Item 1. Business
General
Brocade Communications Systems, Inc. (“Brocade” or the “Company”) is a leading supplier of networking equipment, including end-to-end Internet Protocol (“IP”)-based Ethernet networking solutions and storage area networking solutions for the Global 1000 enterprises and service providers such as telecommunication firms, cable operators or mobile carriers. Brocade offers a comprehensive line of high-performance networking hardware and software products and services that enable businesses to make their networks and data centers more efficient, reliable and adaptable. Brocade’s products, services and solutions simplify information technology (“IT”) infrastructure, increase resource utilization, ensure availability of mission critical applications, and support advanced data, voice, video and mobility applications.
Brocade products and services are marketed, sold and supported worldwide to end-user customers through distribution partners, including original equipment manufacturers (“OEMs”), distributors, systems integrators, value-added resellers (“VARs”) and directly to end-users by the Brocade direct sales force.
For revenue and other information regarding Brocade’s operating segments, see Note 15, “Segment Information,” of the Notes to Consolidated Financial Statements, which is incorporated herein by reference.
Products and Services
IP Layer 2-3
Brocade’s enterprise-class Layer 2 and Layer 3 switches and routers are designed to connect users in an enterprise network, enabling network connectivity such as, access to the Internet, new forms of network-based communications such as voice over IP, and higher levels of collaboration through unified messaging applications and greater degrees of productivity through mobility. Brocade offers a variety of platforms to allow customers to design a network to meet their needs, including the Brocade BigIron, FastIron, EdgeIron and TurboIron product families. Brocade’s Layer 2 and Layer 3 switches provide cost-effective delivery of the intelligence, speed and manageability required to support the increasing use of bandwidth-intensive and Internet-based applications.
Brocade’s carrier-class switches and routers are designed to handle network traffic within and across service provider networks, whether telecommunications providers, cable multiservice operators or mobile carriers. Brocade offers a full portfolio of Ethernet-optimized platforms designed for service provider environments that include support for legacy technologies such as Synchronous Optical Network to ease the migration to an all-IP service provider network architecture. Brocade specializes in offering products and technologies that support various service provider network environments including the data center, metro aggregation and high-capacity IP/Multiprotocol Label Switching core. Brocade also offers an industry-leading portfolio of service provider-specialized Carrier Ethernet products from the metro edge into the network core, including the Brocade NetIron MLX and XMR router families, as well as the Brocade NetIron CES switches. Brocade’s Metro and Internet routers are designed to deliver the capabilities and performance needed to provide efficient and reliable routing services to Internet data centers around the world.
IP Layer 4-7/Application Delivery Products
Brocade’s Layers 4 - 7 platforms, including the Brocade ServerIron family of products, are designed for application traffic management and server load balancing, allowing customers to enable specific features to improve the performance of specific applications, or improve the performance of a server farm. These high-performance data center traffic management systems with network intelligence capabilities allow enterprises and service providers to build reliable network infrastructures that efficiently manage the flow of traffic over extended distances, known as metro area networks and wide area networks.
Storage Networking
Brocade’s storage networking products and services are designed to help customers reduce the cost and complexity of managing business information within a shared data storage environment, while enabling high levels of availability of mission critical business applications. In addition, Brocade’s products and services assist customers in the development and delivery of storage and server consolidation, disaster recovery and data security, and in meeting compliance issues regarding data management. Customers use Brocade’s products to build storage area networks (“SAN”s), which are also known colloquially as “fabrics.” Brocade’s products are generally used in conjunction with servers and storage subsystems, SAN interconnection components such as host bus adapters (“HBAs”), and server and storage management software applications and tools. By utilizing a shared storage, or networked storage solution, enterprises of all types and sizes can more easily share and consolidate server and storage resources, centralize and simplify data management, scale and provision storage resources more effectively, and improve application efficiency, performance and availability. As a result, these enterprises are able to better utilize IT assets, improve productivity of IT personnel, reduce capital and operational expenditures, and more reliably and securely store, manage and administer business information.
Brocade’s family of Fibre Channel SAN backbones, directors, fabric and embedded switches provide interconnections, bandwidth and high-speed routing of data between servers and storage devices. Product models range from entry-level 8-port fabric switches to 896-port directors with multiple options, addressing the needs of small departments and global enterprises alike. These high-performance solutions are available to support requirements both for open systems and mainframe operations. Switches and directors support key applications such as data backup, remote mirroring and high-availability clustering, as well as high-volume transaction processing applications such as enterprise resource planning and data warehousing. Brocade’s storage networking products have been designed to meet the storage networking needs of end-users in environments ranging from small and medium-sized businesses to large enterprises with storage network fabrics that scale to thousands of ports, spread across multiple locations around the world. Brocade’s storage networking products also include HBAs, which connect host computers to a Fibre Channel network.
Brocade offers a variety of fabric extension, switching and routing solutions that are designed to connect two or more data centers over long distances to enhance business continuity and disaster recovery. Brocade’s fabric extension solutions support SAN extension (Fibre Channel), mainframe extension (Fibre Connectivity), as well as other multiprotocol switching and routing technologies including optical, asynchronous transfer mode, and IP networks. Through its Data Center Fabric Manager, Brocade offers end-to-end management across multiple fabrics with high levels of scalability and performance designed to maximize data availability even over extended distances.
To enable industry-leading encryption-based security, Brocade offers high-speed, highly reliable hardware in both modular and fixed-switch form factors that provides fabric-based encryption and compression services. Brocade works with industry-leading security solution vendors to offer customers a wide choice of enterprise-class key management systems options. These solutions provide high-performance disk encryption processing power to meet the needs of the most demanding enterprise environments with flexible, on-demand performance.
Brocade also introduced a new class of data center networking products that support an emerging technology called Fibre Channel over Ethernet (“FCoE”). Brocade is one of the pioneers of FCoE technology and has been instrumental in driving the protocol toward standardization. FCoE enables the consolidation of server connectivity by being able to support both Fibre Channel and Ethernet connections simultaneously. Customers benefit from this consolidation by having to deploy fewer switches and peripheral cards inside of servers, thereby reducing costs and complexity. Brocade is one of the industry’s first vendors to offer customers a comprehensive suite of FCoE products that includes both switches and FCoE peripheral cards known as converged network adapters (“CNAs”).
Global Services
Brocade offers a wide range of consulting and support services that assist customers in designing, implementing, deploying and managing advanced networking solutions, as well as post-contract customer support (“PCS”) and separately priced extended warranties. These services address a number of customer priorities that must be managed during the life cycle of a storage network or data center infrastructure and are meaningful to customers because they bring valuable experience and expertise to a customer challenge. Brocade’s services may be delivered directly to end-user customers or via partners as a component of a broader service and support offering.
Industry Initiatives and Standards Development
Brocade believes that as the need for networking solutions continues to grow, enterprises will look to further simplify the tasks of storing, managing and administering their data, while also looking to maximize their IT investments and reduce both capital and operational expenditures. Data networking solutions provide a platform that helps enterprises optimize their IT assets and support future data growth, and have been installed at many of the world’s leading companies since the mid-1990s. Brocade also believes enterprises will continue to expand the size and scope of their networks and the number and types of applications that these networks support.
Brocade believes that the future evolution of networking and data center management markets will be led by the providers of products and services that simplify the management of heterogeneous server and storage environments and maximize end-users’ IT investments on an ongoing basis. Brocade also believes that data networking and data center infrastructure solutions will evolve to provide increased capabilities that enable new types of data management applications that simplify the management of data, increase operational efficiencies and reduce operating expense. As a result, many of Brocade’s initiatives and investments are aimed at expanding the capabilities enabled by networks, increasing end-to-end interoperability, protecting end-user investments in existing and new IT resources, and making it easier for Brocade and its partners to deliver solutions that provide efficiencies in managing large, complex and growing enterprise data center environments.
Brocade works with industry-leading organizations to facilitate the development of standards, technologies, products and services that focus on the simplification of data center infrastructure management and the implementation and management of data networking environments. Brocade has a partner-centric approach to building solutions and works with nearly every leading provider of server, storage and storage network management applications and technologies.
Brocade has a long history of being a major contributor to the evolution of industry standards ranging from Fibre Channel communication technology to storage network interoperability to storage and storage network management. Brocade contributes to related industry standards committees and has authored or co-authored the majority of the Fibre Channel protocol standards in existence today. As Brocade continues to expand its leadership presence in new technologies, Brocade’s participation in associated standards groups continues to grow. In fiscal year 2009, Brocade was a member of the SNIA Green Working Group, Ethernet Alliance, FCIA Board, SNIA Technical Council, DMTF Technical Council and Fibre Channel-related industry associations and standards bodies. Brocade also currently chairs the INCITS T11 Committee, the lead governing body for all Fibre Channel-related standards, which includes FCoE.
Education and Technical Certification Services
Brocade’s education and training organization delivers technical education and training on Brocade technology that encompasses design, implementation and management solutions to its partners and their customers. Brocade curriculum is delivered worldwide using diverse methodologies, which include instructor-led classes and an online web-based training portfolio as well as a “live” virtual classroom capability. Brocade Education Services trains over 18,000 IT professionals annually. The Brocade Certification Programs offer certification on Brocade solutions for IT professionals who have completed certain tests administered by an
independent testing organization. These certification programs are designed to measure the knowledge and proficiency of IT professionals in Brocade data center and data management solutions and technologies, and to help ensure that Brocade’s customers receive superior customer service and support. More than 12,500 certification tests have been delivered with more than 8,900 IT professionals certified worldwide. Brocade’s education and training services are made available through its own education facilities and through its worldwide training provider network.
Distribution Channels
Brocade’s products and services are marketed, sold and supported worldwide to end-user customers through distribution partners, including OEMs, distributors, systems integrators, VARs and direct to end-users by the Brocade direct sales force.
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Brocade’s OEM partners are leading server, storage and systems providers who offer Brocade’s products under their own private label or as Brocade-branded solutions. Sales of these products through OEM partners comprise the majority of Brocade’s business.
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Other distribution partners include a global network of authorized distributors, systems integrators and VARs. Brocade authorizes these partners to market, sell and support its products and services. Some of these partners also sell training and other value-added services.
Brocade has OEM or distribution agreements with most of the major companies that sell enterprise servers and storage systems. In addition, Brocade employs a worldwide sales force to assist its distribution partners in marketing Brocade solutions, assessing customer requirements and designing, implementing and maintaining Brocade-based solutions.
Customers
Brocade’s major OEM customers for the fiscal year ended October 31, 2009, in alphabetical order, include Dell Computer Corporation (“Dell”), EMC Corporation (“EMC”), Hitachi Data Systems (“HDS”), Hewlett-Packard Company (“HP”), International Business Machines Corporation (“IBM”), NetApp, Inc., and Sun Microsystems, Inc. Brocade’s primary non-OEM customers for the fiscal year ended October 31, 2009, in alphabetical order, include AT&T, Inc., CyberCore Technologies, LLC and Tokyo Electron Limited.
For the fiscal years ended October 31, 2009, October 25, 2008 and October 27, 2007, EMC, HP and IBM each represented greater than 10% of Brocade’s total net revenues for combined totals of 48% (EMC with 18%, HP with 13% and IBM with 17%), 65% (EMC with 25%, HP with 18% and IBM with 22%) and 68% (EMC with 24%, HP with 22% and IBM with 22%) of its total net revenues, respectively. The level of sales to any OEM customer may vary from quarter to quarter. Brocade expects that it will continue to expand its routes-to-market to sell its products through distributors, global systems integrators and VARs in addition to its OEM channel.
In the Ethernet market, Brocade cultivates business in a number of key customer markets such as the U.S. government, education and service provider segments. Customers in these market segments represented a significant part of Brocade’s overall business. Brocade’s strategy includes leveraging customer markets that it has a significant presence in to expand its sales of Ethernet products, including international markets, Global 1000 customers, financial services companies and OEMs. As an example, Brocade recently expanded its OEM partnerships with IBM and Dell, which enables IBM and Dell to rebrand and sell certain of Brocade’s enterprise Ethernet networking products.
Geographic Information
From fiscal year 2004 to fiscal year 2009, domestic revenues have accounted for between 56% and 69% of total net revenues. For the year ended October 31, 2009, domestic and international revenues were approximately 65% and 35% of total net revenues, respectively. For the year ended October 25, 2008, domestic and international revenues were approximately 63% and 37% of total net revenues, respectively. For the year ended
October 27, 2007, domestic and international revenues were approximately 61% and 39% of total net revenues, respectively. International revenues primarily consist of sales to customers in Western Europe, the greater Asia Pacific region and Japan. For the year ended October 31, 2009, international revenues decreased as a percentage of total net revenues primarily as a result of Brocade’s acquisition of Foundry Networks, Inc. (“Foundry”), which had a higher concentration of its customer base in North America. For the years ended October 25, 2008 and October 27, 2007, the mix of international revenues increased partly as a result of market growth in Europe and partly as a result of Brocade’s acquisition of McDATA Corporation (“McDATA”), which had a higher concentration of European revenue.
Revenues are attributed to geographic areas based on where Brocade’s products are shipped. However, certain OEM customers take possession of Brocade’s products domestically and then distribute these products to their international customers. Because Brocade accounts for all of those OEM revenues as domestic revenues, Brocade cannot be certain of the extent to which its domestic and international revenue mix is impacted by the practices of its OEM customers. Nevertheless, data provided by OEM customers indicate that international customers may account for a higher percentage of end-user demand than that indicated by Brocade’s mix of domestic and international revenues.
The majority of Brocade’s assets as of October 31, 2009 were attributable to its United States operations. For additional geographic information on Brocade’s revenues and long-lived assets, see Note 15, “Segment Information,” of the Notes to Consolidated Financial Statements, which is incorporated herein by reference. Also, for a discussion of the risks attendant to Brocade’s foreign operations, see Part I, Item 1A.
Item 1A. Risk Factors
Intense competition in the market for networking solutions could prevent Brocade from maintaining or increasing revenue, profitability and cash flows with respect to its networking solutions.
The market for data and storage networking solutions is intensely competitive. In particular, Cisco maintains a dominant position in the Ethernet networking market and several of its products compete directly with Brocade’s products. Purchasers of networking solutions may choose Cisco’s products because of its longer operating history, different product line and strong reputation in the networking market. In addition, Cisco may develop new technologies that directly compete with Brocade’s products or render its products obsolete.
Brocade also competes with other companies, such as 3Com, Alcatel-Lucent, Enterasys Networks, Inc., Extreme Networks, Inc., Networks, Inc., Force10 Networks, Inc., HP ProCurve Division, Huawei Technologies Co. Ltd., and Juniper. Brocade also faces significant competition from providers of Fibre Channel switching products for interconnecting servers and storage. These principal competitors include Cisco and QLogic Corporation. Brocade also faces other competitors in markets adjacent to the SAN and Ethernet networking markets, such as QLogic and Emulex Corporation in the server connectivity or HBA market. Brocade may continue to face competitors with well-established market share and customer relationships in adjacent markets. Some of Brocade’s current and potential competitors have greater market leverage, longer operating histories, greater financial, technical, sales, marketing and other resources, more name recognition and larger installed customer bases. Brocade’s competitors could also adopt more aggressive pricing policies than Brocade. Brocade believes that competition based on price may become more aggressive than it has traditionally experienced. Brocade’s competitors could also devote greater resources to the development, promotion and sale of their products than Brocade and, as a result, may be able to respond more quickly to changes in customer or market requirements. Brocade’s failure to successfully compete in the market would harm Brocade’s business and financial results.
Convergence and consolidation trends within the information technology industry are also beginning to bring historically separated computing, storage and Ethernet networking technologies together. These trends are shifting long-standing industry partnerships/alliances, go-to-market routes, technology models and represent risks for Brocade. For example, the ongoing development of new networking protocols such as FCoE and CEE are designed to merge storage and Ethernet network traffic inside of data centers. Brocade recently introduced new products that support FCoE/CEE. If the adoption rate of FCoE/CEE products varies significantly to what is currently projected by Brocade and other industry experts, this may negatively impact Brocade’s businesses.
Competitors are likely to use emerging technologies and alternate routes-to-market to compete with Brocade. In addition, Brocade’s OEM partners, who also have relationships with some of Brocade’s current competitors, could become new competitors by developing and introducing products that compete with Brocade’s product offerings, by choosing to sell Brocade’s competitors’ products instead of Brocade’s products, or by offering preferred pricing or promotions on Brocade’s competitors’ products. For example, even though Brocade and IBM announced an agreement in April 2009 for IBM to sell certain Brocade Ethernet products and IP routers, Juniper and IBM announced a similar agreement in July 2009 with respect to certain of Juniper’s Ethernet switches and enterprise IP routers.
Competitive pressure will also likely intensify as technology trends may impact long-standing alliances, partnerships and go-to-market routes. For example, in November 2009 Cisco, EMC and VMware announced a coalition called the “Virtual Computing Environment” ( or “VCE”) through which it and its business partners would sell packaged “cloud computing” and data center virtualization solutions. Further, Cisco and EMC announced a joint venture called “Acadia”, which is designed to serve as a support and services arm of VCE. EMC is currently Brocade’s top OEM in terms of Fibre Channel sales and has been a go-to-market and technology partner since 1997. The tightening relationship between Cisco and EMC may harm the Brocade and EMC partnership. In addition, on November 11, 2009, HP, a Brocade OEM partner, announced its intent to
acquire 3Com, a Brocade competitor in the Ethernet market. If this acquisition of 3Com is completed, it may increase the competitive dynamics in the Ethernet market for Brocade and could negatively impact important routes to market for Brocade’s storage and converged networking products.
Brocade’s future revenue growth depends on its ability to introduce new products and services on a timely basis and achieve market acceptance of these new products and services.
The market for networking solutions is characterized by rapidly changing technology, accelerating product introduction cycles, changes in customer requirements and evolving industry standards. Brocade’s future success depends largely upon its ability to address the rapidly changing needs of its customers by developing and supplying high-quality, cost-effective products, product enhancements and services on a timely basis and by keeping pace with technological developments and emerging industry standards. This risk will likely become more pronounced as the networking markets become more competitive and as demand for new and improved technologies increases.
Brocade has introduced a significant number of new products in recent history, including products across its family of Data Center Infrastructure solutions, which accounts for a substantial portion of Brocade’s revenues. Developing new offerings requires significant upfront investments that may not result in revenue for an extended period of time, if at all. Brocade must achieve widespread market acceptance of Brocade’s new product and service offerings on a timely basis in order to realize the benefits of Brocade’s investments. In addition, Brocade’s plans to sell its offerings through new channels also requires that market acceptance be successful. For example, in April 2009 Brocade announced an expanded relationship with IBM whereby IBM will rebrand and sell a set of Brocade enterprise Ethernet networking products through the IBM global sales force and authorized IBM business partners, extending the existing relationship between Brocade and IBM for storage area networking products. This expanded relationship also requires Brocade to make certain significant upfront investments, which costs may not be recovered or provide the desired return on investment if the anticipated benefits of the expanded relationship are not ultimately successful.
The success of Brocade’s product and service offerings depends on numerous factors, including its ability to:
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Properly define the new products and services;
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Timely develop and introduce the new products and services;
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Differentiate Brocade’s new products and services from its competitors’ technology and product offerings;
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Address the complexities of interoperability of Brocade’s products with its installed base, OEM partners’ server and storage products and its competitors’ products; and
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Maintain high levels of product quality and reliability.
Various factors impacting market acceptance are outside of Brocade’s control, including the following:
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The availability and price of competing products and alternative technologies;
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The cost of certain product subcomponents, which could reduce Brocade’s gross margins;
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Product qualification requirements by Brocade’s OEM partners, which can cause delays in the market acceptance;
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The timing of the adoption of new industry standards relative to Brocade’s development of new technologies and products;
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The ability of its OEM partners to successfully distribute, support and provide training for its products; and
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Customer acceptance of Brocade’s products, including its Ethernet solutions.
If Brocade is not able to successfully develop and market new and enhanced products and services on a timely basis, its business and results of operations will likely be harmed.
The prices of Brocade’s products have declined in the past and Brocade expects the prices of Brocade’s products to continue to decline, which could reduce Brocade’s revenues, gross margins and profitability.
The average selling price for Brocade’s products has declined in the past, and Brocade expects it to continue to decline in the future as a result of changes in competitive pricing pressure, broader macroeconomic factors, product mix, increased sales discounts, new product introductions by Brocade or Brocade’s competitors, the entrance of new competitors and other factors. Price declines may also increase as competitors ramp up product releases that compete with Brocade’s products. Furthermore, as a result of cautious capital spending in the technology sector, coupled with broader macroeconomic factors, both Brocade and its competitors may pursue more aggressive pricing strategies in an effort to maintain or seek to increase sales levels. If Brocade is unable to offset any negative impact that changes in competitive pricing pressures, broader macroeconomic factors, product mix, increased sales discounts, enhanced marketing programs, new product introductions by Brocade or Brocade’s competitors, or other factors may have on its average selling price by increasing the volume of products shipped or reducing product manufacturing costs, Brocade’s total revenues and gross margins will be negatively impacted.
In addition, to maintain Brocade’s gross margins, Brocade must maintain or increase the number of products shipped, develop and introduce new products and product enhancements, and continue to reduce the manufacturing costs of Brocade’s products. While Brocade has successfully reduced the cost of manufacturing Brocade’s products in the past, Brocade may not be able to continue to reduce cost of production at historical rates. Moreover, most of Brocade’s expenses are fixed in the short-term or incurred in advance of receipt of corresponding revenue. As a result, Brocade may not be able to decrease its spending quickly enough or in sufficient amounts to offset any unexpected shortfall in revenues. If this occurs, Brocade could incur losses and Brocade’s operating results and gross margins could be below expectations. Additionally, Brocade’s gross margins may be negatively affected by fluctuations in manufacturing volumes, component costs, the mix of product configurations sold and the mix of distribution channels through which its products are sold. For example, on a historical basis, Brocade’s Ethernet networking products generally realized higher gross margins on direct sales to an end-user than on sales through its resellers or to its OEMs. As a result, any significant shift in revenue through resellers or to OEMs could harm Brocade’s gross margins. In addition, if product or related warranty costs associated with Brocade’s products are greater than previously experienced, Brocade’s gross margins may also be adversely affected. Finally, increased costs resulting from higher-than-anticipated oil prices and the volatility of the value of the U.S. dollar may affect the costs of components used in Brocade’s products and negatively affect Brocade’s gross margins.
The slowdown in the domestic and global economies and their delayed recovery may increasingly adversely affect Brocade’s operating results and financial condition.
The domestic and global economies have undergone a period of significant uncertainty and slowdown, which has resulted in reduced demand for information technology, including high-performance data networking solutions, and an extended delay in the recovery of such economies may continue to negatively impact demand further. Information technology spending has historically declined as general economic and market conditions have worsened. If the domestic and global economic slowdown is prolonged, or if Brocade’s customers believe such a slowdown will continue for a sustained period, Brocade’s customers may further reduce their information technology spending and future budgets. Brocade is particularly susceptible to reductions in information technology spending because the purchase of IT-related products is often discretionary and may involve a significant commitment of capital and other resources. Different geographic regions (e.g. North America, Western Europe, Asia Pacific region) may experience greater economic slowdown and/or a longer recovery period. Future delays or reductions in information technology spending, domestically and/or internationally, could harm Brocade’s business, results of operations and financial condition in a number of ways, including
longer sales cycles, increased inventory provisions, increased production costs, lowered prices for its products and reduced sales volumes. Similarly, if Brocade’s suppliers face challenges in obtaining credit or otherwise in operating their businesses, they may become unable to continue to offer the materials Brocade uses to manufacture its products or may offer the materials at higher prices. These events have caused, and may further cause, reductions in Brocade’s revenue, profitability and cash flows; increased price competition and operating costs; longer fulfillment cycles; and may cause many other risks noted in this Form 10-K, which could adversely affect Brocade’s business, results of operations and financial condition.
Given the current uncertainty about the extent and duration of the global financial slowdown, it is difficult for Brocade, its customers and its suppliers to accurately forecast future product demand. The reduced visibility could cause Brocade to produce excess products that would increase its inventory carrying costs and result in obsolete inventory. Alternatively, this forecasting difficulty could cause a shortage of products or materials used in Brocade’s products that would result in its inability to satisfy demand for its products and a loss of market share.
The economic slowdown has also significantly affected financing markets, the availability of capital and the terms and conditions of financing arrangements, including the overall cost of financing. Circumstances may arise in which Brocade needs or desires to raise additional capital. Such capital may not be available on commercially reasonable terms, or at all, which in turn could adversely affect Brocade’s financial condition and could increase shareholder dilution.
Brocade incurred substantial indebtedness to finance the acquisition of Foundry that decreases Brocade’s business flexibility and access to capital, and increases its borrowing costs, which may adversely affect Brocade’s operations and financial results.
Upon completion of the acquisition of Foundry, Brocade increased its indebtedness by approximately $1.1 billion, which is substantially greater than its indebtedness prior to the acquisition. The financial and other covenants agreed to by Brocade in connection with such indebtedness and the increased indebtedness and higher debt-to-equity ratio of Brocade in comparison to that of Brocade on a recent historical basis will have the effect, among other things, of reducing Brocade’s flexibility to respond to changing business and economic conditions and increasing borrowing costs, and may adversely affect Brocade’s operations and financial results. The increased indebtedness may also adversely affect Brocade’s ability to access sources of capital or incur certain liens. Certain types of financing, certain types of sale and leaseback transactions, or other transactions may require Brocade to seek an amendment or waiver under its Senior Secured Credit Facility. Any such amendment or waiver may require a demand payment to Brocade’s debt holders or may not be available on commercially reasonable terms, if at all. In addition, Brocade’s failure to comply with these covenants could result in a default under the Senior Secured Credit Facility and its other debt, which could permit the holders to accelerate such debt or demand payment in exchange for a waiver of such default. If any of Brocade’s debt is accelerated, Brocade may not have sufficient funds available to repay such debt. The current debt under the Senior Secured Credit Facility has a floating interest rate and an increase in interest rates may negatively impact Brocade’s financial results. The mandatory debt repayment schedule on the Senior Secured Credit Facility and the maturity of the existing convertible subordinated debt in fiscal year 2010 may negatively impact Brocade’s cash position and reduce Brocade’s financial flexibility. In addition, any changes by rating agencies to Brocade’s credit rating in connection with such indebtedness may negatively impact the value and liquidity of Brocade’s debt and equity securities and Brocade’s ability to access sources of capital.
The failure to accurately forecast demand for Brocade’s products or the failure to successfully manage the production of Brocade’s products could negatively affect the supply of key components for Brocade’s products and Brocade’s ability to manufacture and sell Brocade’s products.
Brocade provides product forecasts to its contract manufacturers and places purchase orders with them in advance of the scheduled delivery of products to Brocade’s customers. Moreover, in preparing sales and demand forecasts, Brocade relies largely on input from its OEM partners and its resellers and end-user customers.
Therefore, if Brocade or its OEM partners are unable to accurately forecast demand, or if Brocade fails to effectively communicate with its distribution partners about end-user demand or other time-sensitive information, the sales and demand forecasts may not reflect the most accurate, up-to-date information. If these forecasts are inaccurate, Brocade may be unable to obtain adequate manufacturing capacity from its contract manufacturers to meet customers’ delivery requirements or Brocade may accumulate excess inventories. Furthermore, Brocade may not be able to identify forecast discrepancies until late in its fiscal quarter. Consequently, Brocade may not be able to make adjustments to its business model. If Brocade is unable to obtain adequate manufacturing capacity from its contract manufacturers, if Brocade accumulates excess inventories, or if Brocade is unable to make necessary adjustments to Brocade’s business model, revenue may be delayed or even lost to Brocade’s competitors and Brocade’s business and financial results may be harmed. In addition, Brocade may experience higher fixed costs as it expands its contract manufacturer capabilities and thus be less able to react quickly if demand suddenly decreases.
Brocade’s ability to accurately forecast demand also may become increasingly more difficult as Brocade enters new or adjacent markets, begins phasing out certain products, or acquires other companies or businesses. Forecasting demand for new or adjacent markets, particularly where the markets are not yet well-established, may be highly speculative and uncertain. For products that are nearing end of life or are being replaced by new versions, it may be difficult to forecast how quickly to decrease production on the older products and ramp up production on the new products. Acquired companies or businesses may offer less visibility into demand than Brocade typically has experienced, may cause customer uncertainty regarding purchasing decisions, and may use different measures to evaluate demand that are less familiar to Brocade and thus more difficult to accurately predict.
In addition, although the purchase orders placed with Brocade’s contract manufacturers are cancelable, in certain circumstances Brocade could be required to purchase certain unused material not returnable, usable by, or sold to other customers if Brocade cancels any of Brocade’s orders. This purchase commitment exposure is particularly high in periods of new product introductions and product transitions. If Brocade is required to purchase unused material from Brocade’s contract manufacturers, Brocade would incur unanticipated expenses and Brocade’s business and financial results could be negatively affected. In the past, Brocade’s Ethernet products have experienced delays in product shipments from its contract manufacturers and OEMs, which in turn delayed product shipments to its customers. Brocade may in the future experience similar delays or other problems, such as insufficient quantity of product, acquisition by a competitor or business failure of any of its OEMs, any of which could harm Brocade’s business and operating results.
Brocade is subject to and may be subject to more intellectual property infringement claims and litigation that are costly to defend and/or settle, and that could result in significant damage and cost awards against Brocade and limit Brocade’s ability to use certain technologies in the future.
Brocade competes in markets that are frequently subject to claims and related litigation regarding patent and other intellectual property rights. From time to time, third parties have asserted patent, copyright and trade secret rights against Brocade, and as particular examples, against its products and services, subcomponents of its products, methods performed by its products or used in its operations, or uses of its products by its customers. Brocade and companies acquired by Brocade, such as Foundry, have in the past incurred, are currently incurring and will in the future incur substantial expenses to defend against such third-party claims. For instance, Brocade currently is involved in patent-related lawsuits with Enterasys Networks, Inc., Network-1 Security Solutions, Inc., and Chrimar Systems, Inc. In addition, Brocade may be subject to indemnification obligations with respect to infringement of third-party intellectual property rights pursuant to Brocade agreements with suppliers, OEM and channel partners or customers. The third party asserters of such intellectual property claims may be unreasonable in their settlement demands, or may simply refuse to settle, which could lead to expensive settlement payments and/or prolonged periods of litigation expenses. In the event of an adverse determination, Brocade could incur substantial monetary liability and be prohibited from shipping certain products or incorporating necessary components into Brocade’s products. Suppliers of components or OEM systems to
Brocade may be unwilling to, or not be able to, defend or indemnify Brocade against third-party assertions directed at the components or systems they supply to Brocade, and may be unwilling to take licenses that would assure Brocade’s supply of such components or OEM systems. Customers may perceive such third-party intellectual property claims as risks, and may, as a result, be less willing to do business with Brocade. Any of the above scenarios could have a material adverse effect on Brocade’s financial position, results of operations, cash flows, and future business prospects.
Brocade relies on a combination of patent, copyright, trademark and trade secret laws and contractual restrictions on disclosure to protect its intellectual property rights in its proprietary technologies, but none of these methods of protection may be entirely reliable, due to, for instance, employee hiring and turnover, geographic dispersion of employees, technology disclosures with suppliers, customers, and partners, unpredictable events or negligence, and other aspects of doing business on the scale of Brocade’s operations. Brocade attempts to identify its technological developments for assessment of whether to file patent applications, but there can be no assurance that all patentable technological developments will be captured in patent applications. Further, although Brocade has patent applications pending, there can be no assurance that patents will be issued from pending applications, or that claims allowed on any future patents will be sufficiently broad to protect its technology. The value, validity, and enforceability of intellectual property rights generated by Brocade’s operations, obtained from acquired companies, or purchased from third parties, are subject to many unknowns, and may not ultimately have the value originally anticipated.
Brocade has a high concentration of customers, including a limited number of OEM partners, which it relies on for a substantial portion of its revenues. The loss of any of these customers or OEM partners or a decrease in their purchases could significantly reduce Brocade’s revenues and negatively affect Brocade’s financial results.
Brocade depends on recurring purchases from a limited number of large OEM partners for a substantial portion of its revenues. As a result, these large OEM partners have a significant influence on Brocade’s quarterly and annual financial results. For fiscal years 2009, 2008 and 2007, the same three customers each represented 10% or more of Brocade’s total net revenues for a combined total of 48%, 65% and 68%, respectively. Brocade’s agreements with its OEM partners are typically cancelable, non-exclusive, have no minimum purchase requirements and have no specific timing requirements for purchases. Brocade’s OEM partners could also elect to reduce, or rebalance, the amount they purchase from Brocade and increase the amount purchased from Brocade’s competitors. Also, one or more of Brocade’s OEM partners could elect to consolidate or enter into a strategic partnership with one of Brocade’s competitors, which could have the effect of reducing or eliminating Brocade’s future revenue opportunities with that OEM partner. Brocade anticipates that a significant portion of its revenues and operating results will continue to depend on sales to a relatively small number of OEM partners. The loss of any one significant OEM partner, or a decrease in the level of sales to any one significant OEM partner, or unsuccessful quarterly negotiation on key terms, conditions or timing of purchase orders placed during a quarter, would likely cause serious harm to Brocade’s business and financial results.
Brocade’s OEM partners evaluate and qualify Brocade’s products for a limited time period before they begin to market and sell them. Assisting Brocade’s OEM partners through the evaluation process requires significant sales, marketing and engineering management efforts on Brocade’s part, particularly if Brocade’s products are being qualified with multiple distribution partners at the same time. In addition, once Brocade’s products have been qualified, its customer agreements have no minimum purchase commitments. Brocade may not be able to effectively maintain or expand its distribution channels, manage distribution relationships successfully, or market its products through distribution partners. Brocade must continually assess, anticipate and respond to the needs of its distribution partners and their customers, and ensure that its products integrate with their solutions. Brocade’s failure to successfully manage its distribution relationships or the failure of its distribution partners to sell Brocade’s products could reduce Brocade’s revenues significantly. In addition, Brocade’s ability to respond to the needs of its distribution partners in the future may depend on third parties producing complementary products and applications for Brocade’s products. If Brocade fails to respond successfully to the needs of these groups, its business and financial results could be harmed.
The loss of continued orders from any of Brocade’s more significant customers, such as the U.S. government or individual agencies within the U.S. government, or companies within the financial services, education and health sectors, could also cause its revenue and profitability to suffer. For example, if Brocade is unable to offer qualified products to such government customers due to governmental procurement regulations and requirements with respect to country of origin designation, Brocade’s government orders could decrease, which would negatively impact its revenue and operating results. In addition, Brocade’s ability to attract new customers will depend on a variety of factors, including the cost-effectiveness, reliability, scalability, breadth and depth of its products. In addition, a change in the mix of Brocade’s customers, or a change in the mix of direct and indirect sales, could adversely affect its revenue and gross margins.
Brocade is dependent on sole source and limited source suppliers for certain key components, the loss of which may significantly impact results of operations.
Although Brocade uses standard parts and components for its products where possible, Brocade’s CMs currently purchase, on Brocade’s behalf, several key components used in the manufacture of its products from single or limited supplier sources. Brocade’s principal single source components include ASICs and Brocade’s principal limited source components include memory, certain oscillators, microprocessors, certain connectors, certain logic chips, power supplies, programmable logic devices, printed circuit boards, certain optical components, packet processors and switching fabrics. Brocade generally acquires these components through purchase orders and have no long-term commitments regarding supply or pricing with such suppliers. If Brocade is unable to obtain these and other components when required or if Brocade experiences significant component defects, Brocade may not be able to deliver Brocade’s products to Brocade’s customers in a timely manner. In addition, the recent global economic slowdown may cause some of these sole source or limited source suppliers to delay production or go out of business and could result in a disruption to Brocade’s supply chain. As a result, Brocade’s business and financial results could be harmed.
In addition, the loss of any of Brocade’s major third-party contract manufacturers could significantly impact Brocade’s ability to produce its products for an indefinite period of time. Qualifying a new contract manufacturer and commencing volume production is typically a lengthy and expensive process. If Brocade is required to change its contract manufacturers or if any of its contract manufacturer experiences delays, disruptions, capacity constraints, component parts shortages or quality control problems in its manufacturing operations, shipment of Brocade’s products to Brocade’s customers could be delayed and result in loss of revenues and Brocade’s competitive position and relationship with customers could be harmed.
Brocade’s failure to successfully manage the transition between its new products and its older products may adversely affect Brocade’s financial results.
As Brocade introduces new or enhanced products, Brocade must successfully manage the transition from older products to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories and provide sufficient supplies of new products to meet customer demands. When Brocade introduces new or enhanced products that feature higher-performance, higher-density and new technology options, Brocade faces numerous risks relating to product transitions, including the inability to accurately forecast demand, address new or higher product cost structures, and manage different sales and support requirements due to the type or complexity of the new products. In addition, any customer uncertainty regarding the timeline for rolling out new products or Brocade’s plans for future support of existing products, may negatively impact customer purchase decisions.
Changes in industry structure and market conditions could lead to charges related to discontinuances of certain of Brocade’s products or businesses and asset impairments.
Brocade carries a substantial amount of acquired intangible assets and goodwill on its balance sheet. Brocade’s determination of fair value of long-lived assets relies on management’s assumptions of future revenues, operating costs, and other relevant factors. In response to changes in industry and market conditions,
Brocade may be required to realign its resources strategically and consider restructuring, disposing of, or otherwise exiting businesses. Any decision to limit investment in, or dispose of or otherwise exit businesses may result in the recording of special charges, such as inventory and technology-related write-offs, workforce reduction costs, charges relating to consolidation of excess facilities, or claims from third parties who were resellers or users of discontinued products. Similarly, if management’s estimates of future operating results change or if there are changes to other assumptions, such as the discount rate applied to future cash flows, the estimate of the fair value of Brocade’s reporting units could change significantly, which could result in goodwill impairment charges. Brocade’s estimates with respect to the useful life or ultimate recoverability of Brocade’s carrying basis of assets, including purchased intangible assets, could change as a result of such assessments and decisions. For example, during the three months ended May 2, 2009, Brocade recorded a non-cash $53.3 million impairment charge in connection with the decision to no longer offer Brocade’s suite of Files products.
Brocade’s estimates relating to the liabilities for excess facilities are also affected by changes in real estate market conditions. In addition, Brocade has made investments in certain private companies which could become impaired if the operating results of those companies change adversely. Brocade is required to perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances, and future goodwill impairment tests may result in a charge to earnings.
Brocade has extensive international operations, which subjects it to additional business risks.
A significant portion of Brocade’s sales occur in international jurisdictions. In addition, Brocade’s contract manufacturers have significant operations in China. Brocade plans to continue to expand its international operations and sales activities. Brocade’s international sales of its Ethernet networking products have primarily depended on its resellers, including Pan Dacom GmbH in Europe, Stark Technology Inc. in Taiwan and Samsung Corporation in Korea. The failure by international resellers to sell Brocade’s products could limit its ability to sustain and grow revenue. Expansion of international operations will involve inherent risks that Brocade may not be able to control, including:
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Supporting multiple languages;
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Recruiting sales and technical support personnel with the skills to design, manufacture, sell and support Brocade’s products;
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Complying with governmental regulation of encryption technology and regulation of imports and exports, including obtaining required import or export approval for its products;
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Increased complexity and costs of managing international operations;
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Increased exposure to foreign currency exchange rate fluctuations;
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Commercial laws and business practices that favor local competition;
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Multiple, potentially conflicting, and changing governmental laws, regulations and practices, including differing export, import, tax, labor, anti-bribery and employment laws;
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Longer sales cycles and manufacturing lead times;
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Difficulties in collecting accounts receivable;
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Reduced or limited protection of intellectual property rights;
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Managing a research and development team in geographically diverse locations, including China and India; and
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Increased complexity of logistics and distribution arrangements.
Failure to manage expansion effectively could seriously harm Brocade’s business, financial condition and prospects. In addition, international political instability may halt or hinder Brocade’s ability to do business and may increase Brocade’s costs. Various events, including the occurrence or threat of terrorist attacks, increased
national security measures in the United States and other countries, and military action and armed conflicts, may suddenly increase international tensions. Such events may have an adverse effect on the world economy and could adversely affect Brocade’s business operations or the operations of Brocade’s OEM partners, contract manufacturers and suppliers.
To date, no material amount of Brocade’s international revenues and cost of revenues have been denominated in foreign currencies. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could make Brocade’s products more expensive and, thus, not competitively priced in foreign markets. Additionally, a decrease in the value of the U.S. dollar relative to foreign currencies could increase Brocade’s operating costs in foreign locations. In the future, a larger portion of Brocade’s international revenues may be denominated in foreign currencies, which will subject Brocade to additional risks associated with fluctuations in those foreign currencies. In addition, Brocade may be unable to successfully hedge against any such fluctuations.
Business interruptions could adversely affect Brocade’s business.
Brocade’s operations and the operations of its suppliers, contract manufacturers and customers are vulnerable to interruptions by fire, earthquake, hurricane, power loss, telecommunications failure and other events beyond Brocade’s control. For example, a substantial portion of Brocade’s facilities, including its corporate headquarters, is located near major earthquake faults. Brocade does not have multiple site capacity for all of its services in the event of any such occurrence. In the event of a major earthquake, Brocade could experience business interruption, destruction of facilities and loss of life. Brocade does not carry earthquake insurance and has not set aside funds or reserves to cover such potential earthquake-related losses. Additionally, health issues such as an outbreak of a pandemic or epidemic, including the H1N1 flu (swine flu) virus, may interrupt business operations in those geographic regions affected by the disease. In addition, one of Brocade’s contract manufacturers has a major facility located in an area that is subject to hurricanes. In the event that a material business interruption occurs that affects Brocade, its suppliers, contract manufacturers or customers, shipments could be delayed and Brocade’s business and financial results could be harmed. Despite Brocade’s implementation of network security measures, its servers may be vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with its computer systems. Brocade may not carry sufficient insurance to compensate for losses that may occur as a result of any of these events.
Brocade’s business is subject to cyclical fluctuations and uneven sales patterns, which make predicting results of operations difficult.
Many of Brocade’s partners experience uneven sales patterns in their businesses due to the cyclical nature of information technology spending. For example, some of Brocade’s partners close a disproportionate percentage of their sales transactions in the last month, weeks and days of each fiscal quarter, and other partners experience spikes in sales during the fourth calendar quarter of each year. Because a large portion of Brocade’s sales are derived from a small number of OEM partners, when they experience seasonality, Brocade typically experiences similar seasonality. Historically, Brocade’s first and fourth fiscal quarters are seasonally stronger quarters than its second and third fiscal quarters. These OEM partners make decisions to purchase inventory based on a variety of factors, including their product qualification cycles and their expectations of end customer demand, which may be affected by seasonality and their internal supply management objectives. Others require that Brocade maintain inventories of Brocade’s products in hubs adjacent to their manufacturing facilities and purchase Brocade’s products only as necessary to fulfill immediate customer demand. In addition, Brocade has experienced quarters where uneven sales patterns of Brocade’s OEM partners have resulted in a significant portion of Brocade’s revenue occurring in the last month of Brocade’s fiscal quarter. For example, Brocade’s Ethernet networking business typically experiences significantly higher levels of sales towards the end of a period. Such non-linearity in shipments due to sales patterns can increase costs, as irregular shipment patterns result in periods of underutilized capacity and additional costs associated with higher inventory levels and inventory planning. Furthermore, orders received towards the end of the period may not ship within the period due to Brocade’s
manufacturing lead times. This exposes Brocade to additional inventory risk because Brocade must order products in anticipation of expected future orders and additional sales risk if Brocade is unable to fulfill unanticipated demand. In addition, receipt of a high number of customer orders towards the end of a fiscal quarter will increase reported receivables outstanding as a fraction of reported sales and result in higher days sales outstanding. Brocade is not able to predict the degree to which the seasonality and uneven sales patterns of Brocade’s OEM partners or other customers will affect Brocade’s business in the future, particularly as Brocade releases new products.
Undetected software or hardware errors could increase Brocade’s costs, reduce Brocade’s revenues and delay market acceptance of Brocade’s products.
Networking products frequently contain undetected software or hardware errors, or bugs, when first introduced or as new versions are released. Brocade’s products are becoming increasingly complex and particularly as Brocade continues to expand Brocade’s product portfolio to include software-centric products, including software licensed from third parties, errors may be found from time to time in Brocade’s products. In addition, through its acquisitions, Brocade has assumed, and may in the future assume, products previously developed by an acquired company that have not been through the same level of product development, testing and quality control processes used by Brocade, and may have known or undetected errors. Some types of errors also may not be detected until the product is installed in a heavy production or user environment. In addition, Brocade’s products are often combined with other products, including software, from other vendors, and these products often need to interface with existing networks, each of which have different specifications and utilize multiple protocol standards and products from other vendors. As a result, when problems occur, it may be difficult to identify the source of the problem. These problems may cause Brocade to incur significant warranty and repair costs, may divert the attention of engineering personnel from product development efforts, and may cause significant customer relations problems. Moreover, the occurrence of hardware and software errors, whether caused by another vendor’s storage, data management or Ethernet products or Brocade’s, could delay market acceptance of Brocade’s new products.
Brocade’s quarterly and annual revenues and operating results may fluctuate in future periods due to a number of factors, which could adversely affect the trading price of Brocade’s stock.
Brocade’s quarterly and annual revenues and operating results may vary significantly in the future due to a number of factors. Factors that may affect the predictability of Brocade’s annual and quarterly results include, but are not limited to, the following:
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Disruptions or a continued decline in general economic conditions, particularly in the information technology industry;
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Announcements of pending or completed acquisitions or other strategic transactions by Brocade, its competitors or its partners;
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Announcements, introductions and transitions of new products by Brocade, its competitors or its partners;
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The timing of customer orders, product qualifications and product introductions of Brocade’s partners;
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Seasonal fluctuations;
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Long and complex sales cycles;
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Declines in average selling prices for Brocade’s products as a result of competitive pricing pressures or new product introductions by Brocade or its competitors;
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The emergence of new competitors and new technologies in the networking markets;
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Deferrals of customer orders in anticipation of new products, services, or product enhancements introduced by Brocade or its competitors;
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Brocade’s ability to timely produce products that comply with new environmental restrictions or related requirements of its customers;
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Brocade’s ability to obtain sufficient supplies of sole- or limited-sourced components, including ASICs, microprocessors, certain connectors, certain logic chips and programmable logic devices;
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Increases in prices of components used in the manufacture of Brocade’s products;
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Brocade’s ability to attain and maintain production volumes and quality levels;
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Variations in the mix of Brocade’s products sold and the mix of distribution channels and geographies through which they are sold;
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Pending or threatened litigation;
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Stock-based compensation expense that is affected by Brocade’s stock price;
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New legislation and regulatory developments; and
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Other risk factors detailed in this section.
Accordingly, the results of any prior periods should not be relied upon as an indication of future performance. Brocade cannot assure you that in some future quarter Brocade’s revenues or operating results will not be below Brocade’s projections or the expectations of stock market analysts or investors, which could cause Brocade’s stock price to decline.
Brocade’s business is subject to increasingly complex corporate governance, public disclosure, accounting and tax requirements, and environmental regulations that could adversely affect Brocade’s business and financial results.
Brocade is subject to changing rules and regulations of federal and state government as well as the stock exchange on which Brocade’s common stock is listed. These entities, including the Public Company Accounting Oversight Board, the SEC, the IRS and NASDAQ, have issued a significant number of new and increasingly complex requirements and regulations over the course of the last several years and continue to develop additional regulations and requirements in response to laws enacted by Congress. In addition, the Department of Treasury, the SEC and various Congressional representatives have recently proposed additional rules and regulations that may go into effect in the near future. Brocade is also subject to various rules and regulations of certain foreign jurisdictions, including applicable tax regulations. Brocade’s efforts to comply with these requirements have resulted in, and are likely to continue to result in, an increase in expenses and a diversion of management’s time from other business activities. A change in the tax law in the jurisdictions in which Brocade does business, including an increase in tax rates or an adverse change in the treatment of an item of income or expense, could result in a material increase in Brocade’s tax expense. For example, in May 5, 2009, the President of the United States and the U.S. Treasury Department proposed changing certain of the U.S. tax rules for U.S. corporations doing business outside the United States. Specific legislation has not yet been proposed or enacted, but it is possible that these or other changes in the U.S. tax laws could increase Brocade’s U.S. income tax liability in the future.
Brocade is subject to periodic audits or other reviews by such governmental agencies. For example, Brocade is under examination by the IRS for its domestic federal income tax return for the fiscal years 2003 through 2006. In May 2006, the Franchise Tax Board notified Brocade that its California income tax returns for the years ended October 25, 2003 and October 30, 2004 were subject to audit. In February 2009, the IRS commenced an examination of Foundry’s federal income tax returns for the years ended December 31, 2006 and 2007. All these examination cycles remain open as of October 31, 2009. The SEC also periodically reviews Brocade’s public company filings. Any such examination or review frequently requires management’s time and diversion of internal resources and, in the event of an unfavorable outcome, may result in additional liabilities or adjustments to Brocade’s historical financial results.
The IRS is contesting the Company’s transfer pricing for the cost sharing and buy-in arrangements with its foreign subsidiaries. The Company appealed the Revenue Agent’s Report to the Appeals Office of the IRS for the years under examination. The IRS also notified the Company that it will audit the fiscal year 2007 and 2008 income tax returns. The IRS may make similar claims against the Company’s transfer pricing arrangements in future examinations. Audits by the IRS are subject to inherent uncertainties and an unfavorable outcome could occur, such as fines or penalties. The occurrence of an unfavorable outcome in any specific period could have a material adverse effect on Brocade’s results of operations for that period or future periods. The expense of defending and resolving such an audit may be significant. The amount of time to resolve an audit is unpredictable and defending Brocade may divert management’s attention from Brocade’s day-to-day business operations, which could adversely affect Brocade’s business.
Brocade is subject to various environmental and other regulations governing product safety, materials usage, packaging and other environmental impacts in the various countries where Brocade’s products are sold. For example, many of Brocade’s products are subject to laws and regulations that restrict the use of lead, mercury, hexavalent chromium, cadmium and other substances, and require producers of electrical and electronic equipment to assume responsibility for collecting, treating, recycling and disposing of Brocade’s products when they have reached the end of their useful life. For example, in Europe, substance restrictions apply to products sold, and certain of Brocade’s partners require compliance with these or more stringent requirements. In addition, recycling, labeling, financing and related requirements apply to products Brocade sells in Europe. China has also enacted similar legislation with similar requirements for Brocade’s products or its partners. Despite Brocade’s efforts to ensure that its products comply with new and emerging requirements, Brocade cannot provide absolute assurance that its products will, in all cases, comply with such requirements. If Brocade’s products do not comply with the substance restrictions under local environmental laws, Brocade could become subject to fines, civil or criminal sanctions and contract damage claims. In addition, Brocade could be prohibited from shipping non-compliant products into one or more jurisdictions and required to recall and replace any non-compliant products already shipped, which would disrupt its ability to ship products and result in reduced revenue, increased obsolete or excess inventories, and harm to Brocade’s business and customer relationships. Brocade’s suppliers may also fail to provide it with compliant materials, parts and components despite Brocade’s requirement to do so, which could impact Brocade’s ability to timely produce compliant products and, accordingly, could disrupt its business.
Brocade may not realize the anticipated benefits of past or future acquisitions and strategic investments, and integration of acquired companies or technologies may negatively impact Brocade’s business.
Brocade has in the past acquired, or made strategic investments in, other companies, products or technologies, and Brocade expects to make additional acquisitions and strategic investments in the future. Examples of recent acquisitions include Foundry in December 2008, Strategic Business Systems, Inc. in March 2008 and McDATA Corporation in January 2007. Brocade may not realize the anticipated benefits of the acquisition of Foundry or any other acquisitions or strategic investments, which involve numerous risks, including:
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Difficulties in successfully integrating the acquired businesses;
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Revenue attrition in excess of anticipated levels if existing customers alter or reduce their historical buying patterns;
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Unanticipated costs, litigation and other contingent liabilities;
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Diversion of management’s attention from Brocade’s daily operations and business;
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Adverse effects on existing business relationships with suppliers and customers;
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Risks associated with entering into markets in which Brocade has limited or no prior experience;
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Inability to attract and retain key employees;
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Inability to retain key customers, distributors, vendors and other business partners of the acquired business;
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Inability to effectively coordinate sales and marketing efforts to communicate the capabilities of the combined company;
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Inability to successfully develop new products and services on a timely basis that address the market opportunities of the combined company;
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Inability to compete effectively against companies already serving the broader market opportunities expected to be available to the combined company;
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Inability to qualify the combined company’s products with OEM customers on a timely basis, or at all;
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Failure to consolidate the combined company’s professional services and customer support organizations;
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Inability to successfully integrate and harmonize financial reporting and information technology systems;
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Failure to successfully manage additional remote locations, including the additional infrastructure and resources necessary to support and integrate such locations;
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Assumption or incurrence of debt and contingent liabilities and related obligations to service such liabilities and Brocade’s ability to satisfy financial and other negative operating covenants;
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Additional costs such as increased costs of manufacturing and service costs, costs associated with excess or obsolete inventory, costs of employee redeployment, relocation and retention, including salary increases or bonuses, accelerated amortization of deferred equity compensation and severance payments, reorganization or closure of facilities, taxes, advisor and professional fees, and termination of contracts that provide redundant or conflicting services;
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Incurrence of significant exit charges if products acquired in business combinations are unsuccessful;
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Incurrence of acquisition and integration related costs, accounting charges, or amortization costs for acquired intangible assets, that could negatively impact Brocade’s operating results and financial condition;
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Potential write-down of goodwill and/or acquired intangible assets, which are subject to impairment testing on an annual basis, and could significantly impact Brocade’s operating results; and
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Dilution of the percentage of Brocade’s stockholders to the extent equity is used as consideration or option plans are assumed, such as in the case of the Foundry acquisition, in which approximately 125.1 million additional shares of Brocade common stock became issuable in connection with the assumption or substitution of Foundry equity awards.
If Brocade is not able to successfully integrate businesses, products, technologies or personnel that Brocade acquires, or to realize expected benefits of Brocade’s acquisitions or strategic investments, Brocade’s business and financial results would be adversely affected.
Brocade relies on licenses from third parties and the loss or inability to obtain any such license could harm its business.
Many of Brocade’s products are designed to include software or other intellectual property licensed from third parties. While it may be necessary in the future to seek or renew licenses relating to various aspects of its products, Brocade believes that, based upon past experience and standard industry practice, such licenses generally can be obtained on commercially reasonable terms. Nonetheless, there can be no assurance that the necessary licenses will be available on acceptable terms, if at all. Brocade’s inability to obtain certain licenses or
other rights on favorable terms could have an adverse effect on Brocade’s business, operating results and financial condition. In addition, if Brocade fails to carefully manage the use of “open source” software in Brocade’s products, Brocade may be required to license key portions of Brocade’s products on a royalty-free basis or expose key parts of source code.
Brocade is exposed to various risks related to legal proceedings or claims that could adversely affect its operating results.
Brocade is a party to lawsuits in the normal course of its business. Litigation in general can be expensive, lengthy and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. Responding to lawsuits brought against Brocade, or legal actions initiated by Brocade, can often be expensive and time-consuming. For example, in the past, Brocade has incurred significant expenses pursuant to certain indemnification obligations to various current and former officers and directors in connection with Brocade’s historical stock option granting practices and other related matters. Unfavorable outcomes from these claims and/or lawsuits could adversely affect Brocade’s business, results of operations, or financial condition.
If Brocade loses key talent or is unable to hire additional qualified talent, Brocade’s business may be harmed.
Brocade’s success depends, to a significant degree, upon the continued contributions of key management, engineering, sales and other talent, many of whom would be difficult to replace. Brocade believes its future success will also depend, in large part, upon Brocade’s ability to attract and retain highly skilled managerial, engineering, sales and other talent, and on the ability of management to operate effectively, both individually and as a group, in geographically diverse locations. There is a limited number of qualified talent in the applicable market and competition for such employees is strong. In the past, Brocade has experienced difficulty in hiring qualified talent in areas such as application-specific integrated circuits, software, system and test, sales, marketing, service, key management and customer support. Although Brocade’s stock price generally increased during the twelve months ended October 31, 2009, any future declines in Brocade’s stock price could result in additional “underwater” stock options held by its employees. If such a decline in Brocade’s stock price were to occur, any resulting underwater options could decrease Brocade’s ability to incentivize or retain qualified talent. Brocade’s ability to retain qualified talent may also be affected by future and recent acquisitions, which may cause uncertainty and loss of key talent. The loss of the services of any of Brocade’s key employees, the inability to attract or retain qualified talent in the future, or delays in hiring required talent, particularly engineers and sales talent, could delay the development and introduction of Brocade’s products or services, and negatively affect Brocade’s ability to sell its products or services.
In addition, companies in the computer storage, networking and server industries whose employees accept positions with competitors may claim that their competitors have engaged in unfair hiring practices or that there will be inappropriate disclosure of confidential or proprietary information. Brocade may be subject to such claims in the future as Brocade seeks to hire additional qualified talent. Such claims could result in litigation. As a result, Brocade could incur substantial costs in defending against these claims, regardless of their merits, and be subject to additional restrictions if any such litigation is resolved against Brocade.
Provisions in Brocade’s charter documents, customer agreements and Delaware law could prevent or delay a change in control of Brocade, which could hinder stockholders’ ability to receive a premium for Brocade’s stock.
Provisions of Brocade’s certificate of incorporation and bylaws may discourage, delay or prevent a merger or mergers that a stockholder may consider favorable. These provisions include:
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Authorizing the issuance of preferred stock without stockholder approval;
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Providing for a classified board of directors with staggered, three-year terms;
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Prohibiting cumulative voting in the election of directors;
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Limiting the persons who may call special meetings of stockholders;
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Prohibiting stockholder actions by written consent; and
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Requiring supermajority voting to effect amendments to the foregoing provisions of Brocade’s certificate of incorporation and bylaws.
Certain provisions of Delaware law also may discourage, delay or prevent someone from acquiring or merging with Brocade, and Brocade’s agreements with certain of Brocade’s customers require that Brocade give prior notice of a change of control and grant certain manufacturing rights following a change of control. Brocade’s various change-of-control provisions could prevent or delay a change in control of Brocade, which could hinder stockholders’ ability to receive a premium for Brocade’s stock.
Brocade may not realize the anticipated benefits in connection with its recent purchase of real estate and plans to develop and construct office buildings, which could disrupt its business and negatively impact its financial performance.
Brocade’s recent purchase of real estate in San Jose, California and its commitment to build a new campus of several buildings on that real estate constitute a substantial investment. Brocade may not realize the anticipated benefits with respect to the purchase and development of such property. Brocade is devoting significant capital resources to developing the campus, which will reduce Brocade’s liquidity and financial flexibility. Additionally, the development, construction and maintenance of the new campus may result in unexpected costs or delays, which may negatively impact Brocade’s financial position. Moreover, any delays in the development or construction of the new campus may also suspend Brocade’s ability to move into the new campus on a timely basis and, as a result, may disrupt Brocade’s business.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Brocade’s principal administrative, sales, marketing, education, customer support, and research and development facilities are located in approximately 405,000 square feet in San Jose, California. Additional administrative and research and development facilities are located in approximately 520,000 square feet, in aggregate, in Santa Clara and Alviso, California, Broomfield, Colorado and Plymouth, Minnesota. Approximately 563,000 square feet of such space is leased and 362,000 square feet is owned. Brocade believes that its existing properties, including both owned and leased, are in good condition and are suitable for the conduct of its business. Brocade also productively utilizes the majority of the space in its facilities.
Brocade’s leased properties have expirations through November 2019. In addition to the noted facilities, Brocade leases administrative, sales and marketing office space in various locations to serve its customers throughout the world. On May 23, 2008, the Company purchased property located in San Jose, California, which consists of three unimproved building parcels that are entitled for approximately 562,000 square feet of space in three buildings. In connection with the purchase, Brocade also engaged a third party as development manager to manage the development and construction of improvements on the property that will serve as the Company’s headquarters. The Company plans to develop the land through June 2010 and finance the purchase and the development through operating cash flows.
Brocade has four operating segments. Due to the interrelation of these segments, these segments use substantially all of the properties at least in part, and Brocade retains the flexibility to use each of the properties in whole or in part for each of the segments.
Item 3.
Item 3. Legal Proceedings
The information set forth in Note 10 (see “Legal Proceedings” of Note 10) of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K is incorporated herein by reference.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Brocade’s common stock is quoted on the NASDAQ Global Select Market under the symbol “BRCD.” Prior to Brocade’s initial public offering on May 24, 1999, there was no public market for its common stock. Information regarding the high and low closing sales prices per share of Brocade’s common stock as reported on the NASDAQ Global Select Market is set forth in “Quarterly Summary” in Part II, Item 8 of this Form 10-K.
According to records of Brocade’s transfer agent, Brocade had 1,031 stockholders of record as of December 7, 2009 and it believes there is a substantially greater number of beneficial holders. Brocade has never declared or paid any cash dividends on its common stock. Brocade currently expects to retain any future earnings for use in the operation and expansion of its business and does not anticipate paying any cash dividends in the foreseeable future.
Except as previously described in the Form 10-Q filed on June 4, 2009, there were no unregistered sales of equity securities during the three fiscal years ended October 31, 2009. Information with respect to securities authorized for issuance under equity compensation plans is set forth in Note 13 (see “Equity Compensation Plan Information” of Note 13) of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K.
Stock Performance Graph
The graph below shows a comparison of the annual percentage change in the cumulative total stockholder return for Brocade common stock, with the cumulative total stockholder returns for (i) the NASDAQ Composite Index, (ii) the NASDAQ Computer Index, (iii) the NASDAQ Telecommunications Index and (iv) the SIC Code 3577 Index, for the period commencing on October 30, 2004 and ending on October 31, 2009, assuming the investment of $100.00 on October 30, 2004. Brocade has begun to use the NASDAQ Telecommunications Index for the comparison provided in the graph below because of Brocade’s current business and its role in the Ethernet and storage networking industries following its acquisition of Foundry. The NASDAQ Computer Index and the SIC Code 3577 Index will no longer be included in the graph after this year. The stockholder returns over the indicated period below are weighted based on market capitalization at the beginning of each measurement point and are not indicative of, or intended to forecast, future performance of Brocade’s common stock. Data for the NASDAQ Composite Index, the NASDAQ Computer Index, the NASDAQ Telecommunications Index and the SIC Code 3577 Index assume reinvestment of dividends. Brocade has never declared or paid dividends on its common stock and has no present plans to do so.
Item 6.
Item 6. Selected Financial Data
The following selected financial data should be read in conjunction with the Consolidated Financial Statements and related notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and other financial information appearing elsewhere in this Annual Report on Form 10-K. The information set forth below is not necessarily indicative of Brocade’s future financial condition or results of operations.
(1) The fiscal year ended October 31, 2009 includes the impact of the acquisition of Foundry, which was completed in the first fiscal quarter (see Note 3, “Acquisitions,” of the Notes to Consolidated Financial Statements), and the one-time $26.9 million in-process research and development charge in connection with this acquisition. The fiscal year ended October 31, 2009 also includes the impact of the impairment of the Files reporting unit (see Note 4, “Goodwill and Intangible Assets,” of the Notes to Consolidated Financial Statements).
(2) The fiscal year ended October 25, 2008 includes the impact of the release of the valuation allowance of deferred tax assets which resulted in a tax benefit of $174.4 million during the year ended October 25, 2008 (see Note 14, “Income Taxes,” of the Notes to Consolidated Financial Statements). The fiscal year ended October 25, 2008 also includes the provision for a class action lawsuit of $160.0 million relating to a preliminary settlement reached between Brocade and the lead plaintiffs for the federal securities class action on May 30, 2008.
(3) The fiscal year ended October 27, 2007 includes the impact of the acquisition of McDATA, which was completed in the second fiscal quarter (see Note 3, “Acquisitions,” of the Notes to Consolidated Financial Statements).
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K.
Overview
Our goal is to be a leading provider of end-to-end networking solutions and services to Global 1000, enterprise and service provider customers.
In the first fiscal quarter of 2009, we completed our acquisition of Foundry. As a result of this acquisition in the first fiscal quarter of 2009, we reorganized into four operating segments: Data Storage, IP Layer 2-3, IP Layer 4-7/Application Delivery Products (“IP Layer 4-7/ADP”), and Global Services. The objective of this new organization is to enable us to more effectively focus on growth opportunities, while being well-positioned to more rapidly scale and accommodate new business opportunities, including potential future acquisitions.
Our primary focus for this year has been on the following markets:
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Enterprise Data Center Solutions, which is served by our Data Storage operating segment, where we offer directors, switches, top-of-rack switches, end-of-row and backbones, file management solutions, application delivery, HBAs, converged network products and server virtualization solutions;
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Enterprise LAN Campus, which is served by our IP Layer 2-3 operating segment, where we offer modular and stackable 1 GbE and 10GbE solutions, Enhanced Power Over Ethernet plus, as well as security and wireless solutions; and
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Service Providers, which is served by our IP Layer 2-3 and IP Layer 4-7/ADP operating segments, where we offer metro Edge, high-availability aggregation and Ethernet Backbone solutions.
Results of Operations
We report our fiscal year on a 52/53-week period ending on the last Saturday in October. As is customary for companies that use the 52/53-week convention, every fifth year contains a 53-week year. As a result, our fiscal year 2009 is a 53-week fiscal year, with our second quarter of fiscal year 2009 consisting of fourteen weeks, which is one week longer than a typical quarter. Fiscal year 2008 was a 52-week fiscal year. Our next 14-week quarter will be in the second quarter of fiscal year 2014.
Two of our operating segments are individually reportable segments: Data Storage and Global Services; and two, IP Layer 2-3 and IP Layer 4-7/ADP, are combined into one reportable segment: Ethernet Products (see Note 15, “Segment Information,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K).
Our results of operations for the years ended October 31, 2009, October 25, 2008 and October 27, 2007 are reported in this discussion and analysis as a percentage of total net revenues, except for cost of revenues and gross margin (loss) with respect to each segment, which are indicated as a percentage of the respective segment net revenues. Prior period segment results have been conformed to the new measurements of segment financial reporting implemented in the first quarter of fiscal year 2009.
Revenues. Our data networking solutions enable network convergence and end-to-end networking from the edge to the core of our customers’ networking infrastructures. Our revenues are derived primarily from sales of our Data Storage family of SAN products, sales of our Ethernet products, and our service and support offerings related to those products.
Our total net revenues are summarized as follows (in thousands, except percentages):
The increase in total net revenues for the year ended October 31, 2009 compared with fiscal year 2008 reflects growth in sales of Ethernet Products and Global Services offerings.
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Data Storage product revenues for the period were slightly down and reflect a 3.3% decrease in the number of ports shipped from our director and switch products and a decrease in average selling price per port of 10.4%, offset by a mix shift from 4 Gb director and switch products to 8 Gb director products, which carry a higher price per port. The Company believes the decline in revenues was related to the macroeconomic environment during fiscal year 2009;
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The increase in revenues from Ethernet Products was due to sales of network switching and router products as a result of our acquisition of Foundry in December 2008; and
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The increase in Global Services revenues was a result of the acquisition of Foundry in December 2008 and the inclusion of SBS, which was acquired in March 2008, for the full fiscal year 2009, as well as the continued expansion of our installed base.
The increase in total net revenues for the year ended October 25, 2008 compared with fiscal year 2007 reflects growth in sales of Data Storage products and Global Services offerings.
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Data Storage product revenues for the period reflect a 13.8% increase in the number of ports shipped due to our acquisition of McDATA in January 2007, additional market demand and market share growth, mix shift from lower port density switch products to higher port density director products, and our continued growth in the embedded switch market, partially offset by a 3.2% decrease in average selling price per port;
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The decrease in revenues from Ethernet Products was due to a decrease in the volume of our former Files business; and
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The increase in Global Services revenues was a result of the acquisition of SBS in March 2008 and the inclusion of McDATA, which was acquired in January 2007, for the full fiscal year 2008, as well as the continued expansion of our installed base.
For both the years ended October 31, 2009 and October 25, 2008, the declines in average selling prices were the result of a continuing competitive pricing environment, offset by a mix shift to higher port density and price per port products. For the year ended October 31, 2009, we believe that the IT spending environment remained cautious due to the uncertain macroeconomic environment and therefore, our business was affected by a decrease in overall market demand, partially offset by an increase in our market share in the Enterprise Data Center Solutions market. The increase in the number of Ethernet Products ports shipped primarily reflects the Foundry acquisition.
Going forward, we expect the number of ports shipped to fluctuate depending on the demand for our existing and recently introduced Ethernet Products and Data Storage products, as well as the timing of product transitions by our OEM customers. We currently expect that average selling prices per port will likely decline at rates consistent with historical rates of low- to mid-single digits per quarter, however, there are risks that pricing pressure could accelerate due to macroeconomic issues, new product introductions by us or our competitors, or other factors. Historically, our first and fourth fiscal quarters are seasonally stronger quarters from a revenue perspective than our second and third fiscal quarters.
Our total net revenues by geographical area are summarized as follows (in thousands, except percentages):
From fiscal year 2004 to fiscal year 2009, domestic revenues have accounted for between 56% and 69% of total net revenues. International revenues primarily consist of sales to customers in Western Europe, the greater Asia Pacific region and Japan. International revenues decreased as a percentage of total net revenues for the year ended October 31, 2009 compared with fiscal year 2008 primarily as a result of the higher concentration of revenue in North America associated with the Foundry acquisition. International revenues decreased as a percentage of total net revenues for the year ended October 25, 2008 compared with fiscal year 2007 primarily as a result of overall stronger end-user demand in the North America region. Revenues are attributed to geographic areas based on where our products are shipped. However, certain OEM customers take possession of our products domestically and then distribute these products to their international customers. Because we account for all of those OEM revenues as domestic revenues, we cannot be certain of the extent to which our domestic and international revenue mix is impacted by the practices of our OEM customers, but we believe that international revenues comprise a larger percentage of our total net revenues than the attributed revenues may indicate.
A significant portion of our revenue is concentrated among a relatively small number of OEM customers. For the years ended October 31, 2009, October 25, 2008 and October 27, 2007, the same three customers each represented 10% or more of our total net revenues for a combined total of 48% (EMC with 18%, HP with 13% and IBM with 17%), 65% (EMC with 25%, HP with 18% and IBM with 22%) and 68% (EMC with 24%, HP with 22% and IBM with 22%), respectively, of our total net revenues. The decrease in the percentage in fiscal year 2009 reflects the acquisition of Foundry and its dispersion of revenue among a non-OEM customer base. We expect that a significant portion of our future revenues will continue to come from sales of products to a relatively small number of OEM customers and, as a result of the Foundry acquisition, to the U.S. government or individual agencies within the U.S. government. Therefore, the loss of, or a decrease in the level of sales to, or a change in the ordering pattern of any one of these customers could seriously harm our financial condition and results of operations.
A majority of our accounts receivable balance is derived from sales to OEM partners in the computer storage and server industry. As of October 31, 2009, two customers accounted for 16% and 11%, respectively, of total accounts receivable. As of October 25, 2008, three customers accounted for 30%, 17% and 14%, respectively, of total accounts receivable. We perform ongoing credit evaluations of our customers and generally
do not require collateral on accounts receivable balances. We have established reserves for credit losses, sales allowances, and other allowances. While we have not experienced material credit losses in any of the periods presented, there can be no assurance that we will not experience material credit losses in the future.
Gross margin (loss). Gross margin (loss) as stated below is indicated as a percentage of the respective segment net revenues, except for total gross margin, which is stated as a percentage of total net revenues. Gross margin (loss) is summarized as follows (in thousands, except percentages):
For the year ended October 31, 2009 compared with fiscal year 2008, total gross margin increased in absolute dollars, but total gross margin percentage decreased primarily due to increased mix of Ethernet Products revenue, which carries a lower overall gross margin, purchase accounting adjustments associated with the Foundry acquisition, increased stock-based compensation and increased amortization of intangible assets acquired under the Foundry acquisition.
In addition, gross margin percentage by reportable segment increased or decreased for the year ended October 31, 2009 compared with fiscal year 2008 primarily due to the following factors:
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Data Storage product costs relative to net revenues slightly increased primarily due to a 3.4% increase in manufacturing costs and a 0.4% increase in stock-based compensation, both of which are due to headcount growth, partially offset by a 0.8% decrease in product costs and a 0.5% decrease in amortization of intangible assets related to the McDATA acquisition;
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Ethernet Products costs relative to net revenues decreased primarily due to an increase in revenue as a result of the Foundry acquisition, offset by an increase in product costs, amortization of intangible assets and stock-based compensation. The gross loss in Ethernet Products for the year ended October 25, 2008 reflects the former Files operating segment, which has been included within the Ethernet Products reportable segment for the year ended October 31, 2009; and
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Global Services operating costs relative to net revenues decreased primarily due to a 11.2% decrease in service and support spending relative to net revenues as a result of additional revenue generated from the Foundry and SBS acquisitions, partially offset by a 1.6% increase in stock-based compensation and a 0.8% increase in amortization of intangible assets as a result of the SBS acquisition.
For the year ended October 25, 2008 compared with fiscal year 2007, total gross margin percentage increased primarily due to increased mix of Data Storage revenue, which carries a higher overall gross margin.
In addition, gross margin percentage by reportable segment increased or decreased for the year ended October 25, 2008 compared with fiscal year 2007 primarily due to the following factors:
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Data Storage product costs relative to net revenues decreased primarily due to a 4.4% decrease in product costs due to a mix shift from legacy McDATA switch and director products in fiscal year 2007 toward higher margin Brocade switch and director products in fiscal year 2008 and a 2.5% decrease in manufacturing costs;
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Ethernet Products costs relative to net revenues increased primarily due to a 131.0% increase in manufacturing costs primarily due to payroll expenses related to increased headcount in fiscal year 2008, partially offset by a 5.3% decrease in product costs and a 3.9% decrease in amortization of intangible assets; and
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Global Services operating costs relative to net revenues decreased primarily due to a decrease in service and support spending relative to net revenues as a result of additional revenue generated from the McDATA and SBS acquisitions, partially offset by increases in headcount and travel expenses as a result of those acquisitions.
Gross margin is primarily affected by average selling price per port, number of ports shipped and cost of revenues. As described above, we expect that average selling prices per port for our products will continue to decline at rates consistent with historical rates of low single digits per quarter, unless they are further affected by accelerated pricing pressures, new product introductions by us or our competitors, or other factors that may be beyond our control. We believe that we have the ability to partially mitigate the effect of declines in average selling price per port on gross margins by reducing our product and manufacturing operations costs. However, the average selling price per port could decline at a faster pace than we anticipate. If this dynamic occurs, we may not be able to reduce our costs fast enough to prevent a decline in our gross margins. In addition, we must continue to increase the current volume of ports shipped to maintain our current gross margins. If we are unable to offset future reductions in average selling price per port with reductions in product and manufacturing operations costs, or if as a result of future reductions in average selling price per port, our revenues do not grow, our gross margins would be negatively affected.
We recently introduced several new products and expect to introduce additional new products in the near future. As new or enhanced products are introduced, we must successfully manage the transition from older products in order to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories and provide sufficient supplies of new products to meet customer demands. Our gross margins would likely be adversely affected if we fail to successfully manage the introductions of these new products.
Research and development expenses. Research and development (“R&D”) expenses consist primarily of salaries and related expenses for personnel engaged in engineering and R&D activities, fees paid to consultants and outside service providers, nonrecurring engineering charges, prototyping expenses related to the design, development, testing and enhancement of our products, depreciation related to engineering and test equipment, and related IT and facilities expenses.
R&D expenses are summarized as follows (in thousands, except percentages):
The increase in R&D expenses for the year ended October 31, 2009 compared with fiscal year 2008 was primarily due to an increase of $56.7 million in salaries and wages, $5.2 million in nonrecurring engineering
expenses, $7.8 million in expenses related to IT, facilities and other shared functions, $4.5 million in depreciation and $30.0 million in stock-based compensation, partially offset by a decrease of $7.4 million in outside services. The increase in salaries and wages, nonrecurring engineering expenses, expenses related to IT, facilities and other shared functions, depreciation and stock-based compensation was primarily the result of headcount growth from the Foundry acquisition. In addition, salaries and wages and stock-based compensation were higher for the year ended October 31, 2009 compared with fiscal year 2008 due to the extra week during the second quarter of our fiscal year 2009, partially offset by an average of nine days of unpaid time resulting from the implementation of a Company-wide unpaid time off program during fiscal year 2009.
The increase in R&D expenses for the year ended October 25, 2008 compared with fiscal year 2007 was primarily due to an increase of $24.2 million in salaries and wages, $3.3 million in outside services related to product development including our introduction of our 8 Gb switch family, $2.5 million in prototypes and nonrecurring engineering expenses, $13.4 million in expenses related to IT, facilities and other shared functions, partially offset by a decrease of $5.7 million in acquisition and engineering-related bonuses. The increase in salaries and wages was primarily the result of organic headcount growth as well as from the McDATA acquisition.
Sales and marketing expenses. Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in sales, marketing and customer service functions, costs associated with promotional and marketing programs, travel expenses, and related IT and facilities expenses.
Sales and marketing expenses are summarized as follows (in thousands, except percentages):
The increase in sales and marketing expenses for the year ended October 31, 2009 compared with fiscal year 2008 was primarily due to an increase of $63.5 million in salaries and wages, $7.2 million in expenses related to IT, facilities and other shared functions, and $38.2 million in stock-based compensation, offset by a decrease of $8.6 million in advertising and branding expense. The increase in salaries and wages, expenses related to IT, facilities and other shared functions, and stock-based compensation was primarily the result of headcount growth from the Foundry acquisition. In addition, salaries and wages and stock-based compensation were higher for the year ended October 31, 2009 compared with fiscal year 2008 due to the extra week during the second quarter of our fiscal year 2009, partially offset by an average of nine days of unpaid time resulting from the implementation of a Company-wide unpaid time off program during fiscal year 2009.
The increase in sales and marketing expenses for the year ended October 25, 2008 compared with fiscal year 2007 was primarily due to an increase of $14.8 million in salaries and wages, $6.2 million in sales conference, $6.9 million in advertising expense related to the 8 Gb product launch, $13.6 million in sales commissions, and $8.0 million in expenses related to IT, facilities and other shared functions. The increase in salaries and wages was primarily the result of organic headcount growth as well as from the McDATA acquisition.
General and administrative expenses. General and administrative (“G&A”) expenses consist primarily of salaries and related expenses for corporate executives, finance, human resources and investor relations, as well as recruiting expenses, professional fees, other corporate expenses, and related IT and facilities expenses.
G&A expenses are summarized as follows (in thousands, except percentages):
The increase in G&A expenses for the year ended October 31, 2009 compared with fiscal year 2008 was primarily due to an increase of $6.2 million in salaries and wages, $13.4 million in stock-based compensation and $2.5 million in outside services. The increase in salaries and wages and stock-based compensation was primarily the result of headcount growth from the Foundry acquisition. In addition, salaries and wages and stock-based compensation were higher for the year ended October 31, 2009 compared with fiscal year 2008 due to the extra week during the second quarter of our fiscal year 2009, partially offset by an average of nine days of unpaid time resulting from the implementation of a Company-wide unpaid time off program during fiscal year 2009. The increase in outside services was primarily due to our enterprise reporting system integration as a result of the Foundry acquisition.
The increase in G&A expenses for the year ended October 25, 2008 compared with fiscal year 2007 was primarily due to an increase of $4.1 million in salaries and wages, $2.7 million in outside services, $4.3 million increase in stock-based compensation, and $1.2 million in depreciation and amortization. The increase in salaries and wages, outside services and stock-based compensation was primarily the result of headcount growth from the McDATA and SBS acquisitions.
Legal fees associated with indemnification obligations and other related costs, net. These expenses consist of legal fees for various matters, including applicable indemnification obligations, defense of the Company in legal proceedings, and actions to pursue claims by the Special Litigation Committee of the Board of Directors. Pursuant to the Company’s charter documents and indemnification agreements, we have certain indemnification obligations to our directors, officers and employees, as well as certain former directors, officers and employees. As a result of such obligations and claims filed by the Special Litigation Committee of the Board of Directors, we incurred expenses related to amounts paid to certain former directors, officers and employees of the Company who have been and/or are subject to ongoing SEC, civil actions and/or criminal proceedings in connection with Brocade’s historical stock option granting practices. We expect such expenses to decrease during fiscal year 2010 from historical trends.
Legal fees associated with indemnification obligations and other related costs, net, are summarized as follows (in thousands, except percentages):
Legal fees decreased for the year ended October 31, 2009 compared with fiscal year 2008 primarily due to resolution of multiple legal proceedings related to the Special Litigation Committee’s litigation and certain settlements received in connection with that litigation, as well as a decrease in legal expenses in connection with the litigation filed on behalf of the Company by the Special Litigation Committee of the Board of Directors.
Legal fees increased for the year ended October 25, 2008 compared with fiscal year 2007 primarily due to an increase in legal expenses in connection with the litigation filed on behalf of the Company by the Special Litigation Committee of the Board of Directors, partially offset by a one-time contribution of $9.5 million from an outside legal advisor to Brocade in connection with an agreement reached with Brocade’s Special Litigation Committee of the Board of Directors.
Provision for class action lawsuit. This expense is in connection with the resolution of our class action lawsuit. Provision for class action lawsuit is summarized as follows (in thousands, except percentages):
The $160.0 million in provision for class action lawsuit during the year ended October 25, 2008 was based on the preliminary settlement reached on May 30, 2008 between Brocade and the lead plaintiffs for the federal securities class action. In December 2008, we deposited $160.0 million into an escrow account on behalf of the plaintiff class to be released upon final approval of the proposed settlement by the Federal District Court. On January 26, 2009, the Federal District Court granted final approval of the settlement and the amount was released from escrow.
Amortization of intangible assets. Amortization of intangible assets is summarized as follows (in thousands, except percentages):
During the year ended October 31, 2009, we recorded amortization of intangible assets related to the acquisitions of McDATA, Silverback, SBS and Foundry. The increase in amortization of intangible assets for the year ended October 31, 2009 compared with fiscal year 2008 was primarily due to the acquisition of Foundry in December 2008 and the acquisition of SBS in March 2008.
During the year ended October 25, 2008, we recorded amortization of intangible assets related to the acquisitions of McDATA, Silverback, NuView, Inc. and SBS. The increase in amortization of intangible assets for the year ended October 25, 2008 compared with fiscal year 2007 was primarily due to the acquisition of McDATA in January 2007.
Intangible assets are recorded based on estimates of fair value at the time of the acquisition and identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives (see Note 4, “Goodwill and Intangible Assets,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K).
Acquisition and integration costs. Acquisition and integration costs are summarized as follows (in thousands, except percentages):
For the year ended October 31, 2009, we recorded acquisition and integration costs primarily for consulting services and other professional fees in connection with our integration of Foundry.
For the year ended October 25, 2008, we recorded acquisition and integration costs primarily for consulting services and other professional fees in connection with our then pending acquisition of Foundry. For the year ended October 27, 2007, we recorded acquisition and integration costs primarily for consulting services, other professional fees and bonuses paid to transitional employees in connection with our acquisition of McDATA.
Restructuring costs and facilities lease loss benefit, net. Restructuring costs and facilities lease loss benefit, net, are summarized as follows (in thousands, except percentages):
Restructuring costs and facilities lease loss benefit, net, for the year ended October 31, 2009 was primarily due to $2.7 million in restructuring costs primarily related to severance payments in connection with the decision to no longer offer our suite of Files products, partially offset by a benefit of $0.3 million related to estimated facilities lease losses, net of expected sublease income, recorded during the year ended October 31, 2009. This benefit represented a change in estimate. We revised certain estimates and assumptions, including those related to estimated sublease rates, estimated time to sublease the facilities, expected future operating costs, and expected future use of the facilities.
Restructuring costs and facilities lease loss benefit, net, increased for the year ended October 25, 2008 compared with fiscal year 2007. This increase was primarily due to the restructuring of our Files business in the fourth fiscal quarter of 2008 to better align the cost structure with revenue performance, which resulted in $3.3 million in restructuring costs. The increase in restructuring costs was partially offset by a benefit of $0.6 million related to estimated facilities lease losses, net of expected sublease income. This benefit represented a change in estimate associated with the reoccupation of expected sublease space by us.
In-process research and development. We did not record any in-process research and development (“IPR&D”) charge for the years ended October 25, 2008 and October 27, 2007. IPR&D for the year ended October 31, 2009 and October 25, 2008 is summarized as follows (in thousands, except percentages):
On December 18, 2008, we completed our acquisition of Foundry. In connection with this acquisition, we recorded a $26.9 million IPR&D charge (see Note 3, “Acquisitions,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K).
The IPR&D was written off because the acquired technologies had not reached technological feasibility and had no alternative uses. Technological feasibility is defined as being equivalent to completion of a beta-phase working prototype in which there is no remaining risk relating to the development. At the time of the acquisition in December 2008, Foundry was developing new products in multiple product areas that qualify as IPR&D. These efforts included FastIron SuperX Family, FastIron CX, NetIron CER, TurboIron and various other projects. At the time of the acquisition, it was estimated that these development efforts would be completed over the following three to seven months at an estimated total cost of $3.9 million.
The value assigned to the Foundry IPR&D was determined by estimating costs to develop the purchased IPR&D into commercially viable products, estimating the resulting net cash flows from the projects when completed, and discounting the net cash flows to their present values. The revenue estimates used in the net cash flow forecasts were based on estimates of relevant market sizes and growth factors, expected trends in technology, and the nature and expected timing of new product introductions by Foundry and its competitors.
The rate utilized to discount the net cash flows to their present values was based on Foundry’s weighted-average cost of capital. The weighted-average cost of capital was adjusted to reflect the difficulties and uncertainties in completing each project and thereby achieving technological feasibility, the percentage of completion of each project, anticipated market acceptance and penetration, market growth rates, and risks related to the impact of potential changes in future target markets. Based on these factors, a discount rate of 12.5% was deemed appropriate for valuing the IPR&D.
The estimates used in valuing IPR&D were based upon assumptions believed to be reasonable but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur.
Goodwill and acquisition-related intangible assets impairment. We did not record any goodwill and acquisition-related intangible assets impairment for the years ended October 25, 2008 and October 27, 2007. Goodwill and acquisition-related intangible assets impairment for the year ended October 31, 2009 is summarized as follows (in thousands, except percentages):
Consistent with prior years, we selected the second fiscal quarter as the period in which the annual goodwill impairment test was to be completed. We completed the first step of the goodwill impairment test and determined that the fair value of the Files business fell below its carrying value. The excess of the fair value of a reporting unit is determined in the same manner as the amount of goodwill recognized in a business combination, which is the excess of the fair value of the reporting unit, as determined in the first step, over the aggregate fair values of the individual assets, liabilities, and identifiable intangibles as if the business were being acquired in a business combination. If the implied fair value in the “pro forma” business combination accounting as described above exceeds the goodwill assigned to the reporting unit, then there is no impairment. If the goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss recognized cannot exceed the amount of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted under the applicable accounting standards.
Prior to fiscal year 2009, we used the income approach, which utilizes the discounted expected future cash flows (“DCF”) method, and the market approach for estimating the fair values of reporting units. As our market capitalization temporarily declined during fiscal year 2009 and as the technology sector volatility increased, we focused on methods that were more representative of a market participant’s view of fair value given the current market conditions. As a result, in fiscal year 2009, we relied primarily on the DCF method, using management
projections for each reporting unit and risk-adjusted discount rates. The DCF method used at each period-end utilized discount rates that we believe adequately reflect the risk and uncertainty in the technology markets generally and specifically in our internally developed earnings projections.
During the second quarter of fiscal year 2009, we made a decision to no longer offer our suite of Files products. After the acquisition of Foundry, Files was combined with IP Layer 4-7/ADP to create the IP Layer 4-7/ADP operating segment. The integration of Files into the IP Layer 4-7/ADP operating segment was at a preliminary stage when the decision was made to cease development of the Files business. Accordingly, we assessed the potential impairment of the goodwill and long-lived assets relating to the Files business on a standalone basis.
As a result of the goodwill impairment analysis, we determined that all of the goodwill and acquisition-related intangible assets associated with the Files business were impaired. During the three months ended May 2, 2009, we recorded a $53.3 million impairment charge, which is comprised of a non-cash goodwill impairment charge of $45.8 million and a non-cash acquisition-related intangible assets impairment charge of $7.5 million (see Note 4, “Goodwill and Intangible Assets,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K).
Interest and other income (loss), net. Interest and other income (loss), net, are summarized as follows (in thousands, except percentages):
For the year ended October 31, 2009 compared with the corresponding periods in fiscal year 2008, the decrease in interest and other income, net, was primarily related to a decrease in investment balances due to the Foundry acquisition, as well as a $4.4 million increase in acquisition-related financing charges.
For the year ended October 25, 2008 as compared to the year ended October 27, 2007, the decrease in interest and other income, net, was primarily related to decreased average rates of return due to investment mix, a decrease in interest rates and an increase of $4.7 million in acquisition-related financing charges in fiscal year 2008.
Interest expense. Interest expense primarily represents the interest cost associated with our term loan and convertible subordinated debt (see Note 9, “Borrowings,” of the Notes to Consolidated Financial Statements). Interest expense is summarized as follows (in thousands, except percentages):
Interest expense increased for the year ended October 31, 2009 compared with fiscal year 2008 primarily as a result of $92.3 million in interest expense incurred on the term loan and the revolving credit facility which were obtained to finance the Foundry acquisition, partially offset by $9.1 million in capitalization of interest cost in connection with the development of our campus during the year ended October 31, 2009.
Interest expense increased for the year ended October 25, 2008 compared with fiscal year 2007 primarily as a result of $5.0 million in interest expense on the term loan which was obtained to finance a portion of the then pending Foundry acquisition, partially offset by $1.4 million in capitalization of interest cost in connection with the development of our campus during the year ended October 25, 2008.
We obtained the term loan during the fourth fiscal quarter of 2008. As of October 31, 2009 and October 25, 2008, the carrying value of the outstanding balance of our term loan was $898.9 million and $1,055.0 million, respectively. As of October 31, 2009 and October 25, 2008, the carrying value of the outstanding balance of our convertible subordinated debt assumed from the McDATA acquisition was $171.8 million and $169.7 million, respectively.
Gain (loss) on sale of investments, net. Gain (loss) on sale of investments, net, is summarized as follows (in thousands, except percentages):
Loss on sale of investments, net, decreased for the year ended October 31, 2009 compared with fiscal year 2008. The $0.6 million in loss on sale of investments for the year ended October 31, 2009 was due to a loss of $0.6 million on the disposition of portfolio investments at amounts below the carrying value.
We had $6.9 million in loss on sale of investments for the year ended October 25, 2008 as compared to the $13.2 million in gain on sale of investments for the year ended October 27, 2007. The $6.9 million in loss on sale of investments for the year ended October 25, 2008 was due to a loss of $6.0 million on the sale of our equity investment in a publicly traded company and a loss of $0.9 million on the disposition of portfolio investments at amounts below the carrying value. The $13.2 million in gain on sale of investments for the year ended October 27, 2007 was due to the disposition of marketable strategic investments at amounts above the carrying value.
Loss on impairment of portfolio investments. Loss on impairment of portfolio investments is summarized as follows (in thousands, except percentages):
As of October 25, 2008, we determined that the declines in the fair value for certain of our portfolio investments primarily associated with non-marketable investments were other than temporary due to the significant deterioration of the financial condition of the investees. As a result, for the year ended October 25, 2008, we recorded impairment charges of $8.8 million.
Provision for (benefit from) income taxes. Provision for (benefit from) income taxes and the effective tax rates are summarized as follows (in thousands, except effective tax rates):
Our effective tax rate increased for the year ended October 31, 2009 compared with fiscal year 2008 primarily due to the following (see Note 14, “Income Taxes,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K):
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Release of the valuation allowance during the second fiscal quarter of 2008;
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Foreign taxes;
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An increase in R&D credits for the year ended October 31, 2009; and
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A change in uncertain tax positions related to the ongoing IRS examination for the year ended October 31, 2009.
Based on the forecasted financials, we currently expect the effective tax rate for fiscal year 2010 to be higher than fiscal year 2009. However, factors such as the successful integration of Foundry’s international operations and associated structuring could affect the level of our foreign revenues and earnings. As estimates and judgments are used to project such international earnings, the impact to our tax provision could vary if the current planning or assumptions change. Given that the tax rate is driven by several different factors, it is not possible to estimate our future tax rate with a high degree of certainty.
Our effective tax rate decreased for the year ended October 25, 2008 compared with fiscal year 2007 primarily due to a one-time valuation allowance release in the second fiscal quarter of 2008.
To the extent that international revenues and earnings differ from those historically achieved, a factor largely influenced by the buying behavior of our OEM partners or by unfavorable prospective and retrospective effects of changing tax laws and regulations, our income tax provision could change.
Estimates and judgments are required in the calculation of certain tax liabilities and in the determination of the recoverability of certain deferred tax assets, which arise from variable stock option expense, net operating losses, tax carryforwards and temporary differences between the tax and financial statement recognition of revenues and expenses.
We apply a recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken or expected to be taken on a tax return. Recognition of a tax position is determined when it is more likely than not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement with a taxing authority.
The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. The threshold and measurement attribute we apply for the accounting for uncertainty in income taxes recognized in the financial statements will continue to require significant judgment by management. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our results of operations.
The IRS and other tax authorities regularly examine our income tax returns. For additional discussion, see Note 14, “Income Taxes,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K. We are currently undergoing an IRS audit for fiscal year 2003, which we expect to resolve during the next twelve months. As such, after we reach settlement with the IRS, we expect to record a corresponding adjustment to our unrecognized tax benefits. We believe such settlement should not have a material impact to the results of operations. We also believe that our reserves for unrecognized tax benefits are adequate for open tax years.
Stock-based compensation expense. Stock-based compensation expense is summarized as follows (in thousands, except percentages):
The increase in stock-based compensation expense for the year ended October 31, 2009 compared with fiscal year 2008 was primarily due to increased headcount related to the acquisition of Foundry in December 2008, as well as the adoption of our 2009 Employee Stock Purchase Plan for which compensation expense is recognized using the graded vesting method over the twenty-four month offering period.
Stock-based compensation expense for the year ended October 25, 2008 was relatively flat compared with fiscal year 2007.
Stock-based compensation expense was included in the following line items on our Consolidated Statements of Operations as follows (in thousands):
Liquidity and Capital Resources
We use cash generated by operations as our primary source of liquidity. We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors, including fluctuations in our
operating results, the rate at which products are shipped during the quarter, accounts receivable collections, inventory and supply chain management, and the timing and amount of tax and other payments. For additional discussion, see “Part I-Item 1A. Risk Factors.”
Based on past performance and current expectations, we believe that internally generated cash flows are generally sufficient to support business operations, capital expenditures, contractual obligations, and other liquidity requirements associated with our operations for at least the next twelve months. We expect to repay our convertible subordinated debt due on February 15, 2010 through our existing cash balance as of October 31, 2009, as well as through cash from operations during the first fiscal quarter of 2010. Alternatively, we can repay our convertible subordinated debt by drawing on the revolving credit facility or through debt refinancing made available by various foreign and domestic financial institutions, although we cannot be certain whether such financing will be available on commercially reasonable or Company-favorable terms or that such financing will be available at all. In addition to access to capital markets, we could also monetize certain assets, including our real estate holdings, or slow down the development of our campus. There are no other transactions, arrangements, or other relationships with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity and the availability of and our requirements for capital resources.
Financial Condition
Cash and cash equivalents, short-term investments, marketable equity securities, long-term investments and restricted cash as of October 31, 2009 decreased by $1,543.8 million over the balance as of October 25, 2008 primarily due to the use of cash to fund the Foundry acquisition. For the year ended October 31, 2009, we generated $115.5 million in cash from operating activities, which was higher than our net loss for the same period as a result of adjustments to net loss for non-cash items related to depreciation and amortization, stock-based compensation expense, asset impairment and IPR&D write-off, partially offset by the $160.0 million payment of the liability associated with the settlement of the class action lawsuit and an increase in accounts receivable. Accounts receivable days sales outstanding for the year ended October 31, 2009 was 57 days, compared with 39 days for the year ended October 25, 2008. The increase in accounts receivable days sales outstanding was due to the Foundry acquisition which reduced sales linearity.
Net cash used in investing activities for the year ended October 31, 2009 totaled $199.2 million and was primarily the result of $1,297.5 million in cash paid in connection with the Foundry acquisition and $162.8 million in purchases of property and equipment, offset by $1,075.1 million in restricted cash released to finance a portion of the Foundry acquisition and $186.2 million in proceeds resulting from maturities and sales of short-term investments and long-term investments.
Net cash used in financing activities for the year ended October 31, 2009 totaled $37.6 million and was primarily the result of payment of principal related to the term loan of $166.0 million and payment of senior underwriting fees related to the term loan of $30.5 million, offset by proceeds from the issuance of common stock from the employee stock purchase plan (“ESPP”) and stock option exercises of $145.7 million and proceeds from the revolving credit facility of $14.1 million.
Net proceeds from the issuance of common stock in connection with employee participation in our equity compensation plans have historically been a significant component of our liquidity. The extent to which our employees participate in these programs generally increases or decreases based upon changes in the market price of our common stock. As a result, our cash flow resulting from the issuance of common stock in connection with employee participation in equity compensation plans will vary.
Fiscal Year 2009 Compared to Fiscal Year 2008
Operating Activities. Net cash provided by operating activities decreased for the year ended October 31, 2009 compared with fiscal year 2008. The decrease was primarily due to net loss, the $160.0 million payment of
the liability associated with the settlement of the class action lawsuit, decreased accounts receivable collections and increased payments with respect to accounts payable, accrued employee compensation and other accrued liabilities during the year ended October 31, 2009.
Investing Activities. Net cash used in investing activities decreased for the year ended October 31, 2009 compared with fiscal year 2008. The decrease was primarily due to a decrease in restricted cash which was released to finance a portion of the Foundry acquisition, as well as decreased purchases of investments and marketable equity securities as we continued to prioritize our use of cash for debt repayment. The decrease was partially offset by cash paid in connection with the Foundry acquisition and decreased proceeds from the maturities and sales of investments and marketable equity securities.
Financing Activities. Net cash provided by financing activities decreased for the year ended October 31, 2009 compared with fiscal year 2008. The decrease was primarily due to the proceeds received in fiscal year 2008 from the term loan and the payment of principal and senior underwriting fees in fiscal year 2009 related to the term loan, partially offset by decreased common stock repurchases and increased proceeds from the issuance of common stock from ESPP and stock option exercises, and proceeds from the revolving credit facility.
Fiscal Year 2008 Compared to Fiscal Year 2007
Operating Activities. Net cash provided by operating activities increased for the year ended October 25, 2008 compared with fiscal year 2007. The increase was primarily due to higher earnings in fiscal year 2008, an increase in the liability associated with the class action lawsuit and decreased payments with respect to accounts payable, accrued employee compensation and other accrued liabilities during the year ended October 25, 2008, partially offset by the release of the valuation allowance related to our deferred tax assets.
Investing Activities. Net cash used in investing activities increased for the year ended October 25, 2008 compared with fiscal year 2007. The increase was primarily due to an increase in restricted cash which was planned to be used to finance a portion of the then pending Foundry acquisition, increased purchases of property and equipment, an increase in cash paid in connection with acquisitions and decreased proceeds from the maturities of short-term investments, long-term investments and marketable equity securities, partially offset by decreased purchases of short-term investments, long-term investments and marketable equity securities.
Financing Activities. Net cash provided by financing activities increased for the year ended October 25, 2008 compared with fiscal year 2007. The increase was primarily due to proceeds from the term loan.
Liquidity
Manufacturing and Purchase Commitments. We have manufacturing arrangements with Foxconn, Sanmina, Flextronics, Celestica, Flash, Accton and Quanta under which we provide twelve-month product forecasts and place purchase orders in advance of the scheduled delivery of products to our customers. Our purchase commitments reserve reflects our estimate of purchase commitments we do not expect to consume in normal operations within the next twelve months, in accordance with our policy (see Note 10, “Commitments and Contingencies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K).
Guarantee. On November 18, 2003, we purchased a previously leased building located near our San Jose headquarters and issued a $1.0 million guarantee as part of the purchase agreements.
Company Campus Contractual Obligations. On May 23, 2008, we purchased property located in San Jose, California, which consists of three unimproved building parcels that are entitled for approximately 562,000 square feet of space in three buildings. For additional discussion, see Note 10, “Commitments and Contingencies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K).
Income Taxes. We accrue U.S. income taxes on the earnings of our foreign subsidiaries unless the earnings are considered indefinitely reinvested outside of the United States. We intend to reinvest current and accumulated earnings of our foreign subsidiaries for expansion of our business operations outside the United States for an indefinite period of time.
The IRS and other tax authorities regularly examine our income tax returns (see Note 14, “Income Taxes,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K). We believe we have adequate reserves for all open tax years.
Senior Secured Credit Facility. The majority of our outstanding debt is related to the financing of the Foundry acquisition, the costs and expenses related to the merger, and the ongoing working capital and other general corporate purposes of the combined organization after consummation of the merger (see Note 9, “Borrowings,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K). We have the following resources available to obtain short-term or long-term financing, if we need additional liquidity, as of October 31, 2009 (in thousands):
Contractual Obligations
The following table summarizes our contractual obligations, including interest expense, and commitments as of October 31, 2009 (in thousands):
(1) Amount reflects total anticipated cash payments, including anticipated interest payments.
(2) Amount excludes contractual sublease income of $21.8 million, which consists of $4.6 million to be received in less than one year, $5.7 million to be received in one to three years, $5.4 million to be received in three to five years and $6.1 million to be received in more than five years.
(3) Amount reflects total gross purchase commitments under our manufacturing arrangements with third-party contract manufacturers. Of this amount, we have accrued $17.0 million for estimated purchase commitments that we do not expect to consume in normal operations within the next twelve months, in accordance with our policy.
(4) Amount reflects $52.6 million in capital expenditures in connection with the development of the corporate campus. Including the costs incurred to date of $190.9 million, the total contractual obligation on the Company campus is approximately $243.6 million.
(5) As of October 31, 2009, we had a liability for unrecognized tax benefits of $170.9 million and a net accrual for the payment of related interest and penalties of $3.6 million. We expect to resolve the fiscal year 2003 IRS audit during the next twelve months. As such, after we reach settlement with the IRS, we expect to record a corresponding adjustment to our unrecognized tax benefits. Due to availability of net operating losses, the IRS audit settlement is not expected to result in a significant tax payment. Other than the 2003 IRS audit, we are unable to make a reasonably reliable estimate of the timing of payments in individual years due to uncertainties in the timing of tax audit outcome.
Share Repurchase Program. As of November 29, 2007, our Board of Directors authorized a total of $800.0 million for the repurchase of our common stock. Purchases have been made, from time to time, in the open market or by privately negotiated transactions and have been funded from available working capital. The number of shares purchased and the timing of purchases have been based on the level of our cash balances, general business and market conditions, and other factors, including alternative investment opportunities. During the third fiscal quarter of 2008, we suspended our share repurchase program due to the then pending Foundry acquisition. We are prioritizing our use of cash for debt repayment following the close of the Foundry acquisition. As such, we made no share repurchases for the year ended October 31, 2009. For the year ended October 25, 2008, we repurchased 22.8 million shares for an aggregate purchase price of $168.3 million. Approximately $414.1 million remains authorized for future repurchases under this program as of October 31, 2009 and October 25, 2008.
Off-Balance Sheet Arrangements
As part of our ongoing business, we do not participate in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As of October 31, 2009, we did not have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Critical Accounting Estimates
Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these Consolidated Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate, on an ongoing basis, our estimates and judgments, including, but not limited to, those related to sales allowances and programs, bad debts, stock-based compensation, allocation of purchase price of acquisitions, excess inventory and purchase commitments, restructuring costs, facilities lease losses, impairment of goodwill and intangible assets, litigation, income taxes and investments. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results that we report in our Consolidated Financial Statements. We believe the following critical accounting policies, among others, require significant estimates and judgments used in the preparation of our consolidated financial statements.
Revenue recognition and allowances for sales allowances, sales programs and doubtful accounts. We reduce revenue for estimated sales allowances at the time of shipment and sales programs at the later of revenue recognition or communication of the commitment for sales incentives. Sales allowances and sales programs are
estimated based on historical sales levels, the timing and magnitude of historical sales returns, approved sales programs versus claims under such sales programs and a projection of this experience into the future. In addition, we maintain an allowance for doubtful accounts, which is also accounted for as a reduction in revenue, for estimated losses resulting from the inability of our customers to make required payments. We maintain bad debt reserves based upon the analysis of accounts receivable, historical collection patterns, customer concentrations, customer creditworthiness, current economic trends, changes in customer payment terms and practices, and customer communication. We record a specific reserve for individual accounts when we become aware of a customer’s likely inability to meet its financial obligations, such as in the case of bankruptcy filings or deterioration in the customer’s operating results or financial position. If circumstances related to customers change, we would further adjust estimates of the recoverability of receivables. In addition, if actual sales returns, sales programs, and other allowances exceed our estimates, or if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances and charges may be required.
Our multiple-element product offerings include networking hardware and software products and support services. We also sell certain software products and support services separately. For certain of our products, software is generally essential to the functionality of our hardware products. We allocate revenue to each element in a multiple-element arrangement based upon vendor-specific objective evidence (“VSOE”) of the fair value of the element, or if VSOE is not available for the delivered element, by application of the residual method. In the application of the residual method, we allocate revenue to the undelivered elements based on VSOE of fair value for those elements and allocate the residual revenue to the delivered elements. VSOE of the fair value for an element is based upon the price charged when the element is sold separately. Revenue allocated to each element is then recognized when the basic revenue recognition criteria is met for each element. Changes in the inability to determine VSOE for an undelivered element in a multiple-element arrangement may affect the timing of revenue recognition. For sales of products that contain multiple elements and where software is incidental, we determine the separate units of accounting that exist within the arrangement. If more than one unit of accounting exists, the arrangement consideration is allocated to each unit of accounting using the residual fair value method. Revenue is recognized for each unit of accounting when all the revenue recognition criteria have been met for that unit of accounting.
Stock-based compensation. We grant stock options for shares in the Company’s common stock, restricted stock units and other types of equity compensation awards to our employees and directors under various equity compensation plans. For additional discussion, see Note 13, “Stock-Based Compensation,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K.
The compensation expense for stock-based awards includes an estimate for forfeitures and is recognized over the expected term of the award under a graded vesting method. In addition, we record stock-based compensation expense in connection with shares issued under our employee stock purchase plan using the graded vesting method over the twenty-four month offering period.
We use the Black-Scholes option pricing model to determine the fair value of stock options granted when the measurement date is certain. We also use the Black-Scholes option pricing model to determine the fair value of the option component of employee stock purchase plan shares. The determination of the fair value of stock-based awards using the option pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the expected term of the awards, projected and actual employee stock option exercise behaviors, risk-free interest rates, estimated forfeitures and expected dividends.
We estimate the expected term of stock options granted by calculating the average term from our historical stock option exercise experience. We do not anticipate paying any cash dividends in the foreseeable future, and therefore we use an expected dividend yield of zero in the option pricing model. We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest.
The fair value of the restricted stock units to be granted under the Incentive Plan was estimated using a Monte Carlo simulation. For additional discussion, see Note 13, “Stock-Based Compensation,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K).
The assumptions used in calculating the fair value of stock-based awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.
Acquisitions-Purchase Price Allocation. We allocate the purchase price of an acquired business to the assets acquired and liabilities assumed, including identifiable intangible assets, based on their respective fair values at the acquisition date. The excess of the purchase price over the fair value of the underlying acquired net tangible and intangible assets, if any, is recorded as goodwill. We engage outside appraisal firms to assist in the fair value determination of identifiable intangible assets and any other significant assets or liabilities. Management estimates the fair value of assets and liabilities based upon quoted market prices, the carrying value of the acquired assets and widely accepted valuation techniques. We adjust the preliminary purchase price allocation, as necessary, typically up to one year after the acquisition closing date as we obtain more information regarding asset valuations and liabilities assumed. For additional discussion, see Note 3, “Acquisitions,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K.
Inventory valuation and purchase commitment liabilities. We write down inventory and record purchase commitment liabilities for estimated excess and obsolete inventory equal to the difference between the cost of inventory and the estimated fair value based upon forecast of future product demand, product transition cycles and market conditions. Although we strive to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological development could have a significant impact on the value of our inventory and purchase commitments, and our reported results. If actual market conditions are less favorable than those projected, additional inventory write-downs, purchase commitment liabilities and charges against earnings may be required. For additional discussion, see Note 10, “Commitments and Contingencies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K.
Restructuring costs and facilities lease losses. We monitor and regularly evaluate our organizational structure and associated operating expenses. Depending on events and circumstances, we may decide to take additional actions to reduce future operating costs as our business requirements evolve. In determining restructuring charges, we analyze our future operating requirements, including the required headcount by business functions and facility space requirements. Our restructuring costs and any resulting accruals involve significant estimates made by management using the best information available at the time the estimates are made, some of which may be provided by third parties. In recording severance accruals, we record a liability when all of the following conditions have been met: employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered; the obligation relates to rights that vest or accumulate; payment of the compensation is probable; and the amount can be reasonably estimated. In recording facilities lease loss accruals, we make various assumptions, including the time period over which the facilities are expected to be vacant, expected sublease terms, expected sublease rates, expected future operating costs, and expected future use of the facilities. Our estimates involve a number of risks and uncertainties, some of which are beyond our control, including future real estate market conditions and our ability to successfully enter into subleases or lease termination agreements with terms as favorable as those assumed when arriving at our estimates. We regularly evaluate a number of factors to determine the appropriateness and reasonableness of our restructuring and facilities lease loss accruals, including the various assumptions noted above. If actual results differ significantly from our estimates, we may be required to adjust our restructuring and facilities lease loss accruals in the future. For additional discussion, see Note 5, “Liabilities Associated with Facilities Lease Losses,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K.
Impairment of goodwill and intangible assets. We evaluate goodwill for impairment on an annual basis during our second fiscal quarter, or whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s implied fair value. Events which might indicate impairment include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on our customer base, material negative changes in relationships with significant customers, and/or a significant decline in our stock price for a sustained period. For additional discussion, see Note 4, “Goodwill and Intangible Assets,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K.
We conduct a two-step goodwill impairment test at the reporting unit level, which we have determined to be at the operating unit level. For additional discussion, see Note 2, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K. To determine the reporting unit’s fair values, the Company uses the income approach, the market approach, or a combination thereof. The income approach provides an estimate of fair value based on discounted expected future cash flows (“DCF”). Estimates and assumptions with respect to the determination of the fair value of the Company’s reporting units using the income approach include:
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The Company’s operating forecasts;
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Revenue growth rates; and
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Risk-commensurate discount rates and costs of capital.
The Company’s estimates of revenues and costs are based on historical data, various internal estimates and a variety of external sources, and are developed by the Company’s routine long-range planning process.
The market approach provides an estimate of the fair value of the Company’s five reporting units using various price or market multiples applied to the reporting unit’s operating results and then applying an appropriate control premium. The control premium is determined by considering control premiums offered as part of the acquisition in both the Company’s segment and comparable market segments.
We perform an impairment test for long-lived assets whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Examples of such events or circumstances include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of acquired assets or the strategy for our business, significant negative industry or economic trends, and/or a significant decline in our stock price for a sustained period. Impairment is recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on DCF analyses.
Determining the fair value of a reporting unit or an intangible asset is judgmental in nature and involves the use of significant estimates and assumptions. We base our fair value estimates on assumptions we believe to be reasonable, but that are unpredictable and inherently uncertain. As our market capitalization declined and as the technology sector volatility increased, we focused on methods that were more representative of a market participant’s view of fair value given the current market conditions. As a result, in fiscal year 2009, we relied primarily on the DCF method, using management projections for each reporting unit and risk-adjusted discount rates. Actual results may differ from our estimates. In addition, we make certain judgments and assumptions in allocating shared assets and liabilities to determine the carrying values for each of our reporting units.
Litigation costs. We are subject to the possibility of legal actions arising in the ordinary course of business. We regularly monitor the status of pending legal actions to evaluate both the magnitude and likelihood of any potential loss. We accrue for these potential losses when it is probable that a liability has been incurred and the amount of loss, or possible range of loss, can be reasonably estimated. If actual results differ significantly from our estimates, we may be required to adjust our accruals in the future. In addition, recoveries are shown as a reduction in litigation costs in the period in which they are realized.
Accounting for income taxes. The determination of our tax provision is subject to estimates and judgments due to operations in multiple tax jurisdictions inside and outside the United States. Sales to our international customers are principally taxed at rates that are lower than the United States statutory rates. The ability to maintain our current effective tax rate is contingent upon existing tax laws in both the United States and in the respective countries in which our international subsidiaries are located. Future changes in domestic or international tax laws could affect the continued realization of the tax benefits we are currently receiving and expect to receive from international sales. In addition, an increase in the percentage of our total revenue from international customers or in the mix of international revenue among particular tax jurisdictions could change our overall effective tax rate. Also, our current effective tax rate assumes that United States income taxes are not provided for undistributed earnings of certain non-United States subsidiaries. These earnings could become subject to United States federal and state income taxes and foreign withholding taxes, as applicable, should they be either deemed or actually remitted from our international subsidiaries to the United States. In addition, we evaluate the expected realization of our deferred tax assets and assess the need for a valuation allowance on a quarterly basis. We believe that sufficient positive evidence existed from historical operations and projections of U.S. taxable income in future years to conclude that it was more likely than not that we would realize our deferred tax assets.
Accounting for uncertain tax benefits. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. We apply a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Recognition of a tax position is determined when it is more likely than not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement with a taxing authority. The threshold and measurement attribute requires significant judgment by management. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our results of operations.
Recent Accounting Pronouncements
For a description of recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements, see Note 2, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
In the normal course of business, we are exposed to market risks related to changes in interest rates, foreign currency exchange rates and equity prices that could impact our financial position and results of operations. Our risk management strategy with respect to these three market risks may include the use of derivative financial instruments. We use derivative contracts only to manage existing underlying exposures of the Company. Accordingly, we do not use derivative contracts for speculative purposes. Our risks and risk management strategy are outlined below. Actual gains and losses in the future may differ materially from the sensitivity analyses presented below based on changes in the timing and amount of interest rates and our actual exposures and hedges.
Interest Rate Risk
Our exposure to market risk due to changes in the general level of United States interest rates relates primarily to our debt, cash equivalents and short-term investment portfolios.
We are exposed to changes in interest rates as a result of our borrowings under our term loan. As of October 31, 2009, the weighted-average interest rate on the term loan was 7.0%, which represents the minimum interest rate under the credit agreement. The current market rates are such that a 1% increase in market rates would still result in a 7.0% interest rate on the term loan. However, based on outstanding indebtedness of $898.9 million under our term loan as of October 31, 2009, if market rates average 1% above the interest rate floor over the remaining term of the debt, which would result from an increase in market rates of approximately 2.8%, our interest expense would increase by approximately $28.4 million.
Based on outstanding indebtedness of $1.1 billion under our term loan as of October 25, 2008, if market rates average 1% higher over the remaining term of the debt, our interest expense would increase by approximately $43.2 million. Conversely, if market rates average 1% lower over the remaining term of the debt, our interest expense would decrease by approximately $43.2 million.
Our convertible subordinated debt is subject to a fixed interest rate and may be converted into common stock based on a fixed conversion ratio. As of October 31, 2009, the approximate aggregate fair value of the outstanding convertible subordinated debt was $172.1 million. We estimated the fair value of the outstanding convertible subordinated debt as of October 31, 2009 by using the high and low prices per $100 of the Company’s 2.25% Notes as of the last day of trading for the fourth quarter of fiscal year 2009, which were both $99.80. As of October 25, 2008, the approximate aggregate fair value of the outstanding convertible subordinated debt was between $155.5 million and $155.3 million. We estimated the fair value of the outstanding convertible subordinated debt by using the high and low prices per $100 of the Company’s 2.25% Notes as of the last day of trading for the fourth quarter of fiscal year 2008, which were $90.13 and $90.00, respectively.
Our cash, cash equivalents, and short-term investments are primarily maintained at five major financial institutions in the United States. The primary objective of our investment activities is the preservation of principal while maximizing investment income and minimizing risk.
The Company did not have any material investments as of October 31, 2009 that are sensitive to changes in interest rates. The following table presents the hypothetical changes in fair values of our investments as of October 25, 2008 that are sensitive to changes in interest rates (in thousands):
These instruments are not leveraged and are classified as available-for-sale. The modeling technique used measures the change in fair values arising from selected potential changes in interest rates. Market changes reflect immediate hypothetical parallel shifts in the yield curve of plus or minus 50 basis points (“BPS”), 100 BPS and 150 BPS, which are representative of the historical movements in the federal funds rate.
The following table (in thousands) presents our cash equivalents and short-term investments and their related weighted-average interest rates as of October 31, 2009. Carrying value approximates fair value.
Foreign Currency Exchange Rate Risk
We are exposed to foreign currency exchange rate risk inherent in conducting business globally in numerous currencies, of which the most significant to our operations for fiscal year 2009 were the Euro, the Japanese Yen, the British Pound and the Singapore Dollar. We are primarily exposed to foreign currency fluctuations related to operating expenses denominated in currencies other than the U.S. dollar. As such, we benefit from a stronger U.S. dollar and may be adversely affected by a weaker U.S. dollar relative to the foreign currency. We use foreign currency forward contracts designated as cash flow hedges to protect against the foreign currency exchange rate risks inherent in our forecasted operating expenses denominated in currencies other than the U.S. dollar. We recognize the gains and losses on foreign currency forward contracts in the same period as the remeasurement losses and gains of the related foreign currency denominated exposures. Alternatively, we may choose not to hedge the foreign currency risk associated with our foreign currency exposures if such exposure acts as a natural foreign currency hedge for other offsetting amounts denominated in the same currency or if the currency is difficult or too expensive to hedge.
As of October 31, 2009, we held $120.0 million in cash flow derivative instruments. The maximum length of time over which we are hedged as of October 31, 2009 is through November 5, 2010. As of October 25, 2008, we held $18.5 million in cash flow derivative instruments. The maximum length of time over which we were hedged as of October 25, 2008 was through May 4, 2009.
Equity Price Risk
We had no publicly traded equity securities as of October 31, 2009 as compared to the estimated fair value of $182.3 million that we had as of October 25, 2008. We monitor our equity investments for impairment on a periodic basis. In the event that the carrying value of the equity investment exceeds its fair value, and we determine the decline in value to be other-than-temporary, we reduce the carrying value to its current fair value. Generally, we do not attempt to reduce or eliminate our market exposure on these equity securities. We do not purchase our equity securities with the intent to use them for speculative purposes. The aggregate cost of our equity investments in non-publicly traded companies was $6.8 million at October 31, 2009 and October 25, 2008.
Our common stock is quoted on the NASDAQ Global Select Market under the symbol “BRCD.” On October 30, 2009, the last business day of our fourth fiscal quarter of 2009, the last reported sale price of our common stock on the NASDAQ Global Select Market was $8.60 per share.
Item 8.
Item 8. Financial Statements and Supplementary Data
BROCADE COMMUNICATIONS SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm
Consolidated Statements of Operations
Consolidated Balance Sheets
Consolidated Statements of Stockholders’ Equity and Comprehensive Income
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Quarterly Summary (Unaudited)
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Brocade Communications Systems, Inc.:
We have audited the accompanying consolidated balance sheets of Brocade Communications Systems, Inc. and subsidiaries (the Company) as of October 31, 2009 and October 25, 2008, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended October 31, 2009. In connection with our audits of the consolidated financial statements, we also have audited the accompanying financial statement schedule. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Brocade Communications Systems, Inc. and subsidiaries as of October 31, 2009 and October 25, 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended October 31, 2009, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
As discussed in note 2 to the consolidated financial statements, the Company changed its method of accounting for uncertainty in income taxes, effective October 28, 2007, due to the adoption of Financial Accounting Standards Board ASC 740-10, Income Taxes.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of October 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated December 14, 2009 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
/s/ KPMG LLP
Mountain View, California
December 14, 2009
BROCADE COMMUNICATIONS SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
BROCADE COMMUNICATIONS SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
BROCADE COMMUNICATIONS SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
BROCADE COMMUNICATIONS SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
BROCADE COMMUNICATIONS SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS-(Continued)
See accompanying notes to consolidated financial statements.
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
The fiscal year for Brocade Communications Systems, Inc. (“Brocade” or the “Company”) is the 52 or 53 weeks ending on the last Saturday in October. As is customary for companies that use the 52/53-week convention, every fifth year contains a 53-week year. Fiscal year 2009 is a 53-week fiscal year and fiscal year 2008 and 2007 were 52-week fiscal years. The second quarter of fiscal year 2009 consists of fourteen weeks, which is one week longer than a typical quarter. The Company’s next 14-week quarter will be in the second quarter of fiscal year 2014. The Consolidated Financial Statements include the accounts of Brocade and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
The Company has evaluated subsequent events through the date that the financial statements were issued on December 14, 2009.
2. Summary of Significant Accounting Policies
Cash and Cash Equivalents
The Company considers all highly liquid investments with an original or remaining maturity of three months or less at the date of purchase to be cash equivalents.
Restricted Cash
During fiscal year 2009, the Company entered into an agreement with one of the defendants in connection with the Special Litigation Committee’s litigation. Under this agreement, the Company received $12.5 million, which is held in restricted cash until certain contingencies pursuant to the agreement are removed.
On October 7, 2008, the Company entered into a credit agreement under which the Company borrowed $1,100.0 million under a term loan facility. The proceeds of the term loan were deposited into a restricted securities account pending the closing of the acquisition of Foundry Networks, Inc. (“Foundry”) and other release conditions. The Company also deposited an additional $20.7 million of funds into the restricted securities account to cover the interest on the term loan for the period commencing on October 7, 2008 through December 31, 2008, pursuant to the terms of the credit agreement. As of October 25, 2008, $1,075.1 million of restricted cash, net of the $45.6 million discount related to the term loan, was included in the Company’s Consolidated Balance Sheet.
Investments and Equity Securities
Investment securities with an original or remaining maturity of more than three months but less than one year are considered short-term investments. Investment securities with an original or remaining maturity of one year or more and which the Company has the ability and intent to hold are considered long-term investments. Short-term and long-term investments consist of debt securities issued by the United States (“U.S.”) government and its agencies, municipal government obligations, and corporate bonds and notes. Short-term and long-term investments are maintained at five major financial institutions, are classified as available-for-sale and are recorded on the accompanying Consolidated Balance Sheets at fair value.
Equity securities consist of equity holdings in public companies and are classified as available-for-sale when there are no restrictions on the Company’s ability to immediately liquidate such securities. Marketable equity securities are recorded on the accompanying Consolidated Balance Sheets at fair value.
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Unrealized holding gains and losses related to the Company’s investments and equity securities are included as a separate component of accumulated other comprehensive loss on the accompanying Consolidated Balance Sheets, net of any related tax effect. Realized gains and losses are calculated based on the specific identification method and are included in “Interest and other income (loss), net,” on the Consolidated Statements of Operations.
The Company recognizes an impairment charge when the declines in the fair values of its investments and equity securities below the cost basis are assessed to be other-than-temporary. An other-than-temporary impairment is triggered when there is an intent to sell the security, it is more likely than not that the security will be required to be sold before recovery, or the security is not expected to recover the entire amortized cost basis of the security. The Company also considers various factors in determining whether to recognize an impairment charge, including the length of time and extent to which the fair value has been less than the cost basis and the financial condition and near-term prospects of the investee. For impairments involving credit losses, the Company recognizes the credit loss component in earnings and the remainder of the impairment is recorded in accumulated other comprehensive loss.
From time to time the Company makes equity investments in non-publicly traded companies. These investments are included in “Other assets” on the accompanying Consolidated Balance Sheets and are generally accounted for under the cost method as the Company does not have the ability to exercise significant influence over the respective investee’s operating and financial policies nor does it have a liquidation preference that is substantive. The Company monitors its investments in non-publicly traded companies for impairment on a quarterly basis and makes appropriate reductions in carrying values when such impairments are determined to be other-than-temporary. Impairment charges are included in “Interest and other income (loss), net,” on the Consolidated Statements of Operations. Factors considered in determining an impairment include, but are not limited to, the current business environment including competition and uncertainty of financial condition, going concern considerations such as the rate at which the investee company utilizes cash and the investee company’s ability to obtain additional private financing to fulfill its stated business plan, the need for changes to the investee company’s existing business model due to changing business environments and its ability to successfully implement necessary changes, and comparable valuations. If an investment is determined to be impaired, a determination is made as to whether such impairment is other-than-temporary.
Fair Value of Financial Instruments
The fair value of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, restricted cash, accounts payable and accrued liabilities, approximate cost because of their short maturities. The fair value of the Company’s investments and marketable equity securities is primarily determined using quoted market prices for those securities or similar financial instruments. The approximate fair value of the Company’s Senior Secured Credit Facility is based on broker trading prices. The fair value of the Company’s convertible subordinated debt is determined using the high and low prices on the market for the convertible debt (see Note 9, “Borrowings,” of the Notes to Consolidated Financial Statements).
Derivative Financial Instruments
In the normal course of business, the Company is exposed to fluctuations in interest rates and the exchange rates associated with foreign currencies. The derivatives entered into by the Company qualify for and are designated as foreign currency cash flow hedges.
The derivatives are recognized on the Consolidated Balance Sheets at their respective fair values. Changes in fair values of outstanding cash flow hedges that are highly effective are recorded in accumulated other
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
comprehensive loss until earnings are affected by the variability of cash flows of the underlying hedged transaction. In most cases, amounts recorded in accumulated other comprehensive loss will be released to earnings at maturity of the related derivative. The recognition of effective hedge results offsets the gains or losses on the underlying exposure. Cash flows from derivative transactions are classified according to the nature of the risk being hedged.
The Company formally documents all relationships between hedging instruments and hedged items, as well as the risk-management objective and strategy for undertaking hedge transactions. This documentation includes linking all derivatives either to specific assets and liabilities on the consolidated balance sheets or specific firm commitments or forecasted transactions. The Company also formally assesses both at the hedge’s inception and on an ongoing basis whether the derivatives used in hedging transactions have been highly effective in offsetting changes in the cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. When it is determined that a derivative is not, or has ceased to be, highly effective as a hedge, the Company discontinues hedge accounting prospectively, as discussed below.
The Company discontinues hedge accounting prospectively when (i) the derivative is no longer highly effective in offsetting changes in the cash flows of a hedged item (including hedged items such as firm commitments or forecasted transactions); (ii) the derivative expires or is sold, terminated or exercised; (iii) it is no longer probable that the forecasted transaction will occur; or (iv) management determines that designating the derivative as a hedging instrument is no longer appropriate.
When the Company discontinues hedge accounting, but it continues to be probable that the forecasted transaction will occur in the originally expected period, the gain or loss on the derivative remains in accumulated other comprehensive loss and is reclassified into earnings when the forecasted transaction affects earnings. However, if it is no longer probable that a forecasted transaction will occur by the end of the originally specified time period or within an additional two-month period of time thereafter, the gain or loss that was in accumulated other comprehensive loss will be recognized immediately in earnings. In all situations in which hedge accounting is discontinued and the derivative remains outstanding, the Company will carry the derivative at its fair value on the Consolidated Balance Sheet until maturity and will recognize future changes in the fair value in current period earnings. Any hedge ineffectiveness is recorded in current period earnings within “Interest and other loss, net.” Effectiveness is assessed based on the comparison of current forward rates to the rates established on the Company’s hedges.
Inventories
Inventories are stated at the lower of cost or market, using the first-in, first-out method. Inventory costs include material, labor and overhead. The Company records inventory write-downs based on excess and obsolete inventory determined primarily by future demand forecast. A portion of the Company’s inventory is located offsite at customers’ hubs, service depots and at contract manufacturers’ locations. Cash flows related to the sale of inventories are classified as cash flows from operating activities.
Property and Equipment
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. An estimated useful life of 4 years is used for furniture and fixtures and an estimated useful life of 4 years is used for computer equipment and software, except for the Company’s enterprise-wide, integrated business information system which is depreciated over 5 to 7 years. Estimated useful lives of up to 4 years are used for engineering and other equipment and an estimated useful life of 30 years is used for buildings. Leasehold improvements are amortized using the straight-line method over the shorter of the useful life of the asset or the remaining term of the lease.
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Brocade evaluates long-lived assets, such as property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable in accordance with ASC 360-10 Property, Plant and Equipment. Brocade assesses the fair value of the assets based on the undiscounted future cash flow the assets are expected to generate and recognizes an impairment loss when estimated undiscounted future cash flow expected to result from the use of the asset plus net proceeds expected to result from the disposition of the asset, if any, are less than the carrying value of the asset. When Brocade identifies an impairment, Brocade reduces the carrying amount of the asset to its estimated fair value based on a discounted cash flow approach or, when available and appropriate, to comparable market values.
Accrued Employee Compensation
Accrued employee compensation consists of accrued wages, commissions, bonuses, payroll taxes, vacation, payroll deductions for the Company’s employee stock purchase plan and other employee benefit payroll deductions.
Goodwill and Intangible Assets
The Company capitalizes goodwill at cost and evaluates goodwill on an annual basis during its second fiscal quarter or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment loss is recognized to the extent that the carrying amount of goodwill exceeds the asset’s implied fair value. Events which might indicate impairment include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on the Company’s customer base, material negative changes in relationships with significant customers, and/or a significant decline in the Company’s stock price for a sustained period.
Intangible assets are carried at cost less accumulated amortization. Amortization is recognized over the estimated useful life of the respective asset. The Company evaluates intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Examples of such events or circumstances include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of acquired assets or the strategy for the Company’s business, significant negative industry or economic trends, and/or a significant decline in the Company’s stock price for a sustained period. Impairment is recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analyses. For additional discussion, see Note 4, “Goodwill and Intangible Assets,” of the Notes to Consolidated Financial Statements.
Concentrations
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents, short-term investments and accounts receivable. Cash, cash equivalents and short-term investments are primarily maintained at five major financial institutions in the United States. Deposits held with banks may be redeemed upon demand and may exceed the amount of insurance provided on such deposits. The Company principally invests in United States government and government agency debt securities, and corporate bonds and notes, and limits the amount of credit exposure to any single entity.
A majority of the Company’s accounts receivable balance is derived from sales to OEM partners in the computer storage and server industry. As of October 31, 2009, two customers accounted for 16% and 11%, respectively, of total accounts receivable. As of October 25, 2008, three customers accounted for 30%, 17% and
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
14%, respectively, of total accounts receivable. The Company performs ongoing credit evaluations of its customers and generally does not require collateral on accounts receivable balances. The Company has established reserves for credit losses, sales allowances, and other allowances. While the Company has not experienced material credit losses in any of the periods presented, there can be no assurance that the Company will not experience material credit losses in the future, particularly in light of the current economic environment.
For the years ended October 31, 2009, October 25, 2008 and October 27, 2007, the same three customers each represented 10% or more of our total net revenues for a combined total of 48% (EMC with 18%, HP with 13% and IBM with 17%), 65% (EMC with 25%, HP with 18% and IBM with 22%) and 68% (EMC with 24%, HP with 22% and IBM with 22%), respectively. The Company’s future success depends upon the buying patterns of significant customers, such as companies within the financial services, education and health sectors, the U.S. government or individual agencies within the U.S. government, their response to current and future IT investment trends and the continued demand by such customers for the Company’s products. Delays in or a reduction in IT spending, domestically and/or internationally, could harm the Company’s business, results of operations and financial condition in a number of ways, including longer sales cycles, increased inventory provisions, increased production costs, lowered prices for Brocade’s products and reduced sales volumes. In addition, the loss of any one significant OEM partner, or a decrease in the level of sales to any one significant OEM partner, or unsuccessful quarterly negotiation on key terms, conditions or timing of purchase orders placed during a quarter, would likely cause serious harm to Brocade’s business and financial results.
The Company currently relies on single and limited sources for multiple key components used in the manufacture of its products. Additionally, the Company relies on multiple contract manufacturers for the production of its products. The inability of any single or limited source supplier to fulfill supply, or the inability of a contract manufacturer to fulfill production requirements, could have an adverse effect on the Company’s future operating results. Further, if the Company’s suppliers face challenges in obtaining credit or otherwise for operating their businesses, they may become unable to continue to offer the materials the Company uses to manufacture its products.
The Company’s business is concentrated in the networking industry, which from time to time has been impacted by unfavorable economic conditions and reduced information technology (“IT”) spending rates. Accordingly, the Company’s future success depends upon the buying patterns of customers in the networking industry, their response to current and future IT investment trends and the continued demand by such customers for the Company’s products. The Company’s future success, in part, will depend upon its ability to enhance its existing products and to develop and introduce, on a timely basis, new cost-effective products and features that keep pace with technological developments and emerging industry standards.
Revenue Recognition
Product revenue. Certain of the Company’s products are integrated with software that is essential to the functionality of the equipment. Additionally, the Company provides unspecified software upgrades and enhancements related to the equipment through its maintenance contracts for most of its products. Product revenue is generally recognized when all of the following criteria have been met:
•
Persuasive evidence of an arrangement exists;
•
Delivery has occurred;
•
The fee is fixed or determinable; and
•
Collectability is reasonably assured or collection is probable.
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
For newly introduced products, many of the Company’s large OEM customers require a product qualification period during which the Company’s products are tested and approved by the OEM customers for sale to their customers. Revenue recognition and related cost are deferred for shipments to new OEM customers and for shipments of newly introduced products to existing OEM customers until satisfactory evidence of completion of the product qualification has been received from the OEM customer. In addition, revenue from sales to the Company’s Storage Area Network (“SAN”) master reseller customers is recognized in the same period in which the product is actually sold by the master reseller (sell-through) and revenue from sales to the Company’s Ethernet master reseller customers is recognized in the same period in which the product is sold to the master reseller customers (sell-in).
The Company reduces revenue for estimated sales allowances at the time of shipment and sales programs at the later of revenue recognition or communication of the commitment for sales incentives. Sales allowances and sales programs are estimated based on historical sales returns, approved sales programs versus claims under such sales programs, current trends and the Company’s expectations regarding future experience. In addition, the Company maintains an allowance for doubtful accounts, which is also accounted for as a reduction in revenue. The Company establishes the allowance for doubtful accounts to ensure accounts receivables are not overstated due to uncollectability. The Company maintains bad debt reserves based upon the analysis of accounts receivable, historical collection patterns, customer concentrations, customer creditworthiness, current economic trends, changes in customer payment terms and practices, and customer communication. The Company records a specific reserve for individual accounts when it becomes aware of a customer’s likely inability to meet its financial obligations, such as in the case of bankruptcy filings or deterioration in the customer’s operating results or financial position. If circumstances related to customers change, the Company would further adjust estimates of the recoverability of receivables.
Multiple-element arrangements. The Company’s multiple-element product offerings include networking hardware and software products and support. The Company also sells certain software products and support services separately. For certain of the Company’s products, software is generally essential to the functionality of its hardware products. The Company allocates revenue to each element in a multiple-element arrangement based upon vendor-specific objective evidence (“VSOE”) of the fair value of the element, or if VSOE is not available for the delivered element, by application of the residual method. In the application of the residual method, the Company allocates revenue to the undelivered elements based on VSOE of fair value for those elements and allocates the residual revenue to the delivered elements. VSOE of the fair value for an element is based upon the price charged when the element is sold separately. Revenue allocated to each element is then recognized when the basic revenue recognition criteria is met for each element. For sales of products that contain multiple elements and where software is incidental, the Company determines the separate units of accounting that exist within the arrangement. If more than one unit of accounting exists, the arrangement consideration is allocated to each unit of accounting using the residual fair value method. Revenue is recognized for each unit of accounting when all the revenue recognition criteria has been met for that unit of accounting.
Services revenue. Services revenue consists of training and maintenance arrangements, including PCS, separately priced extended warranties and other professional services. PCS services are offered under renewable, annual fee-based contracts or as part of multiple-element arrangements, and typically include telephone support and upgrades and enhancements to the Company’s operating system software. Revenue related to PCS elements is deferred and recognized ratably over the contractual period. PCS contracts are typically one to three years in length.
Separately priced extended warranties are offered under renewable, fee-based contracts which provide customers with hardware repair and replacement parts, access to technical assistance, and unspecified software updates and upgrades on a when-and-if available basis. Revenue from separately priced extended warranties
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
contracts is deferred and recognized ratably over the contractual support period. Separately priced extended warranties contracts are typically one to five years in length.
Professional services are offered under hourly or fixed fee-based contracts or as part of multiple-element arrangements. Professional services revenue is recognized as services are performed. Training revenue is recognized upon completion of the training.
Warranty Expense
The Company provides standard warranties on its products ranging from one year to limited lifetime warranties. Estimated future warranty costs are accrued at the time of shipment and charged to cost of revenues based upon historical experience, current trends and the Company’s expectations regarding future experience.
Foreign Currency
The financial statements of the Company’s international subsidiaries have been translated into U.S. dollars. Assets and liabilities are translated into U.S. dollars at period-end exchange rates, with the exception of nonmonetary assets. Income and expenses are translated into U.S. dollars at the average exchange rates during the period. The resulting translation adjustments are included in the Company’s Consolidated Balance Sheets in the stockholders’ equity section as a component of accumulated other comprehensive loss.
Software Development Costs
Eligible software development costs are capitalized upon the establishment of technological feasibility, which is defined as being equivalent to completion of a beta-phase working prototype in which there is no remaining risk relating to the development. Total eligible software development costs have not been material to date.
Costs related to internally developed software and software purchased for internal use are capitalized. During the year ended October 28, 2000, the Company purchased an enterprise-wide, integrated business information system. Subsequently, the business information system was upgraded during fiscal years 2006 and 2007. As of October 31, 2009 and October 25, 2008, a net book value of $5.4 million and $7.5 million, respectively, related to the purchase and subsequent implementation and upgrade of this system was included in “Property and equipment, net.” These costs are being depreciated over the estimated useful lives of five to seven years.
Advertising Costs
The Company expenses all advertising costs as incurred. Advertising costs were $5.9 million and $8.4 million for the years ended October 31, 2009 and October 25, 2008, respectively, and were not significant for the year ended October 27, 2007.
Capitalized Interest Costs
Interest costs related to major construction projects, specifically the Company campus project, are capitalized until the asset is ready for service (see Note 10, “Commitments and Contingencies,” of the Notes to Consolidated Financial Statements). Capitalized interest is calculated by multiplying the weighted-average interest rate on the Senior Secured Credit Facility and convertible debt by the qualifying costs. Interest
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capitalized may not exceed gross interest expense for the period. As the qualifying asset is moved to the depreciation and amortization pool, the related capitalized interest is also transferred and is amortized over the useful life of the related asset. Interest costs of $9.1 million and $1.4 million were capitalized for the years ended October 31, 2009 and October 25, 2008, respectively. No interest costs were capitalized for the year ended October 27, 2007.
Income Taxes
The Company accounts for income taxes under the assets and liabilities method. Under this method, the Company recognizes income tax expense for the amount of taxes payable or refundable for the current year. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts, along with net operating loss carryforwards and credit carryforwards. A valuation allowance is recognized to the extent that it is more likely than not that the tax benefits will not be realized. For additional discussion, see Note 14, “Income Taxes,” of the Notes to Consolidated Financial Statements.
The Company adopted the provisions of ASC 740-10 Income Taxes (“ASC 740-10”), effective at the beginning of fiscal year 2008. ASC 740-10 prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Recognition of a tax position is determined when it is more likely than not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes. Upon its adoption of ASC 740-10, the Company applied the provisions of ASC 740-10 to all income tax positions. The cumulative effect of applying the provisions of ASC 740-10 in the amount of $3.1 million has been reported as an adjustment to the opening balance of accumulated deficit on the Company’s Consolidated Balance Sheet as of the beginning of fiscal year 2008.
Computation of Net Income (Loss) per Share
Basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the period, less shares subject to repurchase. Diluted net income per share is computed using the weighted-average number of common shares outstanding and potentially dilutive common shares outstanding during the period that have a dilutive effect on earnings per share. Potentially dilutive common shares result from the assumed exercise of outstanding stock options, assumed vesting of outstanding restricted stock units and awards, assumed issuance of stock under the employee stock purchase plan using the treasury stock method, and the assumed conversion of outstanding convertible subordinated debt using the if-converted method. In a net loss position, diluted net loss per share is computed using only the weighted-average number of common shares outstanding during the period, less shares subject to repurchase, as any additional common shares would be antidilutive.
Stock-Based Compensation
The Company accounts for employee equity awards under the fair value method. Accordingly, the Company measures stock-based compensation at the grant date based on the fair value of the award. Compensation cost associated with stock-based awards and other forms of equity compensation recognized beginning in the first quarter of fiscal year 2006 includes (i) amortization related to the remaining unvested portion of stock-based awards granted prior to October 30, 2005; and (ii) amortization related to stock options and restricted stock granted subsequent to October 30, 2005. In addition, the Company records stock-based compensation expense over the twenty-four month offering period in connection with shares issued under its employee stock purchase
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plan. The compensation expense for stock-based awards is reduced by an estimate for forfeitures and is recognized over the expected term of the award under a graded vesting method. For additional discussion, see Note 13, “Stock-Based Compensation,” of the Notes to Consolidated Financial Statements.
The Company accounts for the tax effects of share-based payment awards using the alternative transition method, which includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC Pool”) related to the tax effects of employee stock-based compensation and to determine the subsequent impact on the APIC Pool and consolidated statement of cash flows of the tax effects of employee stock-based compensation awards.
Use of Estimates in Preparation of Consolidated Financial Statements
The preparation of consolidated financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make estimates and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. Estimates are used for, but not limited to sales allowances and programs, bad debts, stock-based compensation, allocation of purchase price allocations, warranty obligations, excess inventory and purchase commitments, restructuring costs, facilities lease losses, impairment of goodwill and intangible assets, litigation, income taxes and investments. Actual results may differ materially from these estimates.
Recent Accounting Pronouncements
In December 2007, the FASB issued ASC 805 Business Combinations (“ASC 805”). ASC 805 requires the acquirer in a business combination to recognize assets and liabilities assumed at their fair values and to recognize acquisition-related costs separately from the acquisition. ASC 805 will be effective for the Company in fiscal year 2010, with early adoption prohibited. The Company expects the implementation of ASC 805 will have an impact on its financial position and results of operations, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acquisitions the Company consummates after the effective date of November 1, 2009.
In May 2008, the FASB issued ASC 470-20 Debt (“ASC 470-20”). ASC 470-20 requires issuers of convertible debt instruments that may be settled in cash upon conversion to account separately for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. ASC 470-20 will be adopted by the Company in the first quarter of fiscal year 2010. The adoption of ASC 470-20 is expected to result in a decrease in the Company’s convertible subordinated debt of approximately $2.6 million and an increase in the Company’s stockholders’ equity of approximately $2.6 million as of the beginning of the first quarter of fiscal year 2010. In addition, the adoption of ASC 470-20 is expected to result in an increase in the Company’s interest expense of approximately $2.8 million in the first quarter of fiscal year 2010. Prior period consolidated statements of operations will be adjusted for comparability purposes to reflect the increase in interest expense of approximately $2.5 million. The Company does not expect the adoption of ASC 470-20 to materially affect the amount of capitalized interest. The Company is currently assessing the impact that ASC 470-20 may have on deferred tax balances and therefore, all amounts presented above do not take into account effects of deferred taxes where applicable.
In June 2008, the FASB issued ASC 815-40 Derivatives and Hedging (“ASC 815-40”). ASC 815-40 provides guidance on determining whether an equity-linked financial instrument, or embedded feature, is indexed to an entity’s own stock. ASC 815-40 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years, and will be adopted by the Company in the
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first quarter of fiscal year 2010. The Company has not yet adopted ASC 815-40, but it is currently assessing the impact that ASC 815-40 may have on its financial position, results of operations, and cash flows.
In November 2008, the FASB ratified ASC 350-30 Intangibles-Goodwill and Other (“ASC 350-30”). ASC 350-30 applies to defensive intangible assets, which are acquired intangible assets that the acquirer does not intend to actively use but intends to hold to prevent its competitors from obtaining access to them. As these assets are separately identifiable, ASC 350-30 requires an acquiring entity to account for defensive intangible assets as a separate unit of accounting. Defensive intangible assets must be recognized at fair value in accordance with SFAS 141R and SFAS 157. ASC 350-30 will be adopted by the Company in the first quarter of fiscal year 2010. The Company expects ASC 350-30 will have an impact on its consolidated financial statements when effective, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the intangible assets purchased after the effective date of November 1, 2009.
In September 2009, the FASB issued ASC 820-10 Measuring Liabilities at Fair Values (“ASC 820-10”). ASC 820-10 provides additional guidance on how companies should measure liabilities at fair value. Specifically, the fair value of a liability is not adjusted to reflect the impact of contractual restrictions that prevent its transfer. ASC 820-10 will be adopted by the Company in the first quarter of fiscal year 2010. The Company is currently evaluating the impact of ASC 820-10, but does not expect the adoption to have a material impact on its financial position, results of operations, and cash flows.
In October 2009, the FASB issued ASC 605-25 Revenue Recognition with Multiple Deliverables (“ASC 605-25”). ASC 605-25 establishes a selling price hierarchy for determining the selling price of a deliverable, eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. ASC 605-25 is effective for financial statements issued for fiscal years beginning on or after June 15, 2010, and interim periods within those fiscal years. Early adoption is permissible and the Company plans to adopt the provisions of ASC 605-25 in the first quarter of fiscal year 2010. The Company does not expect the adoption of ASC 605-25 to have a material impact on its financial position, results of operations, and cash flows.
In October 2009, the FASB issued ASC 985-605 Certain Revenue Arrangements that Include Software Elements (“ASC 985-605”). ASC 985-605 provides additional guidance on how to determine which software, if any, relating to the tangible product would be excluded from the scope of the software revenue guidance in ASC 985-605. ASC 985-605 is effective for financial statements issued for fiscal years beginning on or after June 15, 2010, and interim periods within those fiscal years. Early adoption is permissible and the Company plans to adopt the provisions of ASC 985-605 in the first quarter of fiscal year 2010. The Company does not expect the adoption of ASC 985-605 to have a material impact on its financial position, results of operations, and cash flows.
3. Acquisitions
Foundry Networks, Inc.
On December 18, 2008, the Company completed its acquisition of Foundry in accordance with the Agreement and Plan of Merger, which the Company entered into on July 21, 2008, as well as with Amendment No. 1 to the Agreement and Plan of Merger, which the Company entered into on November 7, 2008 (as amended, the “Foundry Merger Agreement”). As a result of the merger, Foundry is now a wholly-owned subsidiary of the Company.
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The Company recorded the acquisition using the purchase method of accounting and, accordingly, has included the results of operations of Foundry in the accompanying Consolidated Statements of Operations from December 18, 2008, the date the acquisition was completed.
Pursuant to the terms of the Foundry Merger Agreement, each issued and outstanding share of Foundry common stock, other than the shares held by the Company, was canceled and converted into the right to receive $16.50 in cash, without interest. Approximately 137,061,501 shares of Foundry common stock were converted into the right to receive approximately $2.26 billion, which excluded 14,000,000 shares of Foundry common stock held by Brocade that were canceled upon effectiveness of the merger without consideration. In addition, upon the effectiveness of the merger, Brocade: (i) terminated certain outstanding unvested stock options; (ii) in certain circumstances, terminated Foundry’s outstanding vested options and granted, in lieu thereof, a right to be issued shares of fully-vested Brocade common stock upon settlement thereof based on the excess of the per-share merger consideration set forth in the Foundry Merger Agreement over the applicable exercise price of such options; and (iii) (a) assumed certain outstanding equity awards or (b) replaced certain of Foundry’s outstanding equity awards with reasonably equivalent Brocade equity awards based on a conversion ratio derived from the per-share merger consideration as set forth in the Foundry Merger Agreement, in certain cases offsetting the number of shares (on a post-conversion basis) against Brocade’s existing share reserve under its stockholder-approved equity incentive plans.
The total purchase price of the Foundry acquisition was $2.8 billion and is comprised of the following (in thousands):
(1) This amount includes $248.4 million paid by the Company to acquire 14.0 million shares of Foundry common stock in the open market before the consummation of the acquisition, net of $3.5 million in dividends received.
In connection with this acquisition, the Company assumed options to purchase approximately 18.3 million shares of Foundry common stock which became exercisable for approximately 93.5 million shares of Brocade’s common stock at a weighted-average exercise price of approximately $3.23 per share. The Company also assumed approximately 6.8 million of Foundry restricted stock units which were converted into approximately 34.7 million of Brocade’s restricted stock units with a weighted-average grant date fair value of $3.52.
Direct transaction costs include investment banking, legal and accounting fees and other external costs directly related to the acquisition.
The Company allocated the total purchase consideration to the net assets acquired and liabilities assumed, including identifiable intangible assets, based on their respective fair values at the acquisition date, resulting in initial goodwill of approximately $1,475.6 million, which is not deductible for income tax purposes. Goodwill represents the excess of the purchase price over the fair value of the underlying acquired net tangible and intangible assets. The factors that contributed to the recognition of goodwill included securing buyer-specific synergies that increase revenue and profits and are not otherwise available to a marketplace participant, acquiring
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a talented workforce, and significant cost-saving opportunities. The allocation of the purchase price reflects various estimates and analyses.
The following table summarizes the final allocation of the purchase price based on the estimated fair values of the assets acquired and liabilities assumed (in thousands):
(1) In connection with the acquisition of Foundry, the Company recorded a $26.9 million in-process research and development (“IPR&D”) charge during the three months ended January 24, 2009.
During the year ended October 31, 2009, the Company determined it was appropriate to record certain adjustments to the fair value of assets and liabilities acquired from Foundry (see Note 4, “Goodwill and Intangible Assets,” of the Notes to Consolidated Financial Statements).
Of the total purchase price, approximately $392.3 million has been allocated to amortizable intangible assets acquired. The amortizable intangible assets are being amortized on a straight-line basis over their estimated useful lives as follows:
The following unaudited pro forma financial information for the twelve months ended October 31, 2009 and October 25, 2008 presents a summary of the results of operations of the Company assuming the acquisition of
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Foundry occurred at the beginning of each of the periods presented. The unaudited pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the merger had taken place at the beginning of each of the periods presented, nor is it indicative of future operating results:
(1) The unaudited pro forma financial results for the twelve months ended October 31, 2009 include Brocade’s historical results for the twelve months ended October 31, 2009, which include Foundry’s results subsequent to December 18, 2008, and Foundry’s historical results for the period October 26, 2008 to December 18, 2008, including goodwill and acquisition-related intangible assets impairment of $53.3 million, amortization for acquired intangible assets, elimination of IPR&D charge and acquisition-related fees, and related tax effects.
(2) The unaudited pro forma financial results for the twelve months ended October 25, 2008 include Brocade’s historical results for the twelve months ended October 25, 2008 and Foundry’s historical results for the three months ended December 31, 2007 and nine months ended September 30, 2008, including provision for class action lawsuit of $160.0 million, release of the valuation allowance of $174.4 million, amortization for acquired intangible assets, adjustment to interest expense, and related tax effects.
Strategic Business Systems, Inc.
On March 17, 2008, the Company completed its acquisition of Strategic Business Systems, Inc. (“SBS”), a privately held provider of IT professional services for medium-size and large enterprises in both the commercial and federal government sectors. This acquisition expanded the Company’s professional service offerings and was consistent with its goal of building an end-to-end services portfolio.
The results of operations of SBS are included in the accompanying Consolidated Statements of Operations from the date of the acquisition. The Company does not consider the acquisition of SBS to be material to its results of operations and is therefore not presenting pro forma financial information of operations for the fiscal year ended October 25, 2008 and October 27, 2007.
4. Goodwill and Intangible Assets
During the first quarter of fiscal year 2009, Brocade reorganized into four operating segments, of which two are individually reportable segments: Data Storage and Global Services; and two, Internet Protocol (“IP”) Layer 2-3 and IP Layer 4-7/Application Delivery Products (“IP Layer 4-7/ADP”), are combined into one reportable segment: Ethernet Products (see Note 15, “Segment Information,” of the Notes to Consolidated Financial Statements). Prior period allocation of goodwill activity by reportable segment has been conformed to the new measurements of segment financial reporting implemented in the first quarter of fiscal year 2009.
Goodwill is generated as a result of business combinations. Brocade conducts a goodwill impairment analysis annually and as necessary if events or changes in facts and circumstances indicate that the fair value of
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the reporting unit may be less than its carrying amount. Consistent with prior years, the Company performed its annual goodwill impairment test using measurement data as of the first day of the second fiscal quarter.
The Company conducts a two-step approach in testing goodwill for impairment for each reporting unit, which the Company has determined to be at the operating unit level. The Company’s reporting units are determined by the components of their operating segments that constitute a business for which both (i) discrete financial information is available and (ii) segment management regularly reviews the operating results of that component. Data Storage, IP Layer 2-3 and Global Services are individual reporting units, while IP Layer 4-7/ADP includes two reporting units, IP Layer 4-7/ADP and Files.
The first step measures for impairment by applying fair value-based tests at the reporting unit level. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, then goodwill is not impaired and no further testing is performed. The second step, if necessary, measures the amount of impairment by applying fair value-based tests to individual assets and liabilities within each reporting unit. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, the Company records an impairment loss equal to the difference.
To determine the reporting unit’s fair values, the Company uses the income approach, the market approach, or a combination thereof. The income approach provides an estimate of fair value based on discounted expected future cash flows (“DCF”). Estimates and assumptions with respect to the determination of the fair value of the Company’s reporting units using the income approach include:
•
The Company’s operating forecasts;
•
Revenue growth rates; and
•
Risk-commensurate discount rates and costs of capital.
The Company’s estimates of revenues and costs are based on historical data, various internal estimates and a variety of external sources, and are developed by the Company’s regular long-range planning process.
The market approach provides an estimate of the fair value of the Company’s five reporting units using various price or market multiples applied to the reporting unit’s operating results and then applying an appropriate control premium. The control premium is determined by considering control premiums offered as part of the acquisition in both the Company’s segment and comparable market segments.
Determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions. As the Company’s market capitalization temporarily declined during fiscal year 2009 and as the technology sector volatility increased, the Company focused on methods that were more representative of a market participant’s view of fair value given the current market conditions. As a result, in fiscal year 2009, the Company relied primarily on the DCF method, using management projections for each reporting unit and risk-adjusted discount rates.
The Company determined based on its completion of the first step of the goodwill impairment test that no indicators of impairment existed for the Data Storage, IP Layer 2-3, IP Layer 4-7/ADP and Global Services reporting units. During the second quarter of fiscal year 2009, the Company made a decision to no longer offer its suite of Files products and concluded that the fair value of the Files reporting unit was less than its carrying amount. The fair value of the Files business was determined using comparable companies’ data. The Company conducted the second step of the goodwill impairment test and determined that all of the Files goodwill was impaired. Accordingly, the Company recorded a goodwill impairment charge of $45.8 million for the three
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months ended May 2, 2009. As of October 31, 2009, the Company noted no events and circumstances, except as discussed above, that could have an adverse impact on the fair value of the reporting units of the Company.
The following table summarizes the goodwill activity by reportable segment during the years ended October 31, 2009 and October 25, 2008 (in thousands):
(1) The goodwill adjustment of $136.3 million was primarily a result of recording deferred tax assets of acquired companies due to the valuation allowance release and the realization of deferred tax assets of acquired companies.
(2) The goodwill adjustment of $50.5 million was primarily a result of the realization of deferred tax assets and tax benefit of stock options exercised from acquired companies and includes $1.7 million of Foundry purchase accounting adjustments.
The Company records impairment losses on long-lived assets used in operations when indications of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amounts. If such assets are considered to be impaired, the impairment charge recognized is the amount by which the carrying amount of the assets exceeds the fair value of the assets. As a result of the impairment of the Files reporting unit, the Company performed an impairment analysis for long-lived Files assets, including its intangible assets. The analysis indicated that all of the intangible assets associated with the Files business are not recoverable. As a result, the Company recorded an acquisition-related intangible assets impairment charge associated with the Files business of $7.5 million during the second quarter of fiscal year 2009.
Intangible assets other than goodwill are amortized over the following estimated remaining useful lives, unless the Company has determined these lives to be indefinite. Intangible assets as of October 31, 2009 consisted of the following (in thousands, except for useful life):
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Intangible assets as of October 25, 2008 consisted of the following (in thousands):
For the year ended October 31, 2009, amortization expense related to intangible assets of $65.8 million was included in cost of revenues and $68.7 million was included in operating expenses in the Consolidated Statement of Operations. For the year ended October 25, 2008, amortization expense related to intangible assets of $37.4 million was included in cost of revenues and $31.5 million was included in operating expenses in the Consolidated Statement of Operations. For the year ended October 27, 2007, amortization expense related to intangible assets of $34.0 million was included in cost of revenues and $24.7 million was included in operating expenses in the Consolidated Statement of Operations.
The following table presents the estimated future amortization of intangible assets as of October 31, 2009 (in thousands):
5. Liabilities Associated with Facilities Lease Losses
During the year ended October 31, 2009, the Company recorded a purchase accounting adjustment of $3.2 million related to estimated facilities lease losses as a result of the acquisition of Foundry, net of expected sublease income. The Company reevaluates its estimates and assumptions on a quarterly basis and makes adjustments to the reserve balance if necessary.
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The following table summarizes the activity related to the facilities lease loss reserve, net of expected sublease income (in thousands):
Cash payments for facilities leases related to the above noted facilities lease losses will be paid over the respective lease terms through fiscal year 2017.
6. Balance Sheet Details
The following table provides details of selected balance sheet items (in thousands):
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(1) Depreciation expense was approximately $59.9 million, $49.8 million and $45.4 million for the years ended October 31, 2009, October 25, 2008 and October 27, 2007, respectively.
(2) In connection with the purchase of the property located in San Jose, California, the Company engaged a third party as development manager to manage the development and construction of improvements on the property, which is still in progress. Included in the Company campus as of October 31, 2009 and October 25, 2008 is $8.0 million that the Company has agreed to pay the developer on May 22, 2011 or earlier if Brocade decides to transfer any part of the Company campus project before such date.
(3) This liability is in connection with an agreement in principle reached on May 30, 2008 with the lead plaintiffs for the resolution of the Company’s federal securities class action litigation related to Brocade’s restatement of certain financial results due to stock-based compensation accounting issues. The amount was released from escrow after the Court granted final approval of the settlement on January 26, 2009.
7. Investments and Equity Securities
The following table summarizes the Company’s investments and equity securities (in thousands):
At October 31, 2009, the Company had no unrealized holding gains/losses on investments. At October 25, 2008, net unrealized holding losses on investments were $73.6 million. Net unrealized holding losses on investments are included in accumulated other comprehensive (income) loss in the accompanying Condensed Consolidated Balance Sheets.
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The following table provides the breakdown of the investments with unrealized losses as of October 31, 2009 and October 25, 2008 (in thousands):
As of October 25, 2008, the Company had $71.1 million in gross unrealized losses in connection with the 14.0 million shares of Foundry common stock held by Brocade. Effective upon the consummation of the merger with Foundry, the Company reversed the gross unrealized losses of $71.1 million and increased its investment in Foundry to its historical cost, which is reflected in the total purchase price of the acquisition. As such, the Company did not have any realized gains (losses) in connection with these marketable equity securities for the year ended October 31, 2009.
The remaining gross unrealized losses related to fixed income securities as of October 25, 2008 were due to changes in interest rates and the Company’s management determined these gross unrealized losses to be temporary in nature as of October 25, 2008. Substantially all of the Company’s fixed income securities are rated investment grade or better. The Company reviews its investments to identify and evaluate investments that have indications of potential impairment. Factors considered in determining whether a loss is other-than-temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.
8. Fair Value Measurements
Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and it considers assumptions that market participants would use when pricing the asset or liability. The Company applies fair value measurements for financial assets and financial liabilities and will apply such measurements for nonfinancial assets and nonfinancial liabilities at the beginning of fiscal year 2010.
The Company did not elect to measure any eligible financial instruments at fair value and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date.
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Fair Value Hierarchy
The Company utilizes a fair value hierarchy that maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. There are three levels of inputs that may be used to measure fair value:
Level 1
Level 1 applies to assets and liabilities for which there are quoted prices in active markets for identical assets or liabilities. Valuations are based on quoted prices that are readily and regularly available in an active market and do not entail a significant degree of judgment. Brocade’s assets utilizing Level 1 inputs include money market funds.
Level 2
Level 2 applies to assets and liabilities for which there are other than Level 1 observable inputs such as quoted prices for similar assets or liabilities in active markets, quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets), or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data. Brocade’s assets utilizing Level 2 inputs include corporate bonds and derivative receivables.
Level 2 instruments require more management judgment and subjectivity as compared to Level 1 instruments. For instance:
•
Determining which instruments are most similar to the instrument being priced requires management to identify a sample of similar securities based on the coupon rates, maturity, issuer, credit rating and instrument type, and subjectively select an individual security or multiple securities that are deemed most similar to the security being priced; and
•
Determining whether a market is considered active.
Level 3
Level 3 applies to assets and liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities. The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity. Brocade has no assets or liabilities utilizing Level 3 inputs.
Assets Measured at Fair Value on a Recurring Basis
Assets measured at fair value on a recurring basis as of October 31, 2009 were as follows (in thousands):
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The Company uses a midpoint of the highest bid and lowest offering obtained from market makers to value its corporate bonds. The Company uses observable market prices for comparable instruments to value its derivative receivables. During fiscal year 2009, the Company transferred $4.7 million of corporate bonds from assets utilizing Level 1 inputs to assets utilizing Level 2 inputs due to a decrease in quotable prices in an active market, as well as a less active market for the bonds.
9. Borrowings
Senior Secured Credit Facility
On October 7, 2008, the Company entered into a credit agreement with the following lenders, Bank of America, N.A., Morgan Stanley Senior Funding, Inc., HSBC Bank USA National Association and Keybank National Association. The credit agreement provides for (i) a five-year $1,100.0 million term loan facility and (ii) a five-year $125.0 million revolving credit facility, which includes a $25.0 million swing line loan subfacility and a $25.0 million letter of credit subfacility.
The net proceeds of the term loan facility were used to finance a portion of the Company’s acquisition of Foundry. In addition to the term loan facility, during the year ended October 31, 2009, the Company drew $14.1 million from the $125.0 million revolving credit facility to finance a small portion of the merger. The Company may draw additional proceeds from the revolving credit facility in the future for ongoing working capital and other general corporate purposes. The term loan facility and revolving credit facility are referred to together as the “Senior Secured Credit Facility.” As of October 31, 2009, $14.1 million was outstanding under the revolving credit facility. No amount was outstanding under the revolving credit facility as of October 25, 2008.
Loans under the Senior Secured Credit Facility bear interest, at the Company’s option, at a rate equal to either the London Interbank Offered Rate (“LIBOR rate”), plus an applicable margin equal to 4.0% per annum or the prime lending rate, plus an applicable margin equal to 3.0% per annum. The applicable margin with respect to revolving loans is subject to adjustment based on the Company’s consolidated senior secured leverage ratio, as defined in the credit agreement. The LIBOR rate floor is 3.0% per annum and the prime lending rate floor is 4.0% per annum, in each case, for the life of the Senior Secured Credit Facility. For the year ended October 31, 2009, the weighted-average interest rate on the term loan was 7.0%.
The proceeds of the term loan were deposited in a restricted securities account pending the closing of the merger and other release conditions, and are reported as long-term restricted cash on the Consolidated Balance Sheets as of October 25, 2008. On December 19, 2008, the proceeds of the term loan were released from the restricted securities account to fund the merger. As of October 31, 2009, the current portion of the liability associated with the term loan of $38.8 million, net of the debt discount of $10.3 million, is reported as “Current portion of long-term debt,” and the long-term portion of the liability associated with the term loan of $860.1 million, net of the debt discount of $24.7 million, is reported as “Long-term debt, net of current portion” on the Consolidated Balance Sheets. As of October 25, 2008, the current portion of the liability associated with the term loan of $43.6 million, net of the debt discount of $11.4 million, is reported as “Current portion of long-term debt,” and the long-term portion of the liability associated with the term loan of $1,011.4 million, net of the debt discount of $34.2 million, is reported as “Long-term debt, net of current portion” on the Condensed Consolidated Balance Sheets. As of October 31, 2009, the approximate fair value of the Company’s Senior Secured Credit Facility was 101% of the face value of the debt obligation, based on broker trading prices.
The Company is permitted to make voluntary prepayments at any time (without payment of a premium, other than in the case of a repricing transaction in respect of the term loan facility), and is required to make mandatory prepayments on the term loan (without payment of a premium) with (i) net cash proceeds from
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non-ordinary course asset sales (subject to reinvestment rights and other exceptions), (ii) net cash proceeds from issuances of debt (other than certain permitted debt), (iii) a percentage of 50% or 0% of Brocade’s excess cash flow, based on Brocade’s consolidated senior secured leverage ratio, beginning with the fiscal year ending October 31, 2009, and (iv) casualty proceeds and condemnation awards (subject to reinvestment rights and other exceptions). The Company is required to pay quarterly installments on the term loan equal to an aggregate annual amount of 5% of the original principal amount thereof in the first and second years, 10% in the third year, 20% in the fourth year and 60% in the fifth year, with any remaining balance payable on the final maturity date of the term loan. Upon a repricing of the term loan (including through a refinancing) that results in the weighted-average yield or applicable rate of such term loan immediately after such repricing to be lower than such yield or rate immediately prior to such repricing, a 2.0% premium is payable during the first year following the closing and a 1.0% premium is payable during the second year following the closing.
Debt fees totaling $28.7 million associated with the acquisition have been capitalized as deferred financing costs, with $7.3 million amortized as of October 31, 2009. As of October 31, 2009 and October 25, 2008, the short-term portion of the deferred financing costs was $6.6 million and $7.9 million, respectively, and is reported within “Prepaid expenses and other current assets” on the Consolidated Balance Sheets. As of October 31, 2009 and October 25, 2008, the long-term portion of the deferred financing costs was $14.8 million and $23.2 million, respectively, and is reported within “Other assets” on the Consolidated Balance Sheets. All debt fees capitalized are related to the term loan facility. The deferred financing costs are being amortized using the effective interest method over the five-year term of the debt. During the year ended October 31, 2009, the Company paid $166.0 million towards the principal of the term loan, $112.5 million of which were voluntary prepayments.
The obligations of the Company and its subsidiary guarantors under the Senior Secured Credit Facility and the related guarantees thereunder are secured, subject to customary permitted liens and other agreed upon exceptions, by (i) a first priority pledge of all of the equity interests of each of the Company’s direct and indirect subsidiaries and (ii) a perfected first priority interest in and mortgages on all tangible and intangible assets of the Company and each subsidiary guarantor, except, in the case of a foreign subsidiary, to the extent such pledge would be prohibited by applicable law or would result in materially adverse tax consequences (limited, in the case of a first-tier foreign subsidiary, to 65% of the voting stock and 100% of non-voting stock of such first-tier foreign subsidiary). In addition, the term loan has not been registered with the SEC as of October 31, 2009.
The credit agreement contains customary representations and warranties and customary affirmative and negative covenants applicable to the Company and its subsidiaries, including, among other things, restrictions on liens, indebtedness, investments, fundamental changes, dispositions, capital expenditures, prepayment of other indebtedness, redemption or repurchase of subordinated indebtedness, dividends and other distributions. The credit agreement contains financial covenants that require the Company to maintain a minimum consolidated fixed charge coverage ratio, a maximum consolidated leverage ratio and a maximum consolidated senior secured leverage ratio, each as defined in the credit agreement. The credit agreement also includes customary events of default, including cross-defaults on the Company’s material indebtedness and change of control. The Company was in compliance with all applicable covenants as of October 31, 2009. The financial and other covenants agreed to by Brocade in connection with such indebtedness and the increased indebtedness and higher debt-to-equity ratio of Brocade in comparison to that of Brocade on a recent historical basis will have the effect, among other things, of reducing Brocade’s flexibility to respond to changing business and economic conditions and increasing borrowing costs, and may adversely affect Brocade’s operations and financial results. In addition, the Company’s failure to comply with these covenants could result in a default under the Senior Secured Credit Facility and its other debt, which could permit the holders to accelerate such debt or demand payment in exchange for a waiver of such default. If any of the Company’s debt is accelerated, the Company may not have sufficient funds available to repay such debt.
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Convertible Subordinated Debt
On January 29, 2007, effective upon the consummation of the merger with McDATA Corporation (“McDATA”), the Company fully and unconditionally guaranteed and became a co-obligor on the 2.25% Notes of McDATA (“2.25% Notes”). The 2.25% Notes were convertible into McDATA’s Class A common stock at a conversion rate of 93.3986 shares per $1,000 principal amount of notes (aggregate of approximately 16.1 million shares) at any time prior to February 15, 2010, subject to adjustments. Pursuant to Brocade’s merger agreement with McDATA, at the effective time of the merger, each outstanding share of McDATA’s Class A common stock, $0.01 par value per share, was converted into the right to receive 0.75 of a share of Brocade’s common stock, $0.001 par value per share, together with cash in lieu of fractional shares. As a result, an approximate aggregate of 12.1 million shares of Brocade’s common stock are issuable upon conversion of the 2.25% Notes at any time prior to February 15, 2010, subject to adjustments.
The gross principal amount of the outstanding convertible subordinated debt is $172.5 million. As of October 31, 2009, the carrying value of the convertible subordinated debt was $171.8 million, net of $0.7 million debt discount.
As of October 31, 2009, the approximate aggregate fair value of the outstanding convertible subordinated debt was $172.1 million. The Company estimated the fair value of the outstanding convertible subordinated debt as of October 31, 2009 by using the high and low prices per $100 of the Company’s 2.25% Notes as of the last day of trading for the fourth fiscal 2009 quarter, which were both $99.80.
Concurrent with the issuance of the 2.25% Notes, McDATA entered into share option transactions using approximately $20.5 million of net proceeds. As part of these share option transactions, McDATA purchased options that cover approximately 12.1 million shares of common stock, at a strike price of $14.28. McDATA also sold options that cover approximately 12.7 million shares of common stock, at a strike price of $20.11. The net cost of the share option transactions was recorded against additional paid-in capital.
10. Commitments and Contingencies
Operating and Capital Leases
The Company leases certain facilities and certain equipment under various operating and capital lease agreements expiring through November 2019. In connection with its facilities lease agreements, the Company has signed unconditional, irrevocable letters of credit totaling $1.4 million as security for the leases. In addition, in connection with the purchase of a previously leased building located near its San Jose headquarters, the Company issued a $1.0 million guarantee as part of the purchase agreements.
Total rent expense was approximately $30.2 million in fiscal year 2009, $20.0 million in fiscal year 2008 and $19.8 million in fiscal year 2007, net of releases in facilities lease loss reserve, as well as sublease income, of $13.9 million, $9.6 million and $8.2 million, respectively. Future minimum lease payments under all non-cancelable operating leases as of October 31, 2009 total $50.1 million, net of contractual sublease income of $21.8 million. In addition to base rent, many of the facilities lease agreements require that the Company pay a proportional share of the respective facilities’ operating expenses.
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Future minimum lease payments under all non-cancelable operating leases as of October 31, 2009, excluding the contractual sublease income stated above, are as follows (in thousands):
Company Campus Contractual Obligations. On May 23, 2008, Brocade purchased property located in San Jose, California, which consists of three unimproved building parcels that are entitled for approximately 562,000 square feet of space in three buildings. The total purchase price for the property was $50.9 million. In connection with the purchase, Brocade also engaged a third party as development manager to manage the development and construction of improvements on the property. Brocade’s obligation for development and construction of three buildings and a parking garage on the purchased property is approximately $173.0 million (in addition to the purchase price for the property), payable in various installments through approximately June 2010. Brocade plans to develop the land through June 2010 and finance the purchase and the development through operating cash flows. In connection with the purchase, Brocade also obtained a four-year option, exercisable at its sole discretion through May 22, 2012, to purchase a fourth unimproved approximate four acre parcel for a fixed price of approximately $26.0 million.
Product Warranties
The Company’s accrued liability for estimated future warranty costs is included in other accrued liabilities in the accompanying Consolidated Balance Sheets. The following table summarizes the activity related to the Company’s accrued liability for estimated future warranty costs during the years ended October 31, 2009 and October 25, 2008 (in thousands):
(1) Included in the $4.5 million in liabilities accrued for warranties issued during the year ended October 31, 2009 is $1.9 million in warranty liabilities resulting from the Foundry acquisition.
In addition, the Company has standard indemnification clauses contained within its various customer contracts. As such, the Company indemnifies the parties to whom it sells its products with respect to the Company’s product infringing upon any patents, trademarks, copyrights, or trade secrets, as well as against
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bodily injury or damage to real or tangible personal property caused by a defective Company product. As of October 31, 2009, there have been no known material events or circumstances that have resulted in a customer contract-related indemnification liability to the Company.
Manufacturing and Purchase Commitments
Brocade has manufacturing arrangements with Hon Hai Precision Industry Co., Ltd., Sanmina-SCI Corporation, Flextronics International Ltd., Celestica, Inc., Asteel Flash Group, Accton Wireless Broadband Corporation and Quanta Computer Incorporated (collectively, the “CMs”) under which Brocade provides twelve-month product forecasts and places purchase orders in advance of the scheduled delivery of products to Brocade’s customers. The required lead-time for placing orders with the CMs depends on the specific product. The CMs invoice Brocade based on prices and payment terms mutually agreed upon and set forth in purchase orders it issues to them. Although the purchase orders Brocade places with its CMs are cancelable, the terms of the agreements require Brocade to purchase all inventory components not returnable, usable by, or sold to other customers of the CMs.
As of October 31, 2009, the Company’s aggregate commitment to the CMs for inventory components used in the manufacture of Brocade products was $263.9 million, which the Company expects to utilize during future normal ongoing operations, net of a purchase commitments reserve of $17.0 million. The Company’s purchase commitments reserve reflects the Company’s estimate of purchase commitments it does not expect to consume in normal operations within the next twelve months.
Income Taxes
The Company is subject to several ongoing audits. For additional discussion, see Note 14, “Income Taxes,” of the Notes to Consolidated Financial Statements. The Company believes it has adequate reserves for all open tax years.
Legal Proceedings
Initial Public Offering Litigation
On July 20, 2001, the first of a number of putative class actions for violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against Brocade, certain of its officers and directors, and certain of the underwriters for Brocade’s initial public offering (“IPO”) of securities. A consolidated amended class action captioned, In re Brocade Communications Systems, Inc. Initial Public Offering Securities Litigation, No. 01 Civ. 6613, was filed on April 19, 2002. The complaint generally alleges that various underwriters engaged in improper and undisclosed activities related to the allocation of shares in Brocade’s initial public offering and seeks unspecified damages for claims under the Exchange Act on behalf of a purported class of purchasers of common stock from May 24, 1999 to December 6, 2000. The lawsuit against Brocade was coordinated for pretrial proceedings with a number of other pending litigations challenging underwriter practices in over 300 cases as In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS), including actions against McDATA Corporation, Inrange Technologies Corporation (“Inrange”) (which was first acquired by Computer Network Technology Corporation (“CNT”) and subsequently acquired by McDATA as part of the CNT acquisition), and Foundry (collectively, the “Brocade Entities”), and certain of each entity’s respective officers and directors, and initial public offering underwriters.
The parties have reached a global settlement of the coordinated litigation, under which the insurers will pay the full amount of settlement share allocated to the Brocade Entities, and the Brocade Entities will bear no financial liability. On October 5, 2009, the Court granted final approval of the settlement. Certain objectors have indicated their intent to appeal once judgments have been entered.
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Securities Litigation
Beginning on or about May 24, 2005, several derivative actions were filed against certain of Brocade’s current and former officers and directors relating to Brocade’s historical stock option practices. These actions were filed in the United States District Court for the Northern District of California (“Federal Court”) and in the California Superior Court in Santa Clara County (“State Court”). The derivative actions pending in Federal Court were consolidated under the caption In re Brocade Communications Systems, Inc. Derivative Litigation, Case No. C 05-02233 CRB (the “Federal Action”), and the derivative actions pending in State Court were also consolidated under the caption In re Brocade Communications Systems, Inc. Derivative Litigation, Case No. 1:05cv041683 (the “State Action”). An additional, unconsolidated derivative action also was filed in the Federal Court in April 2008.
On February 22, 2008, Brocade’s Board of Directors appointed a Special Litigation Committee of the Board (“SLC”) with plenary authority to, among other things, evaluate and resolve the claims asserted in the federal and state derivative actions. On August 1, 2008, Brocade, acting through the SLC, filed a Second Amended Complaint (the “SLC’s Complaint”) in the Federal Action against ten former officers, directors or employees of Brocade, asserting claims for breach of fiduciary duty and violations of federal and state laws in connection with Brocade’s historical stock option practices. In August 2008, the State Court and Federal Court realigned Brocade as the plaintiff and dismissed the shareholder plaintiffs in the State Action, Federal Action and the unconsolidated federal derivative action, respectively.
On December 12, 2008, the Federal Court dismissed all claims against five of the Federal Action defendants (who were also defendants in the State Action) and some, but not all, of the claims against the remaining five Federal Action defendants. In April 2009, the unconsolidated federal derivative action was dismissed without prejudice, and the claims asserted in the State Action against the defendants who had not also been named in the Federal Action were also dismissed without prejudice.
The SLC has reached settlement agreements with all of the other defendants in the Federal and State Actions. The terms of the settlements differ in each case. Terms contained in some, but not all, of the agreements include the payment of money to Brocade, the surrender of certain shares of Brocade stock to Brocade, the contribution of specified amounts to reduce the legal fees and expenses that Brocade otherwise might have been obligated to pay, and releases. The agreements with all of the five Federal Action defendants have been approved by the Federal Court, and the agreements with four of the five State Action defendants have been approved by the State Court. The other agreement remains subject to review by the State Court.
On October 23, 2007, a class action complaint was filed against Brocade and certain of its former officers and current and former directors. This action was filed in the California Superior Court in Santa Clara County on behalf of individuals who owned Brocade stock between February 21, 2001 and May 16, 2005. On October 15, 2008, plaintiffs filed a second amended complaint alleging that Brocade and the individual defendants violated or conspired to violate the Racketeering Influenced and Corrupt Organizations Act and seeking unspecified monetary damages. On March 3, 2009, the Court dismissed the complaint with prejudice. On May 14, 2009, plaintiffs filed a notice of appeal, which Brocade opposed. On October 15, 2009, plaintiffs filed a voluntary request to dismiss their appeal. The appeal was dismissed on October 19, 2009. Accordingly, this matter has been dismissed with prejudice.
Intellectual Property Litigation
On June 21, 2005, Enterasys Networks, Inc. (“Enterasys”) filed a lawsuit against Foundry (and Extreme Networks, Inc.) in the United States District Court for the District of Massachusetts alleging that certain of Foundry’s products infringe six of Enterasys’ patents and seeking injunctive relief, as well as unspecified
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damages. On August 28, 2007, the Court granted Foundry’s motion to stay the case based on petitions that Foundry filed with the USPTO for reexamination of five of the six Enterasys patents. On July 14, 2009, the United States Patent and Trademark Office (“USPTO”) issued reexamination certificates for two of the patents undergoing reexamination indicating that the patents were valid over the references that Foundry had submitted. On August 7, 2009, Brocade filed a new petition for reexamination of one of the patents that received a reexamination certificate. On October 16, 2009, the USPTO granted the new petition for reexamination. On October 2, 2009, the USPTO issued a notice of intent to issue a reexamination certificate for a third patent, confirming all original claims and new claims added during reexamination. To date, the USPTO has issued final Office Actions (which are published on the USPTO Web site) rejecting all asserted claims of the two remaining Enterasys patents that were submitted for reexamination. Enterasys has filed Notices of Appeal of both of those rejections. The USPTO is currently in the process of reexamining one of the patents as noted above, and the litigation case in Court continues to be stayed.
On September 6, 2006, Chrimar Systems, Inc. (“Chrimar”) filed a lawsuit against Foundry (and D-Link Corporation and PowerDsine, Ltd.) in the United States District Court for the Eastern District of Michigan alleging that certain of Foundry’s products infringe Chrimar’s U.S. Patent 5,406,260 and seeking injunctive relief, as well as unspecified damages. Expert discovery and summary judgment motions are ongoing, and no trial date has been set.
On February 7, 2008, Network-1 Security Solutions, Inc. (“Network-1”) filed a lawsuit against Foundry and other networking companies, namely, Cisco Systems, Inc. (“Cisco”), Cisco-Linksys, LLC, Adtran, Inc., Enterasys, Extreme Networks, Inc., NetGear, Inc., and 3Com Corporation in the United States District Court for the Eastern District of Texas, Tyler Division, alleging that certain of Foundry’s products infringe Network-1’s U.S. Patent No 6,218,930 and seeking injunctive relief, as well as unspecified damages. Trial is set for July 12, 2010.
General
From time to time, the Company is subject to other legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks, copyrights, patents and/or other intellectual property rights, and commercial contract disputes. Third parties assert patent infringement claims against the Company from time to time in the form of letters, lawsuits and other forms of communication. In addition, from time to time, the Company receives notification from customers claiming that they are entitled to indemnification or other obligations from the Company related to infringement claims made against them by third parties. Litigation, even if the Company is ultimately successful, can be costly and divert management’s attention away from the day-to-day operations of the Company. In the event of a result adverse to the Company, the Company could incur substantial monetary liability and/or be required to change its business practices. Any unfavorable determination could have a material adverse effect on the Company’s financial position, results of operations, cash flows or business.
The Company records a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. The Company reviews the need for any such liability on a quarterly basis. As of October 31, 2009, the Company has not recorded any such liabilities other than with respect to one litigation matter relating to a commercial contract dispute.
11. Derivative Instruments and Hedging Activities
In the normal course of business, the Company is exposed to fluctuations in interest rates and the exchange rates associated with foreign currencies. The Company’s primary objective for holding derivative financial
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instruments is to manage foreign currency exchange rate risk. The Company currently does not enter into derivative instruments to manage credit risk. However, the Company manages its exposure to credit risk through its investment policies. The Company generally enters into derivative transactions with high-credit quality counterparties and, by policy, limits the amount of credit exposure to any one counterparty based on its analysis of that counterparty’s relative credit standing. The amounts subject to credit risk related to derivative instruments are generally limited to the amounts, if any, by which a counterparty’s obligations exceed the Company’s obligations with that counterparty.
Foreign Currency Exchange Rate Risk
A majority of the Company’s revenue, expense and capital purchasing activities is transacted in U.S. dollars. However, the Company is exposed to foreign currency exchange rate risk inherent in conducting business globally in numerous currencies, of which the most significant to its operations for the year ended October 31, 2009 were the Euro, the Japanese Yen, the British Pound and the Singapore Dollar. The Company is primarily exposed to foreign currency fluctuations related to operating expenses denominated in currencies other than the U.S. dollar. The Company has established a foreign currency risk management program to protect against fluctuations in the volatility of future cash flows caused by changes in foreign currency exchange rates. This program reduces, but does not always entirely eliminate, the impact of foreign currency exchange rate movements. The Company’s foreign currency risk management program includes foreign currency derivatives with cash flow hedge accounting designation that utilizes foreign currency forward contracts to hedge exposures to the variability in the U.S. dollar equivalent of anticipated non-U.S. dollar-denominated cash flows. These instruments generally have a maturity of less than one year. For these derivatives, the Company reports the after-tax gain or loss from the effective portion of the hedge as a component of accumulated other comprehensive loss in stockholders’ equity and reclassifies it into earnings in the same period in which the hedged transaction affects earnings, and within the same line item on the consolidated statements of operations as the impact of the hedged transaction. For amounts not associated with foreign currency forward contracts, gains and losses from transactions denominated in foreign currencies are included in the Company’s net income (loss) as part of “Interest and other income (loss), net,” in the accompanying Consolidated Statements of Operations. The Company recognized foreign currency transaction gains of $4.5 million, $4.6 million and $2.2 million for the years ended October 31, 2009, October 25, 2008 and October 27, 2007, respectively.
Volume of Derivative Activity
Total gross notional amounts for foreign currency forward contracts, presented by currency, are as follows (in thousands):
The Company utilizes a rolling hedge strategy for the majority of its foreign currency forward contracts with cash flow hedge accounting designation that hedges exposures to the variability in the U.S. dollar equivalent of anticipated non-U.S. dollar-denominated cash flows. All of the Company’s foreign currency forward contracts are single delivery, which are settled at maturity involving one cash payment exchange.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Net unrealized gain and loss positions are recorded within “Other accrued liabilities.” Gross unrealized gain and loss positions are not material. As of October 31, 2009, the Company had a gross unrealized gain of $1.4 million, which is included in Other Accrued Liabilities. The amount of $1.4 million represents effective hedges and is reported as a component of accumulated other comprehensive loss. Hedge ineffectiveness, which is reported in the Consolidated Statements of Operations, was not significant.
12. Equity Compensation Plans
In April 2009, the stockholders of Brocade approved the Company’s 2009 Stock Plan, 2009 Director Plan and 2009 Employee Stock Purchase Plan (“2009 ESPP”), and such plans are now part of the Company’s equity compensation plans. Further, the Company’s 1999 Stock Plan, 1999 Director Option Plan and 1999 Employee Stock Purchase Plan each expired in March 2009 by its terms.
2009 Stock Plan
The 2009 Stock Plan provides for the grant of stock options, restricted stock, restricted stock units, stock appreciation rights, performance units and performance shares, and other stock or cash awards to employees, directors and consultants. Per the terms of the 2009 Stock Plan, 48.0 million shares of the Company’s common stock are reserved for issuance under the plan, plus the following:
•
Any shares subject to stock options or similar awards granted under the Company’s 1999 Stock Plan, 1999 Nonstatutory Stock Option Plan (“NSO Plan”) and 2001 McDATA Equity Incentive Plan that expire or otherwise terminate without having been exercised in full; and
•
Shares issued pursuant to awards granted under the Company’s 1999 Stock Plan, 1999 NSO Plan and 2001 McDATA Equity Incentive Plan that are forfeited to or repurchased by the Company, with the maximum number of shares to be added to the 2009 Stock Plan pursuant to this clause equal to 40,335,624 shares.
2009 Director Plan
The 2009 Director Plan provides for the grant of stock options and restricted stock units to non-employee directors of the Company. The Board of Directors has reserved 2.0 million shares of the Company’s common stock for issuance under the 2009 Director Plan, plus any shares subject to stock options or similar awards granted under the Company’s 1999 Director Option Plan that expire or otherwise terminate without having been exercised in full, and shares issued pursuant to awards granted under the Company’s 1999 Director Option Plan that are forfeited to or repurchased by the Company, with the maximum number of shares to be added to the 2009 Director Plan pursuant to this clause equal to 870,000 shares.
2009 Employee Stock Purchase Plan
The 2009 ESPP permits eligible employees to purchase shares of the Company’s common stock through payroll deductions for up to 15% of qualified compensation during the offering period. The purchase price is 85% of the lesser of the fair market value of the Company’s common stock on (i) the first trading day of the offering period, or (ii) the last day of each six-month purchase period; provided, however, that the purchase price for subsequent offering periods may be determined by the administrator, subject to compliance with the terms of the 2009 ESPP. A total of 35.0 million shares of the Company’s common stock are reserved for issuance under the 2009 ESPP. The 2009 ESPP is implemented through consecutive, overlapping offering periods of up to approximately twenty-four months. The offering periods generally start with the first trading day on or after June 1 and December 1 each year and end on the last trading day in the periods ending twenty-four months later,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
unless the fair market value of the Company’s common stock on the last day of a purchase period is lower than the fair market value of the Company’s common stock on the first trading day of the offering period, in which case the offering period will end early, immediately after the purchase period, and a new offering period will commence on or about such date. Each offering period will be divided into four purchase periods of approximately six months in length. The initial offering period for the 2009 ESPP beginning on June 1, 2009 is twenty-four months. Eligible employees may purchase no more than 3,750 shares of the Company’s common stock during each six-month purchase period. As of October 31, 2009, 35.0 million shares were available for issuance under the 2009 ESPP.
Equity Compensation Plans
The Company grants stock options, restricted stock awards and restricted stock units for shares of the Company’s common stock and other types of equity compensation awards to its employees and directors under the various equity compensation plans described above. In accordance with the terms of the 2009 Stock Plan and the 2009 Director Plan, each award granted with an exercise price that is less than fair market value, which includes all grants of restricted stock awards, restricted stock units, performance shares and performance units, will count against the applicable plan’s share reserve as 1.56 shares for every one share subject to such award. In addition, the exercise price of stock options and stock appreciation rights granted under the 2009 Stock Plan must be at least equal to the fair market value of the Company’s common stock on the date of grant and the exercise price of incentive stock options granted to any participant who owns more than 10% of the total voting power of all classes of the Company’s outstanding stock must be at least 110% of the fair market value of the Company’s common stock on the date of grant.
The term of a stock option and a stock appreciation right may not exceed seven years, except that, with respect to any participant who owns 10% of the voting power of all classes of the Company’s outstanding capital stock, the term of an incentive stock option may not exceed five years. The majority of the stock options, restricted stock awards and restricted stock units granted under the Company’s equity compensation plans vest over a period of four years. Certain options and awards granted under the 2009 Stock Plan vest over shorter or longer periods.
At October 31, 2009, approximately 190.8 million shares were authorized for future issuance under the Company’s equity compensation plans, which include stock options, shares to be issued pursuant to the 2009 ESPP, restricted stock units and other awards, and shares of Brocade common stock that became issuable in connection with the assumption or substitution of Foundry equity awards. A total of 67.1 million shares of common stock were available for grant under the Company’s equity compensation plans as of October 31, 2009. At October 25, 2008, approximately 155.7 million shares were authorized for future issuance under the Company’s equity compensation plans, which include stock options, shares issued pursuant to the 1999 Employee Stock Purchase Plan, and restricted stock units and other awards. A total of 112.3 million shares of common stock were available for grant under the Company’s equity compensation plans as of October 25, 2008. Awards that expire, or are canceled without delivery of shares, generally become available for issuance under the Company’s equity compensation plans.
Nonstatutory Stock Option Plan
In September 1999, the Board of Directors approved the Company’s 1999 NSO Plan. The 1999 NSO Plan provides for the grant of nonstatutory stock options to employees and consultants. A total of 51.4 million shares of the Company’s common stock have been reserved for issuance under the 1999 NSO Plan. As of October 31, 2009, the Company has reserved 4.9 million shares of authorized but unissued shares of common stock for future issuance under the 1999 NSO Plan, all of which were outstanding as of October 31, 2009.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
McDATA Equity Plans
On January 29, 2007, effective upon the consummation of the merger, Brocade assumed the McDATA equity plans. As of October 31, 2009, options to purchase approximately 3.8 million shares of converted common stock, restricted stock and other equity awards remained outstanding under former McDATA equity plans.
Long-Term Incentive Plan
On July 30, 2007, the Board of Directors approved a long-term, performance-based equity incentive plan (“Incentive Plan”) under the Company’s then applicable 1999 Stock Plan. The Incentive Plan provides for the grant of restricted stock units to certain Company executive officers and other selected employees. For each restricted stock unit that vests, the plan participant will be entitled to receive one share of the Company’s common stock. The restricted stock units that vest are subject to the Company’s performance compared to the NASDAQ-100 Index over an initial twenty-seven-month performance period, which is from August 1, 2007 to October 31, 2009. The Incentive Plan participants must also remain a service provider to the Company during the performance period. The fair value of the restricted stock units to be granted under the Incentive Plan was $17.7 million as October 31, 2009, which includes approximately 2.0 million restricted stock units vested as of October 31, 2009 that will be granted to the Incentive Plan participants upon approval of the Compensation Committee of the Board of Directors in the first fiscal quarter of 2010.
Under the principal terms of the Incentive Plan, the Incentive Plan participants are entitled to receive restricted stock units representing up to an aggregate of 2.0% of the amount the Company’s market capitalization growth rate exceeds the growth rate of the NASDAQ-100 Index for the performance period, subject to certain adjustments. The ultimate amount that vests is subject to the discretion of the Board of Directors. The restricted stock units are expected to vest simultaneously with the end of the performance period.
The Company calculated the fair value of the restricted stock units under the Incentive Plan as the expected present value of the pre-forfeiture payments to the Incentive Plan participants at the end of the performance period. The Company used the Monte Carlo simulation-based method to estimate the fair value of the instrument. The Company adjusted the calculated fair value for estimated forfeitures to derive total stock-based compensation expense. The Company recognized stock-based compensation expense ratably over the performance period. Grant dates for awards under the Incentive Plan are established when the Board of Directors approves the number of shares to be granted, which should be approved by the Board of Directors within one month subsequent to the completion of the performance period. The Company remeasured the stock-based compensation expense at the end of each reporting period.
Employee 401(k) Plan
The Company sponsors the Brocade Communications Systems, Inc. 401(k) Plan (“401(k) Plan”), which qualifies under Section 401(k) of the Internal Revenue Code and is designed to provide retirement benefits for its eligible employees through tax-deferred salary deductions.
Employees may elect to contribute up to 60% of their eligible compensation to the 401(k) Plan. Employee contributions are limited to a maximum annual amount as set periodically by the Internal Revenue Service (“IRS”). The Company matches employee contributions dollar for dollar up to a maximum of $3,000 per calendar year per person. All matching contributions vest immediately. The Company’s matching contributions to the 401(k) Plan totaled $7.8 million, $5.8 million and $5.7 million for the years ended October 31, 2009, October 25, 2008 and October 27, 2007, respectively.
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
13. Stock-Based Compensation
Equity Compensation Plan Information
The following table summarizes information with respect to shares of the Company’s common stock that may be issued under the Company’s existing equity compensation plans as of October 31, 2009 (in thousands, except per share amounts):
(1) Primarily consist of the 2009 ESPP, the 2009 and 1999 Director Plans and the 2009 and 1999 Stock Plans.
(2) Consist solely of the 1999 NSO Plan and Foundry’s 2000 NSO Plan.
(3) Amount excludes purchase rights accrued under the 2009 ESPP. As of October 31, 2009, the 2009 ESPP had a stockholder-approved reserve of 35.0 million shares, of which 35.0 million shares were available for future issuance.
(4) Amount consists of shares available for future issuance under the 2009 ESPP, the 2009 Director Plan and the 2009 Stock Plan.
(5) Substantially all shares were granted prior to the fiscal year ended October 25, 2003.
Stock Options
When the measurement date is certain, the fair value of each option granted during the respective period is estimated on the date of grant using the Black-Scholes valuation model and the assumptions noted in the following table. The dividend yield reflects that Brocade has not paid any cash dividends since inception and does not anticipate paying cash dividends in the foreseeable future. The risk-free interest rate is based on the implied yield on a U.S. Treasury zero-coupon issue with a remaining term equal to the expected term of the option. The expected volatility is based on an equal weighted-average of implied volatilities from traded options of the Company’s common stock and historical volatility of the Company’s common stock. The expected term is based on historical exercise behavior.
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company recorded $23.5 million, $15.4 million and $19.0 million of compensation expense related to stock options for the years ended October 31, 2009, October 25, 2008 and October 27, 2007, respectively. Compensation expense computed under the fair value method for stock options issued is being amortized under a graded vesting method over the options’ vesting period. A summary of stock option activity under the equity compensation plans for the years ended October 31, 2009, October 25, 2008 and October 27, 2007 is presented as follows:
The weighted-average grant date fair value of stock options granted during the years ended October 31, 2009, October 25, 2008 and October 27, 2007 was $2.10, $2.69 and $3.55, respectively. The total intrinsic value of stock options exercised for the years ended October 31, 2009, October 25, 2008 and October 27, 2007 was $128.9 million, $12.4 million and $53.1 million, respectively.
As of October 31, 2009, there was $16.4 million of unrecognized compensation expense related to stock options that is expected to be recognized over a weighted-average period of 1.10 years.
From May 1999 through July 2003, the Company granted 98.8 million options subject to variable accounting as the measurement date of the options granted was not certain. As of October 31, 2009, 0.7 million options with a weighted-average exercise price of $25.99 and a weighted-average contractual life of 1.67 years remain outstanding and continue to be accounted for under variable accounting.
Employee Stock Purchase Plan
Under Brocade’s employee stock purchase plans, including the 2009 ESPP and the 1999 Employee Stock Purchase Plan (together, the “Brocade ESPP”), eligible employees can participate and purchase shares semi-annually at the lower of 85% of the fair market value of the Company’s common stock on (i) the first trading day
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
of the offering period, or (ii) the last day of each six-month purchase period. The Brocade ESPP permits eligible employees to purchase common stock through payroll deductions for up to 15% of qualified compensation. The Company accounts for the Brocade ESPP as a compensatory plan and recorded compensation expense of $22.7 million, $6.6 million and $6.0 million for the years ended October 31, 2009, October 25, 2008 and October 27, 2007, respectively. Compensation expense computed under the fair value method for ESPP shares issued is being amortized under a graded vesting method over the twenty-four month offering period. In addition, the Company accounts for changes in percentage contribution elected by employees, as well as decreases in the Company’s common stock price on the last day of each six-month purchase period as compared to the common stock price on the first trading day of the offering period, by applying modification accounting which results in an increase in compensation expense during the period of modification.
The fair value of the option component of Brocade ESPP shares was estimated using the Black-Scholes option pricing model using the following weighted-average assumptions:
(1) The ESPP shares valued for the years ended October 25, 2008 and October 27, 2007 fall under the 1999 Employee Stock Purchase Plan, which is based on a six-month offering period.
As of October 31, 2009, there was $24.5 million of unrecognized compensation expense related to employee stock purchases under the Brocade ESPP. This expense is expected to be recognized over a weighted-average period of 1.1 years.
In addition, as part of its acquisition of Foundry, the Company became the administrator of Foundry’s 1999 Employee Stock Purchase Plan (“Foundry ESPP”), which expired on May 31, 2009. As a result of Brocade’s assumption of rights under the Foundry ESPP, Foundry employees who became Brocade employees were granted the right to purchase shares of the Company’s common stock at the lower of 85% of the fair market value of the Company’s common stock, as adjusted in accordance with the Foundry Merger Agreement at (i) the beginning of a rolling two-year offering period or (ii) the end of each semi-annual offering period, subject to a plan limit on the number of shares that may be purchased in an offering period. During the year ended October 31, 2009, the Company issued 4.9 million shares under the Foundry ESPP. The Company accounts for the Foundry ESPP as a compensatory plan and recorded compensation expense of $2.5 million for the year ended October 31, 2009.
Restricted Stock Awards
No restricted stock awards were issued for the years ended October 31, 2009, October 25, 2008 and October 27, 2007. When and if granted, restricted stock awards are not transferable until fully vested, and all unvested shares upon termination are subject to repurchase. The fair value of each award is based on the Company’s closing stock price on the date of grant.
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
A summary of the nonvested restricted stock awards for the years ended October 31, 2009, October 25, 2008 and October 27, 2007 is presented as follows:
Restricted Stock Units
For the years ended October 31, 2009, October 25, 2008 and October 27, 2007, Brocade issued 13.3 million, 6.3 million and 2.8 million restricted stock units, respectively. Typically, vesting of restricted stock units occurs over one to four years and is subject to the employee’s continuing service to Brocade. The compensation expense related to these awards of $86.7 million, $17.5 million and $3.9 million for the years ended October 31, 2009, October 25, 2008 and October 27, 2007, respectively, was determined using the fair market value of Brocade’s common stock on the date of grant and is recognized under a graded vesting method over the awards’ vesting period.
A summary of the changes in restricted stock units outstanding under Brocade’s equity compensation plans during the years ended October 31, 2009, October 25, 2008 and October 27, 2007 is presented as follows:
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The aggregate intrinsic value of restricted stock units outstanding at October 31, 2009, October 25, 2008 and October 27, 2007 was $288.1 million, $25.7 million and $24.6 million, respectively.
As of October 31, 2009, Brocade had $99.9 million of unrecognized compensation expense, net of estimated forfeitures, related to restricted stock unit grants that is equity classified. These expenses are expected to be recognized over a weighted-average period of 1.93 years. As of October 31, 2009, $17.7 million in compensation expense related to the Incentive Plan, which is liability classified, has been recognized to date. As of October 25, 2008, $1.0 million in compensation expense related to the Incentive Plan had been recognized to date. The fair value of the restricted stock units to be granted under the Incentive Plan was estimated using a Monte Carlo simulation which required assumptions for expected volatilities, correlation coefficients and risk-free rates of return. Expected volatilities were derived using a method that calculates historical volatility over a period equal to the length of the measurement period for the Incentive Plan and the companies included in the related index. Correlation coefficients were based on the same data used to calculate historical volatilities and were used to model how our stock price moves in relation to the companies included in the related index. The Company used a risk-free rate of return that is equal to the yield of a zero-coupon U.S. Treasury bill that is commensurate with each measurement period.
14. Income Taxes
The domestic and international components of income (loss) before provision for (benefit from) income taxes for the years ended October 31, 2009, October 25, 2008 and October 27, 2007 are presented as follows (in thousands):
The income tax provision (benefit) for the years ended October 31, 2009, October 25, 2008 and October 27, 2007 consisted of the following (in thousands):
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The difference between the U.S. federal statutory income tax rate and the Company’s effective tax rate for the years ended October 31, 2009, October 25, 2008 and October 27, 2007 consisted of the following:
U.S. federal income taxes and foreign withholding taxes associated with the repatriation of earnings of the Company’s foreign subsidiaries were not provided for a cumulative total of $263.9 million of undistributed earnings of the Company’s foreign subsidiaries. The Company intends to reinvest current and accumulated earnings of its foreign subsidiaries for expansion of its business operations outside the United States for an indefinite period of time. If these earnings were distributed to the United States in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, the Company could be subject to additional U.S. income taxes, net of foreign tax credits, and foreign withholding taxes. Determination of the amount of unrecognized deferred income tax liability related to these earnings is not practicable.
The components of deferred tax assets and deferred tax liabilities for the years ended October 31, 2009 and October 25, 2008 are presented as follows (in thousands):
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company applies a recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken or expected to be taken on a tax return. Recognition of a tax position is determined when it is more likely than not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement with a taxing authority.
A reconciliation of the beginning and ending amount of total gross unrecognized tax benefits, excluding accrued net interest and penalties, for the year ended October 31, 2009, is as follows (in thousands):
Due to the adoption of certain accounting pronouncements, effective for fiscal year 2010, the total gross unrecognized tax benefits of $170.9 million at October 31, 2009 would affect the Company’s effective tax rate, if recognized. The Company expects to resolve the fiscal year 2003 IRS audit during the next twelve months. As such, after the Company reaches settlement with the IRS, the Company expects to record a corresponding adjustment to its unrecognized tax benefits. The Company believes such settlement should not have a material impact to the results of operations. Excluding the IRS audit, the Company does not expect a significant change in the gross unrecognized tax benefits during the next twelve months.
The Company classifies interest and penalties related to unrecognized tax benefits as a component of income tax expense. During the year ended October 31, 2009, the Company expensed $0.7 million for net interest and penalties related to income tax liabilities through income tax expense. The total net interest and penalties accrued as of October 31, 2009 was $3.6 million. During the year ended October 25, 2008, the Company expensed an additional amount of $0.5 million for net interest and penalties related to income tax liabilities through income tax expense.
During fiscal year 2008, the Company released its valuation allowance on its deferred tax assets. The Company believes that sufficient positive evidence existed from historical operations and projections of taxable income in future years to conclude that it was more likely than not that the Company would realize its deferred tax assets. Accordingly, the Company only applies a valuation allowance on the deferred tax assets relating to capital loss carryforwards, investments and foreign operating loss carryforwards due to limited carryforward periods and the character of such tax attributes. For the year ended October 31, 2009, the valuation allowance decreased by $20.4 million. The decrease was primarily due to the reversal of unrealized capital loss upon acquisition and the release of valuation allowance of foreign tax credits which are now deemed realizable during the carryforward period.
The Company has been examined by the IRS for its domestic federal income tax returns for fiscal years 2003 through 2006. The IRS is contesting the Company’s transfer pricing for the cost sharing and buy-in arrangements with its foreign subsidiaries. The Company has filed a protest to appeal the amount of proposed
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
IRS adjustments in the Revenue Agent’s Report with the Appeals Office of the IRS. The Company believes it is sufficiently reserved for the ultimate settlement amount on this issue. The IRS also notified the Company that it will audit the Company’s fiscal year 2007 and 2008 income tax returns. The IRS may make similar claims against the Company’s transfer pricing arrangements in future examinations. In May 2006, the Franchise Tax Board notified the Company that its California income tax returns for the years ended October 25, 2003 and October 30, 2004 were subject to audit. The IRS and Franchise Tax Board audits are still ongoing and the Company believes its reserves are adequate to cover any potential assessments that may result from these examinations.
In February 2009, the IRS commenced an examination of Foundry’s federal income tax returns for the years ended December 31, 2006 and 2007. The Company has tentatively agreed with the proposed adjustments, but the audit is still ongoing. The Company believes its reserves are adequate to cover any potential assessments that may result from this examination.
For the year ended October 31, 2009, the Company recorded income tax expense of $10.6 million primarily as a result of foreign taxes, change in uncertain tax positions related to the ongoing IRS examination, and an increase in research and development credits. For the year ended October 25, 2008, the Company recorded income tax benefit of $137.1 million primarily as a result of the release of the valuation allowance.
Of the total tax benefits (detriments) resulting from the exercise of employee stock options and employee participation in the Company’s equity compensation plans, the amounts recorded to stockholders’ equity were approximately $(0.8) million in fiscal year 2009, $18.6 million in fiscal year 2008 and $(0.1) million in fiscal year 2007.
As of October 31, 2009, the Company had federal net operating loss carryforwards of $885.8 million, California state net operating loss carryforwards of $156.6 million and other significant states net operating loss carryforwards of approximately $195.7 million. Additionally, the Company had $94.2 million of federal tax credits and $123.1 million of state tax credits. The federal net operating loss and other tax credit carryforwards expire on various dates between 2018 through 2029. The state net operating loss and credit carryforwards expire on various dates between 2009 through 2029. Under the current tax law, net operating loss and credit carryforwards available to offset future income in any given year may be limited by statute or upon the occurrence of certain events, including significant changes in ownership interests.
As a result of the McDATA and Foundry acquisitions, all the tax attributes from both companies are subject to an annual limitation, but the Company expects to use all the tax attributes before expiration.
15. Segment Information
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker (“CODM”), or decision-making group, in deciding how to allocate resources and in assessing performance. Currently, the CODM is the Chief Executive Officer.
As a result of the Foundry acquisition during the first quarter of fiscal year 2009, Brocade reorganized into four operating segments, of which two are individually reportable segments: Data Storage and Global Services; and two, IP Layer 2-3 and IP Layer 4-7/ADP, are combined into one reportable segment: Ethernet Products. The objective of this new organization is to enable the Company to more effectively focus on growth opportunities, while being well-positioned to more rapidly scale and accommodate new business opportunities, including
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
potential future acquisitions. These segments are organized principally by product category. The types of products and services from which each reportable segment derives its revenues are as follows:
•
Data Storage encompasses the SAN business, which includes infrastructure products and solutions including directors, switches, routers, fabric-based software applications, distance/extension products, as well as management applications and utilities to centralize data management. Data Storage also includes the server portfolio, which is comprised of host bus adapters, converged network adapters, mezzanine cards, as well as SAN switch modules for bladed servers. Prior to fiscal year 2009, the SAN business was referred to as Data Center Infrastructure and the server portfolio that is now included in Data Storage was referred to as Server Edge and Storage;
•
Ethernet Products includes Open Systems Interconnection Reference Model (“OSI”) Layer 2-3 switches and routers which enable efficient use of bandwidth-intensive network business applications and digital entertainment on both local area networks and wide area networks, OSI Layer 4-7 switches which allow enterprises and service providers to build highly available network infrastructures that efficiently direct the flow of traffic, and file area network products and associated management solutions; and
•
Global Services include break/fix maintenance, extended warranty, installation, consulting, network management, related software maintenance and support revenue, and telecommunications services. Prior to fiscal year 2009, the Global Services operating segment was referred to as Services, Support and Solutions.
Financial decisions and the allocation of resources are based on the information from the Company’s internal management reporting system. At this point in time, the Company does not track all of its assets by operating segments. The majority of the Company’s assets as of October 31, 2009, October 25, 2008 and October 27, 2007 were attributable to its United States operations.
Fiscal years 2008 and 2007 segment results have been conformed to the new measurements of segment financial reporting implemented in the first quarter of fiscal year 2009. Summarized financial information by reportable segment for the years ended October 31, 2009, October 25, 2008 and October 27, 2007, based on the internal management reporting system, is as follows (in thousands):
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Geographic information for the years ended October 31, 2009, October 25, 2008 and October 27, 2007 is presented below (in thousands):
16. Gain (Loss) on Sale of Investments, net, and Loss on Impairment of Portfolio Investments
The Company had an immaterial loss on sale of investments for the year ended October 31, 2009. For the year ended October 25, 2008, the Company had $6.9 million in net loss on sale of investments primarily due to the sale of the Company’s equity investment in a publicly traded company. The Company also determined that the declines in the fair value for certain of its portfolio investments primarily associated with non-marketable investments were other-than-temporary due to the significant deterioration of the financial condition of the investees. As a result, for the year ended October 25, 2008, the Company recorded impairment charges of $8.8 million. For the year ended October 27, 2007, the Company had $13.2 million in net gain on sale of investments due to the disposition of marketable strategic investments at amounts above the carrying value. The carrying value of the Company’s equity investments in non-publicly traded companies at October 31, 2009, October 25, 2008 and October 27, 2007 was $6.8 million, $6.8 million and $5.0 million, respectively.
17. Net Income (Loss) per Share
The following table presents the calculation of basic and diluted net income (loss) per share (in thousands, except per share amounts):
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
For the years ended October 31, 2009, October 25, 2008 and October 27, 2007, potential common shares in the form of stock options to purchase 68.7 million, 17.5 million and 11.2 million weighted-average shares of common stock, respectively, were antidilutive and, therefore, not included in the computation of diluted net income (loss) per share. For the years ended October 31, 2009, October 25, 2008 and October 27, 2007, potential common shares in the form of stock awards to purchase 17.0 million, 1.2 million and 0.1 million weighted-average shares of common stock, respectively, were antidilutive and, therefore, not included in the computation of diluted net loss per share.
As the Company was in a net loss position for the year ended October 31, 2009, there was no dilutive impact of potential common shares associated with stock options and stock awards, by application of the treasury stock method. The dilutive impact of potential common shares associated with stock options, by application of the treasury stock method, for the years ended October 25, 2008 and October 27, 2007 was 5.0 million and 9.9 million, respectively. The dilutive impact of potential common shares associated with stock awards, by application of the treasury stock method, for the years ended October 25, 2008 and October 27, 2007 was 1.6 million and 3.2 million, respectively. In addition, for the year ended October 31, 2009, potential common shares resulting from the potential conversion, on a weighted-average basis, of the Company’s convertible subordinated debt of 12.1 million common shares were antidilutive and therefore not included in the computation of diluted net loss per share. However, for both the years ended October 25, 2008 and October 27, 2007, potential common shares resulting from the potential conversion, on a weighted-average basis, of the Company’s convertible subordinated debt of 12.1 million common shares were dilutive and therefore included in the computation of diluted net income per share.
18. Related Party and Other Transactions
During the normal course of business, the Company purchases certain equipment from vendors who are also its customers and with whom the Company has contractual arrangements. The equipment purchased by the Company is primarily used for testing purposes in its development labs or otherwise consumed internally. The Company believes that all such transactions are on an arms-length basis and are subject to terms no more favorable than those with unrelated parties.
BROCADE COMMUNICATIONS SYSTEMS, INC.
QUARTERLY SUMMARY
(Unaudited)
(1) In the second, third and fourth quarters of fiscal year 2009, the Company recorded certain immaterial adjustments related to prior periods.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of 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, as of the end of the period covered by this Annual Report on Form 10-K (the “Evaluation Date”).
The purpose of this evaluation is to determine if, as of the Evaluation Date, our disclosure controls and procedures are operating effectively such that the information required to be disclosed in our Securities and Exchange Commission (“SEC”) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were operating effectively.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the quarter ended October 31, 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
The management of Brocade Communications Systems, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) or 15d-15(f) of the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers, and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and implemented, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must
reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within a company are detected. The inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple errors or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.
Our management assessed the effectiveness of the Company’s internal control over financial reporting as of October 31, 2009, utilizing the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework. Based on our management’s assessment, we believe that, as of October 31, 2009, our internal control over financial reporting was effective based on those criteria. The effectiveness of our internal control over financial reporting as of October 31, 2009 has been audited by KPMG LLP, Brocade’s independent registered public accounting firm, as stated in their report which is included on page 110 of this Annual Report on Form 10-K.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Brocade Communications Systems, Inc.:
We have audited Brocade Communications Systems, Inc. and subsidiaries’ internal control over financial reporting as of October 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting appearing in Item 9A. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of October 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Brocade Communications Systems, Inc. and subsidiaries as of October 31, 2009 and October 25, 2008, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended October 31, 2009, and our report dated December 14, 2009 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Mountain View, California
December 14, 2009
Item 9B.
Item 9B. Other Information
None.
PART III
Certain information required by Part III is incorporated by reference from the Company’s definitive Proxy Statement to be filed with the Securities and Exchange Commission in connection with the solicitation of proxies for the Company’s 2010 Annual Meeting of Stockholders (the “Proxy Statement”).
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by this Item with respect to the Company’s directors is incorporated by reference from the Proxy Statement under the section entitled “Election of Directors.” The information required by this Item with respect to the Company’s executive officers is incorporated by reference from the Proxy Statement under the section entitled “Executive Officers.” The information required by this Item with respect to disclosure of any known late filing or failure by an insider to file a report required by Section 16 of the Exchange Act is incorporated by reference from the Proxy Statement under the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance.” The information regarding the Company’s corporate governance is incorporated by reference from the Proxy Statement.
The Board of Directors has adopted a Code of Ethics for Principal Executive and Senior Financial Officers (the “Code of Ethics”), which applies to the Company’s Chief Executive Officer, Chief Financial Officer and any other principal financial officer, controller and any other principal accounting officer, and any other person performing similar functions. The Code of Ethics is available on the Company’s Web site at www.brocade.com in the “Corporate Governance” section of its investor relations webpage. The Company will also provide a copy of the Code of Ethics upon request made by email to ir@brocade.com or in writing to Brocade Communications Systems, Inc., Attention: Investor Relations, 1745 Technology Drive, San Jose, California 95110. The Company will disclose any amendment to the Code of Ethics or waiver of a provision of the Code of Ethics that applies to the Company’s Chief Executive Officer, Chief Financial Officer and any other principal financial officer, controller and any other principal accounting officer, and any other person performing similar functions, and relate to certain elements of the Code of Ethics, including the name of the officer to whom the waiver was granted, on its Web site at www.brocade.com on its investor relations webpage.
Item 11.
Item 11. Executive Compensation
The information required by this Item is incorporated by reference from the Proxy Statement under the section entitled “Executive Compensation and Other Matters.”
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item is incorporated by reference from the Proxy Statement under the sections entitled “Security Ownership of Certain Beneficial Owners and Management” and “Board of Directors Meetings and Committees.”
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this Item is incorporated by reference from the Proxy Statement under the section entitled “Certain Relationships and Related Transactions.”
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by this Item is incorporated by reference from the Proxy Statement under the section entitled “Ratification of Selection of Independent Registered Public Accountants.”
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) The following documents are filed as a part of this Form 10-K:
1. Financial Statements:
The following financial statements of Brocade Communications Systems, Inc. are filed as a part of this Annual Report.
Page
Report of Independent Registered Public Accounting Firm
Consolidated Statements of Operations
Consolidated Balance Sheets
Consolidated Statements of Stockholders’ Equity and Comprehensive Income
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Quarterly Summary (Unaudited)
2. Financial Statement Schedules:
The following financial statement schedule of Brocade Communications Systems, Inc. for the years ended October 31, 2009, October 25, 2008 and October 27, 2007 is filed as part of this Annual Report and should be read in conjunction with the Consolidated Financial Statements of Brocade Communications Systems, Inc.
Schedule II - Valuation and Qualifying Accounts
All other schedules have been omitted as the required information is inapplicable or the information is presented in the Consolidated Financial Statements and notes thereto under Item 8 in Part II of this Form 10-K.
3. Exhibits:
EXHIBIT INDEX
* Indicates management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 15(b) of Form 10-K.
** Filed herewith.
 Confidential treatment granted as to certain portions, which portions were omitted and filed separately with the Securities and Exchange Commission.
 Confidential treatment requested as to certain portions, which portions were omitted and filed separately with the Securities and Exchange Commission.
(b) Exhibits
See Exhibit Index included in Item 15(a) of this Form 10-K.
(c) Financial Statement Schedules
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
Fiscal Years Ended October 31, 2009, October 25, 2008 and October 27, 2007
* Deductions related to the allowance for doubtful accounts and sales allowances represent amounts written off against the allowance less recoveries.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Michael Klayko and Richard Deranleau, and each of them, his and her true and lawful attorneys-in-fact, each with full power of substitution, for him and her in any and all capacities, to sign any amendments to this report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or their substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.