies and contingent consideration be recorded at the date of acquisition at their respective fair values. Goodwill is measured as a residual as of the acquisition date, which in most cases results in measuring goodwill as an excess of the purchase consideration transferred plus the fair value of any noncontrolling interest in the acquiree over the fair value of the net assets acquired, including any contingent consideration. It further requires acquisition-related costs to be recognized separately from the acquisition and expensed as incurred, restructuring costs to be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period to impact the provision for income taxes. In addition, acquired in-process research and development is capitalized as an intangible asset and amortized over its estimated useful life.

The fair value of identifiable intangible assets is based on significant judgments made by management. We typically engage third party valuation appraisal firms to assist us in determining the fair values and useful lives of the assets acquired. Such valuations and useful life determinations require us to make significant estimates and assumptions. These estimates and assumptions are based on historical experience and information obtained from the management of the acquired companies, and also include, but are not limited to, future expected cash flows to be earned from the product-related technology and discount rates applied in determining the present value of those cash flows. Unanticipated events and circumstances may occur that could affect the accuracy or validity of such assumptions, estimates or actual results. Acquisition-related identifiable intangible assets are amortized on a straight-line basis over their estimated economic lives, which are three to seven years for developed technology and patents, five years for core technology, four to seven years for customer relationships and two years for trade names.

We perform goodwill impairment tests annually during our fourth fiscal quarter, and whenever events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. The first step of the test identifies whether potential impairment may have occurred, and the second step of the test measures the amount of the impairment, if any. An impairment of goodwill is recognized when the carrying amount of the assets exceeds their fair value. The process of evaluating the potential impairment of goodwill is highly subjective and requires the application of significant judgment. For purposes of the annual impairment test, we consider our market capitalization compared with the carrying amount of our net assets on the date of the test, since we have only one reporting unit. We performed our annual review of goodwill in the fourth quarter of fiscal 2011 and concluded that no impairment existed at April 30, 2011. During the first six months of fiscal 2012, there were no significant events or changes in circumstances that affect our valuation of goodwill.

 

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We evaluate long-lived assets, including identifiable intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events or changes in circumstances that could result in an impairment review include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for our overall business, and significant negative industry or economic trends. Impairment is recognized when the carrying amount of an asset exceeds its fair value as calculated on a discounted cash flow basis.

Income Taxes

We use the liability method to account for income taxes. As part of the process of preparing our condensed consolidated financial statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. This process involves determining our income tax expense and calculating the deferred income tax expense related to temporary differences resulting from the differing treatment of items for tax and accounting purposes, such as deferred revenue or deductibility of the amortization of certain intangible assets. These temporary differences result in deferred tax assets or liabilities, which are included within the condensed consolidated balance sheets.

We record a valuation allowance to reduce certain deferred tax assets to an amount that we estimate is more likely than not to be realized. We consider estimated future taxable income and prudent tax planning strategies in determining the need for a valuation allowance. When we determine that it is more likely than not that some or all of our deferred tax assets will be realized by either refundable income taxes or future taxable income, the valuation allowance will be reduced and the related tax impact will be recorded as a reduction to the tax provision in that period. Likewise, should we determine that we are not likely to realize all or part of our deferred tax assets in the future, an increase to the valuation allowance would be recorded as an increase to the tax provision in the period in which such determination was made.

As a multinational corporation, we conduct our business in many countries and are subject to taxation in many jurisdictions. The taxation of our business is subject to the application of multiple and conflicting tax laws and regulations, as well as multinational tax conventions. Our effective tax rate is highly dependent upon the geographic distribution of our worldwide earnings or losses, the tax regulations and tax holidays in each geographic region, the availability of tax credits and carryforwards, and the effectiveness of our tax planning strategies. The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws themselves are subject to change as a result of changes in fiscal policy, changes in legislation, and the evolution of regulations and court rulings. Consequently, tax authorities may impose tax assessments or judgments against us that could materially impact our tax liability and/or our effective income tax rate.

We use a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation, if any. The second step is to measure the tax benefit as the largest amount that is more likely than not to be realized upon settlement. We review our uncertain tax benefits quarterly, and we may adjust such uncertain tax benefits as a consequence of: proposed assessments by tax authorities; changes in facts and circumstances; issuance of new regulations or new case law; previously unavailable information obtained during the course of an examination; negotiations with tax authorities of different countries concerning our transfer pricing; resolution with respect to individual audit issues/audit years; or the expiration of statutes of limitations. In addition, our tax contingency reserve includes certain amounts for potential tax assessments for pre-acquisition tax years of acquired companies, which, if recognized, will be recorded to our provision for income taxes.

 

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Legal and Other Contingencies

We are currently involved in various claims and legal proceedings. We review the status of each significant matter and assess our potential financial exposure on a quarterly basis. We record a charge equal to at least the minimum estimated liability for damages arising from litigation or other loss contingencies only when both of the following conditions are met: (i) information available prior to issuance of our condensed consolidated financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements and (ii) the range of loss can be reasonably estimated. As additional information becomes available, we reassess the potential liability related to pending loss contingencies and may revise our estimates. Such revisions in the estimates of the potential liabilities could have a material impact on our results of operations and financial position.

Results of Operations

The following table sets forth, as a percentage of net revenue, condensed consolidated statements of operations data for the periods indicated:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
         2011             2010             2011             2010      

Net revenue:

        

Product

     54.6     60.4     54.0     61.1

Service

     45.4     39.6     46.0     38.9
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net revenue

     100.0     100.0     100.0     100.0

Cost of net revenue:

        

Product

     13.0     12.6     12.8     12.8

Service

     10.6     8.9     10.9     8.7
  

 

 

   

 

 

   

 

 

   

 

 

 

Total cost of net revenue

     23.6     21.5     23.7     21.5

Gross profit

     76.4     78.5     76.3     78.5

Operating expenses:

        

Sales and marketing

     41.0     37.0     42.2     36.7

Research and development

     17.2     17.3     17.4     16.8

General and administrative

     10.1     8.9     9.7     8.6

Amortization of intangible assets

     1.6     1.5     1.6     1.5

Restructuring

     —          —       —          0.1
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     69.9     64.7     70.9     63.7
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating income

     6.5     13.8     5.4     14.8

Interest income

     0.1     0.1     0.1     0.1

Interest expense

     (0.2 )%      (0.2 )%      (0.2 )%      (0.2 )% 

Other income (expense), net

     (0.4 )%      0.1     (0.3 )%      (0.1 )% 
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     6.0     13.8     5.0     14.6

Provision for income taxes

     2.0     3.9     1.7     4.0
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     4.0     9.9     3.3     10.6
  

 

 

   

 

 

   

 

 

   

 

 

 

Net Revenue

Net revenue consists of product and service revenue. Net product revenue primarily consists of revenue from sales of our Web Security and WAN Optimization products. Net service revenue primarily consists of sales of new and renewal service contracts and sales of third party software. Although it is generally our practice to promptly ship products upon receipt of properly finalized purchase orders based on our published shipping lead

 

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times, we occasionally have orders that have not shipped or have otherwise not met all the required criteria for revenue recognition at the end of the quarter. In some of these cases, we may exercise discretion over the timing of shipments, which affects the timing of revenue recognition for those orders. In such cases, we consider a number of factors, including: our operational capacity to fulfill orders at the end of the quarter; our published shipment lead times; the delivery dates requested by customers and resellers; the amount of orders shipped in the quarter; and the concentration of orders received at the end of the quarter.

The following is a summary of net revenue and the changes in net revenue:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2011     2010     2011     2010  
    

    (dollars in thousands)    

 

Total net revenue

   $     114,081      $     121,047      $     223,590      $     243,527   

Change from same period prior year ($)

   $ (6,966   $ 611      $ (19,937   $ 7,102   

Change from same period prior year (%)

     (5.8 )%      0.5     (8.2 )%      3.0

Quarter Ended October 31, 2011 compared with Quarter Ended October 31, 2010: Net revenue, which includes product and service revenue, decreased $7.0 million, or 5.8%, in the second quarter of fiscal 2012 compared with the same period in fiscal 2011. Net product revenue in the second quarter of fiscal 2012 was $62.3 million, a $10.8 million decrease compared with the same period in fiscal 2011, which primarily related to a decrease in sales of our Web Security and WAN Optimization products. Net service revenue in the second quarter of fiscal 2012 was $51.8 million, a $3.9 million increase compared with the same period in fiscal 2011. The increase in service revenue was primarily a result of increased revenue from the sales of renewal services contracts, partially offset by a decrease in revenue from the sales of new service contracts.

Six Months Ended October 31, 2011 compared with Six Months Ended October 31, 2010: Net revenue, which includes product and service revenue, decreased $19.9 million, or 8.2%, in the first six months of fiscal 2012 compared with the same period in fiscal 2011. Net product revenue in the first six months of fiscal 2012 was $120.8 million, a $27.8 million decrease compared with the same period in fiscal 2011, which primarily relates to a decrease in sales of our Web Security and WAN Optimization products. Net service revenue in the first six months of fiscal 2012 was $102.8 million, a $7.9 million increase compared with the same period in fiscal 2011. The increase in service revenue was primarily a result of increased revenue from the sales of renewal services contracts, partially offset by a decrease in revenue the sales of new service contracts.

The following is a summary of net revenue by geographic area:

 

     Three Months Ended October 31,  
     2011     2010  
     (dollars in thousands)  

Americas (1)

   $ 57,649         50.5   $ 56,937         47.0

EMEA (2)

     35,349         31.0        40,889         33.8   

APAC (3)

     21,083         18.5        23,221         19.2   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total net revenue

   $     114,081         100.0   $     121,047         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

     Six Months Ended October 31,  
     2011     2010  
     (dollars in thousands)  

Americas (1)

   $     105,501         47.2   $     111,549         45.8

EMEA (2)

     73,506         32.9        83,096         34.1   

APAC (3)

     44,583         19.9        48,882         20.1   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total net revenue

   $ 223,590         100.0   $ 243,527         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

(1) North America, Central America and Latin America (“Americas”)
(2) Europe, Middle East and Africa (“EMEA”)
(3) Asia and Pacific regions (“APAC”)

 

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Revenues from sales to customers outside of the Americas are a significant part of our revenue mix. Since all of our sales are currently invoiced in U.S. dollars, a change in the value of the dollar relative to foreign currencies could affect the demand for our products and therefore impact our revenues in foreign markets. For the three and six months ended October 31, 2011, approximately 49.5% and 52.8% of our total net revenue, respectively, was derived from customers outside of the Americas compared with 53.0% and 54.2% for the three and six months ended October 31, 2010, respectively.

Net revenue in the Americas increased $0.7 million in the second quarter of fiscal 2012, a 1.3% increase from the same period in fiscal 2011, driven by an increase in service revenue of $3.0 million primarily from the sales of renewal service contracts. This increase was partially offset by a $2.3 million decrease in product revenue primarily related to a decrease in revenue related to our Web Security products. Net revenue in the Americas for the six months ended October 31, 2011 decreased $6.0 million, down 5.4% compared with the same period in fiscal 2011, driven primarily by a $10.6 million decrease in product revenue related to our Web Security products, partially offset by an increase in product revenue related to our WAN Optimization products. This decrease also was partially offset by a $4.6 million increase in service revenue primarily driven by revenue related to the sale of renewal service contracts.

Net revenue in EMEA decreased $5.5 million in the second quarter of fiscal 2012, down 13.5% from the same period in fiscal 2011, primarily driven by a decrease in product revenue related to our Web Security and WAN Optimization products. Service revenue was essentially flat in the second quarter of fiscal 2012 compared with the second quarter of fiscal 2011. Net revenue in EMEA for the six months ended October 31, 2011 decreased $9.6 million, down 11.5% compared with the same period in fiscal 2011, driven primarily by a $11.1 million decrease in product revenue related to our Web Security and WAN Optimization products, partially offset by a $1.5 million increase in service revenue primarily from the sale of renewal service contracts.

Net revenue in APAC decreased $2.1 million in the second quarter of fiscal 2012, down 9.2% from the same period in fiscal 2011. This decrease was driven by a $3.0 million decrease in product revenue primarily related to a decrease in sales of our WAN Optimization products and, to a lesser extent, a decrease in sales of our Web Security products, partially offset by a $0.9 million increase in service revenue primarily related to sales of renewal service contracts. Net revenue in APAC for the six months ended October 31, 2011 decreased $4.3 million, down 8.8% compared with the same period in fiscal 2011, driven by a $6.1 million decrease in product revenue primarily related to our Web Security and WAN Optimization products, partially offset by a $1.8 million increase in service revenue primarily from the sale of renewal service contracts.

Gross Profit

The following is a summary of gross profit:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2011     2010     2011     2010  
     (dollars in thousands)  

Gross profit

   $     87,109      $     95,040      $     170,586      $     191,168   

Gross profit margin

     76.4     78.5     76.3     78.5

Quarter Ended October 31, 2011 compared with Quarter Ended October 31, 2010: Gross profit decreased $7.9 million, or 8.3%, in the second quarter of fiscal 2012 compared with the same period in fiscal 2011, as the result of a decrease in net product revenue partially offset by an increase in service revenue in the second quarter of fiscal 2012 compared with the same quarter in fiscal 2011. Gross profit margin decreased 2.1% in the second quarter of fiscal 2012 compared with the same period in fiscal 2011, primarily as a result of additional costs associated with the launch of our Cloud Security Service as well as an increase in contract manufacturer costs and related expenses in the current quarter.

 

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Six Months Ended October 31, 2011 compared with Six Months Ended October 31, 2010: Gross profit decreased $20.6 million, or 10.8%, in the first six months of fiscal 2012 compared with the same period of fiscal 2011, as a result of an decrease in net revenue and related gross profit margin. Gross profit margin in the first six months of fiscal 2012 decreased to 76.3% from 78.5% in the first six months of fiscal 2011, primarily as a result of additional costs associated with the launch of our Cloud Security Service as well as an increase in contract manufacturer costs and related expenses in the current period.

Sales and Marketing

Sales and marketing expense consists primarily of salaries and benefits, commissions, travel, advertising and promotional expenses. The following is a summary of sales and marketing expense:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2011     2010     2011     2010  
     (dollars in thousands)  

Sales and marketing

   $     46,781      $     44,821      $     94,338      $     89,476   

Sales and marketing as a percentage of net revenue

     41.0     37.0     42.2     36.7

Quarter Ended October 31, 2011 compared with Quarter Ended October 31, 2010: Sales and marketing expense increased $2.0 million, or 4.4%, in the second quarter of fiscal 2012 compared with the same period in fiscal 2011. The increase in sales and marketing expense was primarily attributable to a $3.4 million increase in salaries and benefits, related to increased headcount and increased severance payments, including those associated with the departure of certain sales executives, and increases in marketing program expense, partially offset by a $1.6 million decrease in commission payments and various sales expenses, including travel and sales events. Sales and marketing headcount was 506 at October 31, 2011 compared with 475 at October 31, 2010.

Six Months Ended October 31, 2011 compared with Six Months Ended October 31, 2010: Sales and marketing expense increased $4.9 million, or 5.4%, in the first six months of fiscal 2012 compared with the first six months of fiscal 2011. The increase in sales and marketing expense was primarily attributable to a $5.2 million increase in salaries and benefits, including severance payments, including those associated with the departure of certain sales executives, and increases in market program expense, partially offset by decrease in various sales expenses, including travel and sales events.

We currently expect sales and marketing expense during the third quarter of fiscal 2012 to increase slightly in absolute dollars and as a percentage of net revenue as a consequence of our continued investments designed to drive increased net revenue and market penetration and the expansion of existing marketing programs.

Research and Development

Research and development expense consists primarily of salaries and benefits, prototype costs, and testing equipment costs. The following is a summary of research and development expense:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2011     2010     2011     2010  
     (dollars in thousands)  

Research and development

   $     19,618      $     20,948      $     38,827      $     40,803   

Research and development as a percentage of net revenue

     17.2     17.3     17.4     16.8

Quarter Ended October 31, 2011 compared with Quarter Ended October 31, 2010: Research and development expense decreased $1.3 million, or 6.3%, in the second quarter of fiscal 2012 compared with the same period in fiscal 2011. The decrease in research and development expense was largely attributable to a

 

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decrease in employee related expenses, including salaries and bonus expenses, partially offset by increased severance payments. Research and development headcount was 348 at October 31, 2011, compared with 364 at October 31, 2010.

Six Months Ended October 31, 2011 compared with Six Months Ended October 31, 2010: Research and development expense decreased $2.0 million, or 4.8%, in the first six months of fiscal 2012 compared with the same period in fiscal 2011. The decrease in research and development expense for the first six months of fiscal 2012 was largely attributable to a decrease in bonus expense, partially offset by increased severance payments due to certain executive departures.

We currently expect research and development expense during the third quarter of fiscal 2012 to be relatively flat in absolute dollars and decrease slightly as a percentage of net revenue.

General and Administrative

General and administrative expense consists primarily of salaries and benefits, legal services, accounting and audit services, and other general corporate expenses. The following is a summary of general and administrative expense:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2011     2010     2011     2010  
     (dollars in thousands)  

General and administrative

   $     11,447      $     10,715      $     21,620      $     21,058   

General and administrative as a percentage of net revenue

     10.1     8.9     9.7     8.6

Quarter Ended October 31, 2011 compared with Quarter Ended October 31, 2010: General and administrative expense increased $0.7 million, or 6.8%, in the second quarter of fiscal 2012 compared with the same period in fiscal 2011. The increase was primarily due to severance expenses, including those associated with the departure of our former Chief Executive Officer, partially offset by a decrease in bonus expense. General and administrative headcount was 184 at October 31, 2011 compared with 181 at October 31, 2010.

Six Months Ended October 31, 2011 compared with Six Months Ended October 31, 2010: General and administrative expense increased $0.6 million, or 2.7%, in the first six months of fiscal 2012 compared with the first six months of fiscal 2011. The increase was primarily due to severance expenses, including those associated with the departure of our former Chief Executive Officer, partially offset by a decrease in bonus expense.

Amortization of Intangible Assets

Amortization expense for our intangible assets for the three and six months ended October 31, 2011 and 2010 was allocated as follows:

 

     Three Months  Ended
October 31,
     Six Months Ended
October 31,
 
         2011              2010              2011              2010      
     (in thousands)  

Included in cost of net revenue

   $     1,168       $     1,168       $     2,336       $     2,356   

Included in operating expenses

     1,826         1,843         3,669         3,686   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,994       $ 3,011       $ 6,005       $ 6,042   
  

 

 

    

 

 

    

 

 

    

 

 

 

On January 25, 2010, we acquired 84.5% of the outstanding shares of S7. We acquired an additional 15.5% of the outstanding shares of S7 in fiscal 2011. The acquisition-related intangible assets associated with our acquisition of S7 consist of assumed customer contracts, which represented S7’s underlying relationships with its

 

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customers at the time of the initial acquisition. The fair value assigned to customer relationships was $0.7 million, which will be amortized on a straight-line basis over the expected useful life of 4 years, consistent with the number of periods of prospective cash flow utilized to estimate the fair value of the assets.

For the three and six months ended October 31, 2011 and 2010, the amortization of intangible assets was related to our acquisitions of S7, Packeteer, Inc., certain assets of the NetCache business from Network Appliance, Permeo, Inc., Cerberian, Inc. and Ositis Software, Inc. The amortization of developed technology and trade names is charged to cost of net revenue, while the amortization of customer relationships is charged to operating expense. Our core technology intangible assets prior to being fully amortized were also charged to cost of net revenue. We amortize customer relationships, developed technology and trade names on a straight-line basis over their weighted average expected useful lives of 5, 5 and 2 years, respectively. Total amortization expense for our identifiable intangible assets for the three and six months ended October 31, 2011 was $3.0 million and $6.0 million, respectively, and $3.0 million and $6.0 million for the three and six months ended October 31, 2010. Amortization expense related to our identifiable intangible assets for the remainder of fiscal 2012 is expected to be $6.0 million.

Restructuring Charges

Restructuring charges consist primarily of personnel-related severance costs, contract termination costs and stock-based compensation expense. Stock-based compensation expense included in restructuring charges resulted primarily from the additional vesting of unvested option shares, restricted shares and restricted stock units upon termination of the employment of those employees pursuant to the terms of their separation agreements. The following is a summary of restructuring charges:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
         2011             2010             2011             2010      
     (dollars in thousands)  

Restructuring charges

   $     —        $     38      $     —        $     178   

Restructuring charges as a percentage of net revenue

     —       —       —       0.1

Restructuring charges in the first six months of fiscal 2011 consisted of expenses associated with the Fiscal 2010 Restructuring Plan that was completed in fiscal 2011.

Interest Income, Interest Expense and Other Expense, Net

Interest income consists of interest income earned on our cash and marketable securities. Our cash historically has been invested in highly liquid investments such as time deposits held at major banks, commercial paper, U.S. government agency discount notes, money market mutual funds and other money market securities with maturities at the date of purchase of 90 days or less. At October 31, 2011, our cash was invested in money market mutual funds and a money market savings account. Interest expense primarily relates to amortization of the fair value of warrants and a beneficial conversion feature associated with our convertible senior notes. Other expense, net, consists primarily of foreign currency exchange gains or losses, and non-recurring gains or losses realized outside our normal course of business. The following is a summary of interest income, interest expense and other expense, net:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
         2011             2010             2011             2011      
     (in thousands)  

Interest income

   $     137      $     126      $     250      $     290   

Interest expense

   $ (227   $ (223   $ (462   $ (447

Other income (expense), net

   $ (473   $ 158      $ (819   $ (165

 

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Quarter Ended October 31, 2011 compared with Quarter Ended October 31, 2010: Interest income was essentially flat in the second quarter of fiscal 2012 compared with the same period in fiscal 2011 and is made up of our average investment yield due on the money market funds in which the majority of our cash and cash equivalents was invested. Interest expense was essentially flat in the second quarter of fiscal 2012 compared with the same period in fiscal 2011 and during both periods related to the amortization of the fair value of warrants and a beneficial conversion feature associated with our Convertible Senior Notes (as defined in “Liquidity and Capital Resources”). Other income (expense), net decreased $0.6 million in the second quarter of fiscal 2012 compared with the same period in fiscal 2011 primarily due to an increase in foreign exchange losses incurred during the current period on foreign currency denominated assets and liabilities.

Six Months Ended October 31, 2011 compared with Six Months Ended October 31, 2010: Interest income and interest expense was essentially flat for the first six months of fiscal 2012 compared with the same period of fiscal 2011 for similar reasons as discussed above. Other income (expense), net decreased $0.7 million during the first six months of fiscal 2012 compared with the same period in fiscal 2011 primarily due to an increase in foreign exchange losses incurred during the current period on foreign currency denominated assets and liabilities.

Provision for Income Taxes

The following is a summary of provision for income taxes:

 

     Three Months Ended
October 31,
     Six Months Ended
October 31,
 
         2011              2010              2011              2010      
     (in thousands)  

Provision for income taxes

   $     2,288       $     4,703       $     3,820       $     9,687   

The provision for income taxes primarily reflects current and deferred U.S. federal and state taxes and foreign income taxes in taxable foreign jurisdictions. The provision for income taxes for the three and six months ended October 31, 2011 was $2.3 million and $3.8 million, respectively, compared with $4.7 million and $9.7 million for the three and six months ended October 31, 2010. The primary difference between the effective tax rate and the federal statutory tax rate relates to taxes in foreign jurisdictions with a tax rate different than the U.S. federal statutory rate and non-deductible stock-based compensation expense.

Our total gross unrecognized tax benefits as of October 31, 2011 and April 30, 2011 were $47.0 million and $43.3 million, respectively. The increase is primarily related to uncertainties with respect to the taxation of cross-border arrangements within the consolidated company that were recorded in the period. Included in our gross unrecognized tax benefits as of October 31, 2011 is approximately $44.4 million of tax benefits that, if recognized, would result in an adjustment to our effective tax rate.

Our policy is to classify interest and penalties related to uncertain tax positions as a component of our provision for income taxes. Accrued interest and penalties relating to our unrecognized tax benefits were approximately $3.0 million as of October 31, 2011, including approximately $0.4 million and $0.7 million charged to provision for income taxes for the three and six months ended October 31, 2011.

Due to our taxable loss position from inception through fiscal year 2010, all tax years are subject to examination in U.S. federal and state jurisdictions. We are also subject to examination in various foreign jurisdictions for tax years 2005 forward, none of which are individually material. We are unable to anticipate the change to the balance of our unrecognized tax benefits in the next twelve months due to the possibility of tax examinations and our continued assessment of potential contingencies.

Acquisitions

On January 25, 2010, we acquired 84.5% of the outstanding shares of S7, an IT research and development outsourcing firm based in Bangalore, India. We acquired an additional 15.5% of the outstanding shares of S7 in fiscal 2011. We acquired S7 to serve as the Company’s new development center in India and to provide expertise

 

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in software development, code migration and network security. The total purchase price was $6.4 million in cash, consisting of $4.3 million for the shares initially acquired and $0.8 million of noncontrolling interest subsequently acquired (which amounts include an allocation of $1.1 million for excess working capital remaining as of the closing date), and $1.3 million payable over the 30 months subsequent to the closing date. Under the stock purchase agreement, the selling shareholders will indemnify us for up to $1.3 million for damages caused by inaccuracies in, breaches or violations of or defaults under representations, warranties, covenants or agreements. Any such amounts may be withheld from the $1.3 million remaining due under the purchase agreement. In connection with the acquisition, we recognized $0.1 million of transaction costs, which were included in general and administrative expenses in our consolidated statement of operations. In addition, we agreed to pay potential retention bonuses up to an aggregate amount of $2.0 million to certain S7 shareholders who were also employees. Payment of these bonuses is contingent upon the performance of post-acquisition services by those shareholders over the 30 months subsequent to the initial closing date. Accordingly, the potential bonus amounts will be accrued as compensation expense over that period. Our acquisition of S7 did not result in the creation of a new business segment.

Liquidity and Capital Resources

Since our inception, we have financed our operations and capital expenditures through cash provided by operating activities, private sales of preferred and common stock, bank loans, equipment leases, private sales of convertible notes and warrants and an initial public offering of our common stock.

Cash and Cash Equivalents and Restricted Cash

We consider all highly liquid investments with insignificant interest rate risk and original maturities of three months or less to be cash equivalents. We determine the appropriate classification of our investments at the time of purchase and evaluate such designation as of each balance sheet date based on our intent and whether it is more likely than not that we will be required to sell the instrument before recovery of its amortized cost basis. To date, all of our short-term investments have been classified as available-for-sale and are carried at fair value, with unrealized gains and losses, excluding the portion relating to credit loss, if any, included in accumulated other comprehensive income (loss) in stockholders’ equity. The fair value of these securities is determined based on quoted market prices in active markets.

As of October 31, 2011, we had cash and cash equivalents of $361.4 million and restricted cash of $1.1 million, and approximately 54% of our total cash and cash equivalents was held outside of the United States in various foreign subsidiaries. If our cash and cash equivalents held outside the United States were distributed to the United States in the form of dividends or otherwise, we may be subject to additional U.S. income taxes (subject to an adjustment for foreign tax credits) and foreign withholding taxes. We believe our existing cash and cash equivalents and anticipated cash from operations will be sufficient to meet our operating requirements for at least the next twelve months, including working capital requirements and capital expenditures. We may seek to raise additional capital to strengthen our financial condition, facilitate expansion and pursue strategic acquisitions or investments, or to take advantage of other business opportunities as they arise.

The following summarizes cash and cash equivalents and restricted cash:

 

     As of
October 31, 2011
    As of
April 30, 2011
 
     (dollars in thousands)  

Cash and cash equivalents

   $     361,393      $     375,939   

Restricted cash

     1,066        1,031   
  

 

 

   

 

 

 

Total cash and cash equivalents and restricted cash

   $ 362,459      $ 376,970   
  

 

 

   

 

 

 

Percentage of total assets

     45.4     46.0
  

 

 

   

 

 

 

 

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Cash Flows

 

     Six Months Ended
October 31,
 
     2011     2010  
     (in thousands)  

Cash provided by operating activities

   $     27,675      $     51,437   

Cash used in investing activities

     (4,981     (5,998

Cash (used in) provided by financing activities

     (37,240     6,988   
  

 

 

   

 

 

 

Net (decrease) increase in cash and cash equivalents

   $ (14,546   $ 52,427   
  

 

 

   

 

 

 

Cash Flows from Operating Activities: Our largest source of operating cash is cash collected from our customers who purchase our products and services. Our primary uses of cash from operating activities are for personnel-related costs, product costs and facility costs.

Net cash provided by operating activities was $27.7 million for the first six months of fiscal 2012 compared with $51.4 million for the same period in fiscal 2011. The decrease in operating cash flow in fiscal 2012 compared with fiscal 2011 was primarily driven by lower net income, after excluding the impact of non-cash charges such as stock-based compensation, depreciation and amortization expense, as well as working capital uses of cash from lower accounts payable and deferred revenue balances, partially offset by a decrease in working capital uses of cash related to increased accounts receivable.

Cash Flows from Investing Activities: The changes in cash flows from investing activities primarily related to acquisitions and purchases of property and equipment, and technology licenses.

Net cash used by investing activities was $5.0 million for the first six months of fiscal 2012 compared with $6.0 million for the same period in fiscal 2011, a decrease of $1.0 million. This decrease was primarily due to fiscal 2011 purchases of technology licenses with no comparable activity in fiscal 2012.

Cash Flows from Financing Activities: Cash flows from financing activities related to proceeds from issuance of debt obligations, proceeds from issuances of common stock, stock repurchases and acquisition of noncontrolling interest.

Net cash used for financing activities was $37.2 million for the first six months of fiscal 2012 compared with net cash provided by financing activities of $7.0 million for the same period in fiscal 2011. The net cash used for our financing activities in the first six months of fiscal 2012 primarily related to $43.0 million of cash used to repurchase our common stock, partially offset by cash proceeds from purchases of our stock under our employee stock purchase plan and proceeds from the exercise of employee stock options.

Stock Repurchases

On November 16, 2010, our Board of Directors approved a program to repurchase up to $50 million of our common stock. Repurchases may be made from time to time in the open market or in negotiated transactions and are expected to comply with Rule 10b-18 under the Securities Exchange Act of 1934 and other legal requirements. The timing and amount of the repurchase transactions are determined by management and may depend on a variety of factors, including the trading price of the stock, market conditions, alternative investment opportunities, and other corporate and regulatory considerations. The program does not obligate us to acquire any particular amount of common stock and the program may be modified or discontinued at any time. The repurchases are funded from available working capital. During the six months ended October 31, 2011, we repurchased 1.9 million shares of common stock for $43.0 million under the program. Approximately $7.0 million remains authorized under the program and could be used for additional stock repurchases in the future.

 

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Convertible Senior Notes

On June 2, 2008, we issued $80.0 million aggregate principal amount of Zero Coupon Convertible Senior Notes due June 2, 2013 (the “Convertible Senior Notes”) and warrants (the “Warrants”) to purchase an aggregate of 385,356 shares of our common stock at an exercise price of $20.76 to Manchester Securities Corp., an affiliate of Elliott Associates, L.L.P. (“Manchester”) and Francisco Partners II, L.P. and Francisco Partners Parallel Fund II, L.P. (together, the “FP Entities”) in a private placement. As of October 31, 2011, the Convertible Senior Notes were reported on our condensed consolidated balance sheet at $78.6 million, net of a discount of $1.4 million primarily related to the value assigned to the Warrants, which is being amortized to interest expense over the life of the Convertible Senior Notes.

Contractual Obligations

Leases

We lease certain office facilities and office equipment under non-cancelable operating leases that expire at various dates through 2020. The facility leases generally require us to pay operating costs, including property taxes, insurance and maintenance, and contain scheduled rent increases and certain other rent escalation clauses. Rent expense is recognized in our condensed consolidated financial statements on a straight-line basis over the terms of the respective leases after consideration of rent increases, rent holidays and improvement allowances, if applicable. Any assets purchased using a lessee improvement allowance are capitalized as fixed assets and depreciated over the shorter of their useful lives or the lease term.

As of October 31, 2011, future minimum lease payments under non-cancelable operating leases with initial or remaining terms in excess of one year are as follows:

 

Year ending April 30,

   Total  
     (in thousands)  

Remainder of 2012

   $     5,453   

2013

     10,469   

2014

     8,868   

2015

     8,014   

2016

     4,456   

Thereafter

     1,445   
  

 

 

 

Total future minimum lease payments, net

   $ 38,705   
  

 

 

 

Purchase Commitments and Other

We purchase components from a variety of suppliers and use several contract manufacturers to provide manufacturing services for our products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, we enter into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by us or that establish the parameters defining our requirements. A significant portion of our reported purchase commitments arising from these agreements consists of firm, noncancelable, and unconditional commitments. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. These agreements are enforceable and legally binding against us in the short term and all amounts under these arrangements are due to be paid by the end of fiscal 2012. As of October 31, 2011 our total purchase commitments for inventory were $6.7 million.

Off-Balance Sheet Arrangements

As of October 31, 2011, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow

 

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or limited purposes. Further, we have not guaranteed any obligations of unconsolidated entities, nor do we have any commitment or intent to provide funding to any such entities. As such, we are not materially exposed to any market, credit, liquidity or financing risk that could arise if we had engaged in such relationships.

As of October 31, 2011, we did not have any off-balance sheet transactions, arrangements, or obligations that are reasonably likely to have a material current or future effect on our financial condition, results of operations, liquidity, or capital resources.

Recent Accounting Pronouncements

For information with respect to recent accounting pronouncements and the impact of these pronouncements on our condensed consolidated financial statements, see Note 1 of Notes to Condensed Consolidated Financial Statements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are subject to certain market risks, including changes in exchange rates and interest rates. We do not undertake any specific actions to cover our exposures to exchange and interest rate risks, and we are not a party to any risk management transactions. We also do not purchase or hold any derivative financial instruments for hedging, speculative or trading purposes.

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. As of October 31, 2011, we had cash and cash equivalents of $361.4 million and restricted cash of $1.1 million. These amounts were primarily held in money market funds. We maintain a conservative investment policy, which is intended to enhance the safety and preservation of our invested funds by limiting default risk, market risk and reinvestment risk. The fair value of our investment portfolio would not be significantly impacted by either a 100 basis point increase or decrease in market interest rates, given the short-term nature of the majority of our investment portfolio.

Foreign Currency Exchange Rate Risk

We primarily develop products in the United States and sell them throughout the world. As a result, our financial results are affected by factors such as changes in foreign currency exchange rates and economic conditions in foreign markets. Since all of our sales are currently invoiced and collected in U.S. dollars, a strengthening of the dollar could potentially make our products less price-competitive in foreign markets. As a significant portion of our net revenue and earnings are derived from international operations, this could adversely affect our net revenue and earnings. For the three and six months ended October 31, 2011 approximately 49.5% and 52.8%, respectively of our total net revenue was derived from customers outside of the Americas. In contrast, substantially all of the expenses of operating our foreign subsidiaries are incurred in foreign currencies, which to date have constituted an insignificant portion of our total operating expenses. As a result, our U.S. dollar earnings and net cash flows from international operations may be affected by changes in foreign currency exchange rates. The foreign currency exchange risk associated with our international operations has been material in the past and could be material in the future.

Item 4. Controls and Procedures

Under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial and Accounting Officer, we conducted an evaluation of the effectiveness of the design and operation 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 (the “Exchange Act”), as of the end of the period

 

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covered by this report (the “Evaluation Date”). Based on this evaluation, our Principal Executive Officer and Principal Financial and Accounting Officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to Blue Coat, including our consolidated subsidiaries, required to be disclosed in the reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to Blue Coat’s management, including our Principal Executive Officer and Principal Financial and Accounting Officer, as appropriate to allow timely decisions regarding required disclosure.

Under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial and Accounting Officer, we conducted an evaluation of any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during our most recently completed fiscal quarter. Based on that evaluation, our Principal Executive Officer and Principal Financial and Accounting Officer concluded that there has not been any change in our internal control over financial reporting during that quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The information set forth above under Note 11 contained in the “Notes to Condensed Consolidated Financial Statements” is incorporated herein by reference.

Item 1A. Risk Factors

In addition to the other information contained in this Quarterly Report on Form 10-Q, the following risk factors should be carefully considered by investors before making an investment decision. We have updated a risk factor relating to personnel and a risk factor relating to our third party sales channel partners from those presented in our Annual Report on Form 10-K, Part I, Item 1A, for the fiscal year ended April 30, 2011. Those risk factors are set forth at the end of this section.

Our business, financial condition and results of operations could be seriously harmed as a consequence of any of the following risks and uncertainties. The trading price of our common stock could decline due to any of these risks and uncertainties, and investors may lose all or part of their investment. These risks and uncertainties are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem less significant also may impair our business, financial condition and results of operations, or result in a decline in the trading price of our common stock.

Our quarterly operating results fluctuate significantly, are difficult to predict and may not meet our guidance or third party expectations.

Our net revenue and operating results have in the past, and may in the future, vary significantly from quarter to quarter and year over year due to a number of factors, many of which are outside of our control, including the macroeconomic environment. These factors limit our ability to accurately predict our operating results on a quarterly basis and include factors discussed throughout this “Risk Factors” section, including the following:

 

   

Macroeconomic conditions in our markets, both domestic and international, as well as the level of discretionary IT spending;

 

   

The timing, size and mix of orders from customers, including the timing of large orders, and nonlinear sales and shipping patterns;

 

   

Fluctuations in demand for our products and services;

 

   

Evolving conditions in the markets in which we compete;

 

   

Variability and unpredictability in the rate of growth in the markets in which we compete;

 

   

Our ability to continue to increase our market share consistent with past rates of increase;

 

   

Our variable sales cycles, which may lengthen as the complexity of products and competition in our markets increases and in response to macroeconomic conditions;

 

   

The level of competition in our markets, including the effect of new entrants, consolidation, technological innovation and substantial price discounting;

 

   

Market acceptance of our new products and product enhancements and our services;

 

   

Product announcements, introductions, transitions and enhancements by us or our competitors, which could result in deferrals of customer orders;

 

   

Technological changes in our markets;

 

   

The quality and level of our execution of our business strategy and operating plan, and the effectiveness of our sales and marketing programs;

 

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The level of industry consolidation among our competitors and customers;

 

   

The impact of future acquisitions or divestitures;

 

   

Changes in accounting rules and policies; and

 

   

The need to recognize certain revenue ratably over a defined period or to defer recognition of revenue to a later period.

A high percentage of our expenses, including those related to manufacturing overhead, service and maintenance, research and development, sales and marketing, and general and administrative functions are generally fixed in nature in the short term. As a result, if our net revenue is less than forecasted, such expenses cannot effectively be reduced to compensate for the revenue shortfall and our quarterly operating results will be adversely affected.

We believe that quarter-to-quarter comparisons of our operating results should not necessarily be relied upon as indicators of our future performance. In the past, our quarterly results have on occasion failed to meet our quarterly guidance and the expectations of public market analysts or investors, and it is likely that this will occur in the future. If this occurs our stock price likely will decline, and may decline significantly. Such a decline may also occur even when we meet our published guidance, but our results or future guidance fail to meet third party expectations.

The markets in which we compete are intensely competitive and certain of our competitors have greater resources and experience.

Our products and services currently focus on the markets for Web Security and WAN Optimization products and services, together with our newly available Cloud Security Service, which provides security-as-a-service on a subscription basis over the Internet.

Each of these markets is intensely competitive, and the intensity of this competition is expected to increase, particularly given current economic pressures and industry consolidation. As well, the market for cloud computing services is characterized by extreme competition and we are new to that market. Sales to service provider markets are especially volatile and typically have longer sales cycles. Competition in these markets may result in price reductions, reduced margins, loss of market share and inability to gain market share, any one of which could seriously impact our business, financial condition and results of operations. We may not be able to compete successfully against current or future competitors, including those resulting from consolidation in our historical and new markets and we cannot be certain that the competitive pressures we face will not seriously impact our business.

Our participation in different and diverse markets requires careful resource allocation. To the extent we concentrate our investment in one market, we are required to decrease our investment in our other markets, which could make us more vulnerable to our competitors in those markets. Some of our current and potential competitors have longer operating histories; significantly greater financial, technical, sales and marketing resources; significantly greater name recognition; and a larger installed base of customers than we do. Such competitors also may have well-established relationships with our current and potential customers and extensive knowledge of our industry and the markets in which we compete and intend to compete. As a result, those competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, marketing, promotion and sale of their products than we can. They also may make strategic acquisitions or establish cooperative relationships among themselves or with other providers, thereby increasing their ability to provide a broader suite of products, and potentially causing customers to defer purchasing decisions. Finally, they may engage in aggressive pricing strategies or discounting. Any of the foregoing may limit our ability to compete effectively in the market and adversely affect our business, financial condition and results of operations.

 

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Our gross margin is affected by a number of factors, and we may not be able to sustain it at present levels.

Our gross margin percentage has been and will continue to be affected by a variety of factors, including:

 

   

market acceptance of our products and fluctuations in demand;

 

   

the timing, size and mix of customer orders and product implementations;

 

   

increased price competition and changes in product pricing;

 

   

actions taken by our competitors;

 

   

new product introductions and enhancements;

 

   

manufacturing and component costs;

 

   

availability of sufficient inventory to meet demand;

 

   

purchase of inventory in excess of demand;

 

   

our execution of our strategy and operating plans;

 

   

changes in our sales model;

 

   

geographies in which sales are made; and

 

   

revenue recognition rules.

For example, we have in the past entered into large revenue transactions with certain customers that, because of the product mix and discounting, have decreased our gross margin percentage. We may, in the future, enter into similar transactions. Macroeconomic factors and competitive developments could put further pressure on our gross margin.

We expect that our recent entry into the cloud computing business will put negative pressure on our gross margins, both as a consequence of our need to invest in infrastructure and the ratable recognition of subscription revenue for such services when received.

Even if we achieve our net revenue and operating expense objectives, our net income and operating results may be below our expectations and the expectations of investors and analysts if our gross margins are below expectations.

Our international operations expose us to risks.

We currently have operations in a number of foreign countries and make sales to customers throughout the world. In fiscal 2011, 54.7% of our total net revenue was derived from customers outside of the Americas and during the first six months of fiscal 2012, 52.8% of our total net revenue was derived from customers outside of the Americas; thus, our business is substantially dependent on economic conditions and IT spending in markets outside of the Americas. As well, we currently perform certain of our research and development and other operations offshore in lower cost geographies and we maintain data centers for our Cloud Security Service in geographically dispersed locations outside of the United States. Our international operations and sales into international markets require significant management attention and financial resources, and subject us to certain inherent risks including:

 

   

technical difficulties and costs associated with product localization;

 

   

challenges associated with coordinating product development efforts among geographically dispersed areas;

 

   

potential loss of proprietary information due to piracy, misappropriation or laws that may inadequately protect our intellectual property rights;

 

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our limited experience in establishing a sales and marketing presence, and research and development operations, together with the appropriate internal systems, processes and controls, in certain geographic markets;

 

   

political unrest or economic instability, regulatory changes, war or terrorism, and other unpredictable and potentially long-term events in the countries or regions where we or our customers do business, which could result in delayed or lost sales or interruption in our business operations;

 

   

longer payment cycles for sales in certain foreign countries;

 

   

seasonal reductions in business activity in the summer months in Europe and at other times in various countries;

 

   

the significant presence of some of our competitors in some international markets;

 

   

potentially adverse tax consequences or changes in applicable tax laws;

 

   

import and export restrictions and tariffs and other trade protection initiatives;

 

   

potential failures of our foreign employees and channel partners to comply with both U.S. and foreign laws, including antitrust laws, trade regulations and anti-bribery and corruption laws, including the Foreign Corrupt Practices Act;

 

   

compliance with foreign laws and other government controls, such as those affecting trade, privacy, the environment, corporations and employment;

 

   

management, staffing, legal and other costs of operating a distributed enterprise spread over various countries;

 

   

fluctuations in foreign exchange rates, which we currently do not hedge against; and

 

   

fears concerning travel or health risks that may adversely affect our ability to sell our products and services in any country in which the business sales culture encourages face-to-face interactions.

To the extent we are unable to effectively manage our international operations and these risks, our international sales or operations may be adversely affected, we may incur additional and unanticipated costs, and we may be subject to litigation or regulatory action. As a consequence, our business, financial condition and results of operations could be seriously harmed.

Economic uncertainty and adverse macroeconomic conditions may harm our business.

Our revenues and margins are dependent on various economic factors, including rates of inflation, currency fluctuations, energy costs, levels of consumer sentiment and other macroeconomic factors, which may impact levels of business spending. These conditions may adversely affect corporate spending for IT products and services in specific geographies or more broadly, and could result in:

 

   

a significant reduction in our net revenue, gross margin and operating margin;

 

   

increased price competition for our products and services;

 

   

risk of excess and obsolete inventory;

 

   

higher overhead costs as a percentage of net revenue;

 

   

difficulty in accurately forecasting demand for our products and services;

 

   

insolvency or credit difficulties confronting our customers and channel partners, affecting their ability to purchase or pay for our products and services; and

 

   

insolvency or credit difficulties confronting our key suppliers, which could disrupt our supply chain.

In addition, a significant percentage of our operating expenses are generally fixed in nature, particularly in the short term, which could limit our ability to mitigate any negative impact on our profit margins.

 

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Our new Cloud Security Service offering presents financial, market, security, legal and operational risks.

We recently released our Blue Coat Cloud Security Service offering, which presents certain financial, market, security, legal and operational risks different from the risks present in marketing and selling our traditional product offerings. We have invested considerable resources in developing the Cloud Security Service and in building out its infrastructure, including amounts spent on internal research and development, equipment purchases and long-term leases or service agreements associated with acquiring space for the data centers that support the service, and there is no assurance that we will generate sufficient revenue from sales of subscriptions to recoup this investment. Moreover, our entry into the cloud computing business may adversely affect our gross margin, revenue and expense as a consequence of the ratable recognition of subscription revenue for our Cloud Security Service. We will need to create new sales and marketing programs and channels to effectively market our Cloud Security Service, and there is no assurance that our Cloud Security Service will achieve a significant degree of market acceptance with either end users or our channel partners.

The customer data that is electronically transmitted through our Cloud Security Service also subjects us to new security and legal compliance risks. While we believe our cloud product complies with current regulatory and security requirements in the jurisdictions in which we operate the service, there can be no assurance that such requirements will not change or that we will not otherwise be subject to legal or regulatory actions. Additionally, we must maintain high availability of our Cloud Security Service, which is subject to risks arising from hardware or software problems, connectivity or networking issues, scalability problems, human error, issues with third party data centers, natural disasters and hacker attacks. Should any of the foregoing risks related to our Cloud Security Service materialize, it may damage our reputation and result in the loss of customers and potential customers.

We must continue to develop market awareness of our company and our products and services.

We focused our business strategy and investments on the markets for Web Security and WAN Optimization products and services during the past fiscal year. We have also moved into the market for the delivery of Web Security functionality as a service, or security-as-a-service, with our new Cloud Security Service.

Market awareness of our brand and of the products and services that we offer is essential to our continued growth and our success in the markets in which we compete and intend to compete. If our advertising and marketing programs are not successful in creating market awareness of our participation and positioning in these markets, the need for our products and services, and the value and capabilities of our specific products and services, we may not be able to achieve sustained growth. Moreover, if the markets for our products and services fail to grow as we anticipate, we may not be able to sell as many of our products and services as we currently project, which would reduce our anticipated net revenue and could result in a decline in our stock price.

We must anticipate market needs, and develop and introduce new products and enhancements to rapidly meet those needs.

To maintain our competitive position in markets characterized by rapid rates of technological advancement, we must correctly anticipate market requirements and invest our research and development resources to meet those requirements. The introduction of new products by others, market acceptance of products based on new or alternative technologies, or the emergence of new industry standards, could render our existing products obsolete or make it easier for other products to compete with our products. Our future success will depend in part upon our ability to:

 

   

develop and maintain competitive products;

 

   

enhance our products by adding innovative features that differentiate our products from those of our competitors;

 

   

bring products to market on a timely basis at competitive prices;

 

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identify and respond to emerging technological trends in the market; and

 

   

respond effectively to new technological changes or new product announcements by others.

There is no guarantee that we will accurately predict the direction in which the markets in which we compete or intend to compete will evolve. Failure on our part to anticipate the direction of our markets and to develop products, enhancements and service offerings that meet the demands of those markets will significantly impair our business, financial condition and results of operations.

Our internal investments in research and development may not yield the benefits we anticipate.

The success of our business is predicated on our ability to create new products and technologies and to anticipate future market requirements and applicable industry standards. We presently are investing in enhancing our Web Security products, our WAN Optimization products and our Cloud Security Service. To accomplish these investments, we intend to continue to add personnel and other resources to our research and development function. We will likely recognize costs associated with these investments earlier than the anticipated benefits. If we do not achieve the anticipated benefits from these investments, or if the achievement of these benefits is delayed, our business, financial condition and results of operations may be adversely affected.

The process of developing new technologies is time consuming, complex and uncertain, and requires commitment of significant resources well in advance of being able to fully determine market requirements and industry standards. Furthermore, we may not be able to timely execute new product or technical initiatives because of errors in product planning or timing, technical difficulties that we cannot timely resolve, or a lack of appropriate resources. This could result in competitors bringing products to market before we do and a consequent decrease in our market share and net revenue. Our inability to timely and cost-effectively introduce new products and product enhancements, or the failure of these new products or enhancements to achieve market acceptance and comply with industry standards, could seriously harm our business, financial condition and results of operations. Additionally, our introduction of new products and product enhancements could result in the obsolescence of previously purchased or committed inventory, which would reduce our net income.

We are subject to various governmental regulations that could subject us to liability or impair our ability to sell our products or services.

Our products and services are subject to various governmental regulations. Our ability to sell our products internationally is subject to U.S. and foreign import and export control laws and various environmental regulations, including the Waste Electrical and Electronic Equipment (WEEE) and Restriction of the Use of Certain Hazardous Substances in Electrical and Electric Equipment (RoHS) regulations adopted by the European Union. In addition, our products contain encryption technology and various countries regulate the import or export of certain encryption technology and have enacted laws that could limit our ability to distribute our products or could limit our customers’ ability to implement our products in those countries. As well, the failure to comply with these regulations could result in the assessment of fines or penalties or other relief against us.

Certain of our products enable the filtering of Internet content and provide the end user customer with the ability to selectively block access to certain Web sites. It is possible that our end user customers may filter content in a manner that is unlawful or that is believed or found to be contrary to the exercise of personal rights. If this occurs, our ability to distribute and sell those products as presently designed or as customers desire to use them may be affected and our reputation may be harmed.

Changes in our products or changes in applicable regulations or enforcement may create delays in the introduction of our products, prevent our customers with international operations from deploying our products globally or, in some cases, prevent the export or import of our products to certain countries altogether. Any decreased use of our products, limitation on our ability to distribute our products or services in specific jurisdictions, or limitation on our customers’ ability to use our products or services could adversely affect our business, financial condition and results of operations.

 

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Our business operations and the use of our technology are subject to evolving legal regulation regarding privacy.

We currently operate our business in a number of jurisdictions where our operations are subject to evolving privacy-related or data protection laws and regulations. As well, our new Blue Coat Cloud Security Service transmits and stores customer data in various jurisdictions, which subjects the operation of that service to privacy-related or data protection laws and regulations in those jurisdictions. In addition, our appliances, when configured by our end user customers, may intercept data or content in a manner that may subject the use of those appliances to privacy-related or data protection laws and regulations in those jurisdictions in which our end user customers operate.

Any failure or perceived failure by us or by our products or services to comply with these laws and regulations may subject us to legal or regulatory actions, damage our reputation or adversely affect our ability to sell our products or services in the jurisdiction that has enacted the law or regulation. Moreover, if these laws and regulations change, or are interpreted and applied in a manner that is inconsistent with our data practices or the operation of our products and services, we may need to expend resources in order to change our business operations, data practices or the manner in which our products or services operate. This could adversely affect our business, financial condition and results of operations.

The security of our computer systems may be compromised and harm our business.

A significant portion of our business operations is conducted through use of our computer network. As well, we offer security-as-a-service to our customers through computer systems located at third party data centers in geographically dispersed areas. Although we have implemented security systems and procedures to protect the confidential information stored on these computer systems, experienced computer programmers and hackers may be able to penetrate our network security and misappropriate our confidential information or that of third parties. As well, they may be able to create system disruptions, shutdowns or effect denial of service attacks. Computer programmers and hackers also may be able to develop and deploy viruses, worms, and other malicious software programs that attack our networks or client computers, or otherwise exploit any security vulnerabilities, or that misappropriate and distribute confidential information stored on these computer systems. Any of the foregoing could result in damage to our reputation and customer confidence in the security of our Cloud Security Service and other products and services, and could require us to incur significant costs to eliminate or alleviate the problem. Additionally, our ability to transact business may be affected. Such damage, expenditures and business interruption could seriously impact our business, financial condition and results of operations.

We may not be able to successfully manage the growth of our business and may suffer other losses if we are unable to improve our systems and processes.

Our growth together with evolving regulatory requirements, our expanded international operations and changes in financial accounting and reporting standards, has placed increased demands on our management and our business infrastructure. We need to continue to improve our systems and processes to effectively manage our operations and growth, including our growth into new geographies. We may not be able to successfully implement improvements to these systems and processes in a timely or efficient manner. As well, our systems and processes may not prevent or detect all errors, omissions or fraud. Our failure to improve our systems and processes, or their failure to operate in the intended manner, may result in our inability to manage the growth of our business, to accurately forecast our revenue, expenses and earnings, or to prevent certain losses. This could adversely affect our business, financial condition and results of operations.

If the protection of our proprietary technology is inadequate, our competitors may gain access to our technology.

Our success is heavily dependent on our ability to create proprietary technology and to protect and enforce our intellectual property rights in that technology, as well as our ability to defend against adverse claims of third parties with respect to our technology and intellectual property. To protect our proprietary technology, we rely

 

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primarily on a combination of contractual provisions, confidentiality procedures, trade secrets, copyright and trademark laws, and patents. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult. In addition, the laws of some foreign countries, including countries where we sell products and have operations, do not protect our proprietary rights to as great an extent as do the laws of the United States. Our means of protecting our proprietary rights may not be adequate and unauthorized third parties, including current and future competitors, may independently develop similar or superior technology, duplicate or reverse engineer aspects of our products, or design around our patented technology or other intellectual property.

As of October 31, 2011, we had 134 issued U.S. patents, 62 pending U.S. patent applications (provisional and non-provisional) and 4 foreign-issued patents. There can be no assurance that any of our pending patent applications will issue or that the patent examination process will not result in our narrowing the claims applied for. Furthermore, there can be no assurance that we will be able to detect any infringement of our existing or future patents (if any) or, if infringement is detected, that our patents will be enforceable or that any damages awarded to us will be sufficient to adequately compensate us for the infringement.

There can be no assurance or guarantee that any products, services or technologies that we are presently developing, or will develop in the future, will result in intellectual property that is subject to legal protection under the laws of the United States or a foreign jurisdiction and that produces a competitive advantage for us.

Third parties may assert that our products or services infringe their intellectual property rights.

Third parties have in the past, and may in the future, claim that our current or future products or services infringe their intellectual property rights, and these claims, even if without merit, could harm our business by increasing our costs, reducing our net revenue or by creating customer concerns that result in delayed or reduced sales. This is particularly true in the patent area, as an increasing number of U.S. patents covering computer networking and Internet technology have been issued in recent years. Patent owners, including those that do not commercially manufacture or sell products, may claim that one or more of our products infringes a patent they own.

We expect that companies in the Internet and networking industries will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. The defense or settlement of any such claims, even if unmeritorious, could be time-consuming and costly. As well, such claims may require us to enter into royalty or licensing agreements, or to develop non-infringing technology. Injunctive relief could also be entered against us or trade restrictions could be imposed. Any of the foregoing could seriously harm our business, financial condition and results of operations.

Third parties may bring legal actions against us.

In the past, third parties have brought legal actions against us and other parties to whom we provided indemnification. We incurred substantial costs to defend those lawsuits and related legal proceedings. It is likely that in the future other parties may bring legal actions against us. Such actions, even if without merit, could harm our business. Any material litigation or arbitration inevitably results in the diversion of the attention of our management and other relevant personnel. To the extent uninsured, such claims further require the expenditure of our resources for defense costs for us and for parties to whom we may have indemnification obligations. We also may be required to pay material amounts in settlement costs or damages. As well, if the matter relates to intellectual property infringement, we may be required to enter into royalty or licensing agreements or to develop non-infringing technology, and injunctive relief could be entered against us. Customer concerns with respect to material litigation can result in delayed or lost sales. Any of the foregoing could seriously harm our business and have a material adverse effect on our business, financial condition and results of operations.

 

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If we fail to accurately predict our manufacturing requirements and manage our supply chain we could incur additional costs or experience manufacturing delays that could harm our business.

We provide forecasts of our requirements to our supply chain partners on a rolling 12-month basis. If our forecast exceeds our actual requirements, a supply chain partner may assess additional charges or we may have liability for excess inventory, each of which could negatively affect our gross margin. If our forecast is less than our actual requirements, the applicable supply chain partner may have insufficient time or components to produce or fulfill our product requirements, which could delay or interrupt manufacturing of our products or fulfillment of orders for our products, and result in delays in shipments, customer dissatisfaction, and deferral or loss of revenue. As well, we may be required to purchase sufficient inventory to satisfy our future needs in situations where a component or product is being discontinued. If we fail to accurately predict our requirements, we may be unable to fulfill those orders or we may be required to record charges for excess inventory. Any of the foregoing could adversely affect our business, financial condition and results of operations.

We depend on single and, in some cases, limited source suppliers for several key products and components of products.

We have limited sources of supply for certain key components of our products, which exposes us to the risk of component shortages or unavailability. In addition, we are unable to rapidly change quantities and delivery schedules because the procurement of certain components is subject to lengthy lead times and the qualification of additional or alternate sources is time consuming, costly and difficult. In the event our business growth exceeds our projections, or required components are otherwise in scarce supply, we may be subject to shortages, delays or unavailability of such components, or potential price increases, which may be substantial. If we are unable to secure sufficient components at reasonable prices in order to timely build our products, customer shipments may be delayed. This would adversely affect both our relationships with those customers and our net revenue. Alternatively, we may pay increased prices, which would impact our gross margin. Any of the foregoing could adversely affect our business, financial condition and results of operations.

We are dependent on original design manufacturers, contract manufacturers and third party logistics providers to design and manufacture our products and to fulfill orders for our products.

We depend primarily on original design manufacturers (each of which is a third party original design manufacturer for numerous companies) to co-design and co-develop the hardware platform for our products. We also depend on independent contract manufacturers (each of which is a third party manufacturer for numerous companies) to manufacture and fulfill our products. These supply chain partners are not committed to design or manufacture our products, or to fulfill orders for our products, on a long-term basis in any specific quantity or at any specific price. Also, from time to time, we may be required to add new supply chain partner relationships or new manufacturing or fulfillment sites to accommodate growth in orders or the addition of new products. It is time consuming and costly to qualify and implement new supply chain partner relationships and new manufacturing or fulfillment sites, and such additions increase the complexity of our supply chain management. Our ability to ship products to our customers could be delayed if we fail to effectively manage our supply chain partner relationships; if one or more of our design manufacturers does not meet our development schedules; if one or more of our contract manufacturers experiences delays, disruptions or quality control problems in manufacturing our products; or if one or more of our third party logistics providers experiences delays or disruptions or otherwise fails to meet our fulfillment schedules; or if we are required to add or replace design manufacturers, contract manufacturers, third party logistics providers or fulfillment sites. In addition, these supply chain partners have access to certain of our critical confidential information and could wrongly disclose such information. Moreover, an increasing portion of our manufacturing is performed outside the United States, primarily in China, and is, therefore, subject to risks associated with doing business in foreign countries. This includes risks resulting from the perception that certain jurisdictions, including China, do not comply with internationally recognized rights of freedom of expression and privacy and may permit labor practices that are deemed unacceptable under evolving standards of social responsibility. If manufacturing or logistics in these foreign countries is disrupted for any reason, including natural disasters, information technology system failures,

 

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military or government actions or economic, business, labor, environmental, public health, or political issues, or if the purchase or sale of products from such foreign countries is prohibited or disfavored our business, financial condition and results of operations could be adversely affected.

If our products do not interoperate with our customers’ infrastructures, or if customers implement certain proprietary protocols, sales of our products could be adversely affected.

Our products must interoperate with our customers’ existing infrastructures, which often have different specifications, utilize multiple protocol standards, deploy products and applications from multiple vendors, and contain multiple generations of products that have been added to that infrastructure over time. As well, our customers may implement proprietary encryption protocols that our products are unable to recognize, de-crypt or otherwise manage. If we are unable to successfully manage and interpret new protocol standards and versions, if we encounter problematic network configurations or settings, or if we encounter proprietary encryption protocols, we may have to modify our software or hardware so that our products will interoperate with our customers’ infrastructures and can address and manage our customers’ traffic in the manner intended. It may be necessary for us to obtain a license to implement proprietary encryption or other protocols, and there can be no assurance that we will be able to obtain such a license. As a consequence of any of the foregoing, we may suffer delays in development or installation or our products or may be unable to provide performance improvements for applications deployed in our customers’ infrastructures, which could affect our ability to sell or install our products, and adversely affect our business, financial condition and results of operations.

Forecasting our estimated annual effective tax rate is complex and subject to uncertainty, and there may be material differences between our forecasted and actual tax rates.

Forecasts of our income tax position and effective tax rate are complex and subject to uncertainty because our income tax position for each year combines the effects of a mix of profits and losses earned by us and our subsidiaries in various tax jurisdictions with a broad range of income tax rates, as well as changes in the valuation of deferred tax assets and liabilities, the impact of various accounting rules and changes to these rules and tax laws, the results of examinations by various tax authorities, and the impact of any acquisition, business combination or other reorganization or financing transaction. To forecast our global tax rate, we estimate our pre-tax profits and losses by jurisdiction and forecast our tax expense by jurisdiction. If the mix of profits and losses, our ability to use tax credits, or effective tax rates by jurisdiction is different than those estimated, our actual tax rate could be materially different than forecasted, which could have a material impact on our financial condition and results of operations.

As a multinational corporation, we conduct our business in many countries and are subject to taxation in many jurisdictions. The taxation of our business is subject to the application of multiple and conflicting tax laws and regulations as well as multinational tax conventions. Our effective tax rate is highly dependent upon the geographic distribution of our worldwide earnings or losses, the tax regulations and tax holidays in each geographic region, the availability of tax credits and carryforwards, and the effectiveness of our tax planning strategies. The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws themselves are subject to change as a result of changes in fiscal policy, changes in legislation, and the evolution of regulations and court rulings. Consequently, taxing authorities may impose tax assessments or judgments against us that could materially impact our tax liability and/or our effective income tax rate.

In addition, we may be subject to examination of our income tax returns by the Internal Revenue Service and other tax authorities. If tax authorities challenge the relative mix of U.S. and international income, our future effective income tax rates could be adversely affected. While we regularly assess the likelihood of adverse outcomes from such examinations and the adequacy of our provision for income taxes, there can be no assurance that such provision is sufficient and that a determination by a tax authority will not have an adverse effect on our business, financial condition and results of operations.

 

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Our ability to sell our products depends on the quality of our support and services offerings.

Our end user customers look to us and, as applicable, to our channel partners to ensure that our products are properly configured and installed, and efficiently and effectively operate within their networks. To the extent we or our channel partners fail to effectively assist our end user customers in their efforts to deploy and operate our products, or fail to timely and adequately address product problems, it may adversely affect our ability to sell our products to those customers in the future and could harm our business and product reputation and impact other sales. Any failure to maintain high quality support and services may harm our business, financial condition and results of operations.

Our acquisitions may not provide the benefits we anticipate and may disrupt our existing business.

In the past, we have acquired other businesses or assets, and it is likely we will acquire additional businesses or assets in the future. There is no guaranty that such acquisitions will yield the benefits we anticipate. The success of any acquisition is impacted by a number of factors, and may be subject to the following risks:

 

   

inability to successfully integrate the operations, technologies, products and personnel of the acquired companies;

 

   

diversion of management’s attention from normal daily operations of the business;

 

   

loss of key employees; and

 

   

substantial transaction costs.

Acquisitions may also result in risks to our existing business, including:

 

   

dilution of our current stockholders’ percentage ownership to the extent we issue new equity;

 

   

assumption of additional liabilities;

 

   

incurrence of additional debt or a decline in available cash;

 

   

adverse effects to our financial statements, such as the need to make large and immediate write-offs or the incurrence of restructuring and other related expenses;

 

   

liability for intellectual property infringement and other litigation claims, which we may or may not be aware of at the time of acquisition;

 

   

creation of goodwill or other intangible assets that could result in significant amortization expense or impairment charges; and

 

   

incurrence of tax expense related to the effect of acquisitions on our intercompany research and development cost sharing arrangements and legal structure.

The occurrence of any of the above risks could seriously impact our business, financial condition and results of operations.

We rely on technology that we license from third parties, including software that is integrated with internally developed software and used with our products.

We rely on technology that we license from third parties, including third party commercial software and open source software, that is used with certain of our products. If we are unable to continue to license any of this software on commercially reasonable terms, we will face delays in releases of our software or we will be required to delete this functionality from our software until equivalent technology can be licensed or developed and integrated into our current product. In addition, the inability to obtain certain licenses or other rights might require us to engage in litigation regarding these matters, which could have a material adverse effect on our business, financial condition and results of operations.

 

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Product quality problems may result in delayed market acceptance, additional costs, reduced sales or litigation.

Our products are highly complex and may contain undetected operating errors or quality problems, particularly when first introduced or as new versions or upgrades are released. Despite testing by us and by current and potential customers, errors or quality problems may not be found in new products or new versions until after commencement of commercial shipments, resulting in customer dissatisfaction and loss of or delay in market acceptance and sales opportunities. This could materially adversely affect our operating results. These errors and quality problems could also cause us to incur significant repair or replacement costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems. We may also incur significant costs in connection with a product recall and any related indemnification obligations, which could materially adversely affect our operating results. In addition, many of our products operate on our internally developed operating system, and any error in the operating system may affect those products. We have experienced errors or quality problems in the past in connection with new products and enhancements to existing products. We expect that errors or quality problems will be found from time to time in new or enhanced products after commencement of commercial shipments, which could seriously harm our business.

Since our end user customers install our appliances directly into their network infrastructures, any errors, defects or other problems with our products could negatively impact their networks or other Internet users, resulting in financial or other losses. While we typically seek by contract to limit our exposure to damages, it is possible that such limitations might not exist or might not be enforced in the event of a product liability claim. Moreover, a product liability claim brought against us, even if not successful, would likely be time-consuming and costly to defend or settle, and could seriously harm the reputation of our business and products.

Our operations could be significantly hindered by the occurrence of a natural disaster, terrorist attack or other catastrophic event.

Our business operations are susceptible to outages due to fire, floods, power loss, telecommunications failures, terrorist attacks and other events beyond our control, and our sales opportunities may also be affected by such events. In addition, a substantial portion of our facilities, including our headquarters, are located in Northern California, an area susceptible to earthquakes. We do not carry earthquake insurance for earthquake-related losses. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any of these events. To the extent that such events disrupt our business or the business of our current or prospective customers, or adversely impact our reputation, such events could adversely affect our business, financial condition and results of operations.

We may be unable to raise additional capital.

We believe that our available cash, cash equivalents and short term investments will enable us to meet our liquidity and capital requirements for at least the next 12 months. However, if cash is required for unanticipated needs, including in connection with a proposed acquisition of a company or technology, we may need additional capital during that period. The development and marketing of new products and our investment in sales and marketing efforts require a significant commitment of resources. If the markets for our products develop at a slower pace than anticipated, we could be required to raise additional capital. We cannot guarantee that, should it be required, sufficient debt or equity capital will be available to us under acceptable terms, if at all. If we were unable to raise additional capital when required, our business, financial condition and results of operations could be seriously harmed.

 

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The market price of our stock is volatile, and is likely to be volatile in the future.

The market price of our common stock has experienced significant fluctuations and may continue to fluctuate significantly. Such volatility in the trading price of our stock can occur in response to general market conditions, changes in the IT or technology market generally or changes in the specific markets in which we operate, and cause an increase or decline in our stock price without regard to our operating performance. The market price of our common stock could decline quickly and significantly if we fail to achieve our guidance or if our performance fails to meet the expectation of public market analysts or investors.

The market price of our common stock may fluctuate significantly in response to the following factors, among others:

 

   

variations in our quarterly operating results;

 

   

changes in financial estimates or investment recommendations by securities analysts;

 

   

changes in macroeconomic conditions;

 

   

the introduction of new products by our competitors;

 

   

our ability to keep pace with changing technological requirements;

 

   

changes in market valuations of information technology companies;

 

   

announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments, or other significant transactions;

 

   

loss of customers who represent a significant portion of our revenues;

 

   

additions or departures of key personnel;

 

   

fluctuations in stock market volumes;

 

   

investor confidence in our stock, technology stocks and the stock market in general;

 

   

speculation in the press or investment community about our strategic position, financial condition, results of operations or business; and

 

   

regulatory or litigation matters.

It is not uncommon for securities class actions or other litigation to be brought against a company after periods of volatility in the market price of a company’s stock We have been subject to such litigation in the past and two such lawsuits were brought against us in the second quarter of fiscal 2012. Such actions could result in management distraction and expense and could result in a decline in our stock price.

We must attract, assimilate and retain key personnel on a cost-effective basis.

We depend on our ability to attract and retain highly qualified and skilled personnel on an ongoing basis. Our success will depend in part on our ability to recruit and retain key personnel. Changes in our executives and other high-level personnel may disrupt our business and could result in other employees leaving the Company. During fiscal 2012, four executive officers have departed the Company, including: our President and Chief Executive Officer; our Senior Vice President, Field Operations; our Chief Product Officer; and our Senior Vice President, Products and Operations. We also experienced substantial employee attrition in fiscal 2011, particularly in our sales organization. This attrition continued, at a lower rate, in the first six months of fiscal 2012.

We presently compensate our key and our high performing employees in part through awards of equity in the Company, including stock options and restricted stock units. We need to provide equity awards that are competitive with awards offered by those companies with whom we compete for talent in order to attract and retain top personnel; however, our ability to make such awards is constrained by the shares available for issuance under our 2007 Stock Incentive Plan. Increases to the reserve of our 2007 Stock Incentive Plan require

 

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stockholder approval, and there is no assurance that we will obtain the necessary stockholder approval for an increase to the reserve of our 2007 Stock Incentive Plan when we believe it is required. The failure to obtain such approval could limit our future ability to grant equity awards, or sufficiently substantial equity awards, to our employees for the purposes of retention of those employees.

The majority of our U.S.-based employees, including our executives, are employed on an “at-will” basis, which may make it easier for key employees to move to new employment. Our inability to timely hire replacement or additional employees may impact our operations, since new hires, particularly sales personnel, frequently require extensive training before they achieve desired levels of productivity. As well, we may be unable to address market opportunities in a timely fashion. This may affect our ability to grow our net revenue. In addition, we may increase our hiring in locations outside of the U.S., such as in connection with our research and development facility in India, which could subject us to additional geopolitical and exchange rate risks.

We rely significantly on third party sales channel partners to sell our products.

Substantially all of our revenue is generated through sales by our channel partners, which include distributors, global systems integrators, managed service providers and value-added resellers. During fiscal 2011, approximately 99% of our sales were made through our channel partners, and 55% of our sales were made through 3 distributors. During the first six months of fiscal 2012, approximately 98% of our sales were made through our channel partners, and 53% of our sales were made through 3 distributors. Although we provide support to these channel partners through our direct sales and marketing activities, we depend upon these partners to generate sales opportunities and to independently manage the sales process for opportunities with which they are involved. In order to increase our net revenue, we will need to maintain our existing sales channel partners and to continue to train and support them, and we will need to add new sales channel partners and effectively train, support and integrate them with our sales process. As well, our entry into new markets, such as our entry into the security-as-a-service market with our new Cloud Security Service, requires us to develop appropriate channel partners and to train them to effectively address these markets. If we are unsuccessful in these efforts, this will limit our ability to grow our business and our business, financial condition and results of operations will be adversely affected.

Our current system of channel distribution may not prove effective in maximizing sales of our products and services. Our products are complex and certain sales can require substantial effort. It is possible that our channel partners will be unable or unwilling to dedicate appropriate resources to support those sales. As well, most of our sales channel partners do not have minimum purchase or resale requirements, and may cease selling our products at any time. They also may market, sell and support products and services that are competitive with ours, and may devote more resources to the marketing, sales and support of those products. There is no assurance that we will retain these sales channel partners, or that we will be able to secure additional or replacement sales channel partners in the future. The loss of one or more of our key sales channel partners in a given geographic area could harm our operating results within that area, as new sales channel partners typically require extensive training and take several months to achieve acceptable productivity.

We also depend on some of our sales channel partners to deliver first line service and support for our products. Any significant failure on their part to provide such service and support could impact customer satisfaction and future sales of our products.

While we require that our third party sales channel partners comply with applicable laws and regulations, they could engage in behavior or practices that expose us to legal or reputational risk. For example, we recently verified that certain appliances that we sold in compliance with U.S. export law to a Middle Eastern affiliate of one of our channel partners were diverted to Syria after that sale. We are conducting an internal review of the matter and are cooperating with the U.S. government in connection with its review. We have terminated the right of the channel partner affiliate to distribute our products, which could result in disruption of sales in the Middle East, delay fulfillment of previously accepted orders, result in the imposition of penalties or fines, and harm our operating results in the Middle East.

 

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Item 6. Exhibits

 

Number

  

Description

  10.86    Stock Option Agreement (which is incorporated herein by reference to Exhibit 99.1 of Form S-8 filed by the Registrant with the Commission on August 31, 2011)
  10.87    Restricted Stock Unit Agreement (which is incorporated herein by reference to Exhibit 99.2 of Form S-8 filed by the Registrant with the Commission on August 31, 2011)
  31.1    Principal Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
  31.2    Principal Financial and Accounting Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
  32.1    Principal Executive Officer and Principal Financial and Accounting Officer Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS*    XBRL Instance Document
101.SCH*    XBRL Taxonomy Extension Schema Document
101.CAL*    XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF    XBRL Taxonomy Extension Definition Linkbase Document
101.LAB*    XBRL Taxonomy Extension Label Linkbase Document
101.PRE*    XBRL Taxonomy Extension Presentation Linkbase Document

 

* XBRL (Extensible Business Reporting Language) information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, and is not otherwise subject to liability under those sections.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

BLUE COAT SYSTEMS, INC.

/s/ Gordon C. Brooks

Gordon C. Brooks
Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)

Dated: December 2, 2011

 

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