QLOGIC CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes. In this discussion and elsewhere in this report, we make forward-looking statements. These forward-looking statements are made in reliance upon safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include, without limitation, descriptions of our expectations regarding future trends affecting our business and other statements regarding future events or our objectives, goals, strategies, beliefs and underlying assumptions that are other than statements of historical fact. When used in this report, the words "anticipates," "believes," "can," "continue," "could," "estimates," "expects," "intends," "may," "plans," "potential," "predicts," "should," "will" and similar expressions, or the negative of such expressions, are intended to identify these forward-looking statements. Statements concerning current conditions may also be forward-looking if they imply a continuation of current conditions. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of several factors, including, but not limited to those factors set forth and discussed in Part II, Item 1A "Risk Factors" and elsewhere in this report. In light of the significant uncertainties inherent in the forward-looking information included in this report, the inclusion of this information should not be regarded as a representation by us or any other person that our objectives or plans will be achieved. You are cautioned, therefore, not to place undue reliance on these forward-looking statements, which are made only as of the date of this report.

We undertake no obligation to update or revise these forward-looking statements, whether as a result of new information, future events or otherwise.

Overview We design and supply high performance network infrastructure products that provide, enhance and manage computer data communication. These products facilitate the rapid transfer of data and enable efficient resource sharing between servers, networks and storage. Our products are used in enterprise data centers, cloud computing, Web 2.0 and other environments dependent on high performance, reliable data networking.

Our products are based primarily on Fibre Channel and Ethernet technologies and are used in connection with storage networks, local area networks, and converged networks. Storage networks are used to provide data across enterprise environments. Fibre Channel is currently the dominant technology for enterprise storage networking. Local area networks, or LANs, are used to provide workstation-to-server, server-to-server, and server-to-storage connectivity using Ethernet. Converged networks are designed to address the evolving data center by consolidating and unifying various classes of connectivity and networks, such as storage area networks and LANs, using Ethernet speeds of 10Gb per second and greater. Fibre Channel over Ethernet, or FCoE, is a converged networking technology that uses an Ethernet LAN for both storage and local area data transmission, thus combining the benefits of Fibre Channel technology with the pervasiveness of Ethernet-based networks. Similarly, Internet Small Computer System Interface, or iSCSI, is an alternative to FCoE, also providing storage over Ethernet capabilities. Our converged products can operate individually as 10Gb Ethernet network products, FCoE products, iSCSI products, or in combination as multi-protocol products.

We classify our products into three broad categories: Host Products, Network Products and Silicon Products. Host Products consist primarily of Fibre Channel adapters, FCoE converged network adapters, and 10Gb Ethernet adapters. Network Products consist of blade, edge and high-port count modular-chassis Fibre Channel switches, Fibre Channel virtualized pass-through modules, universal access point switches, Enhanced Ethernet pass-through modules and storage routers. Silicon Products consist of Fibre Channel controllers, iSCSI controllers, converged network controllers, Ethernet controllers, converged switch controllers, and converged LAN on Motherboard, or cLOM, controllers.

Our adaptive convergence strategy, which we call Adaptive Convergence, is to design and supply networking infrastructure connectivity products for server, fabric, and storage to provide optimal flexibility and utility for our customers. Adaptive Convergence embodies multi-protocol functionality within a single product, support for widely used operating systems and virtualization environments, a broad range of hardware platforms, and multiple physical form-factors.

Our products are sold worldwide, primarily to original equipment manufacturers, or OEMs, and distributors. Our customers rely on our various networking infrastructure products to deliver solutions to information technology professionals in virtually every business sector. Our products are found primarily in server and storage subsystem solutions that are used by small, medium and large enterprises with critical business data requirements. These products are incorporated in solutions from a number of server and storage system OEM customers, including Cisco Systems, Inc., Dell Inc., EMC Corporation, Fujitsu Ltd., Hewlett-Packard Company, Huawei Technology Co. Ltd., Inspur Worldwide Services Ltd., International Business Machines Corporation, NetApp, Inc. and Oracle Corporation.

10 -------------------------------------------------------------------------------- Table of Contents Disposition of Business In February 2012, we completed the sale of the product lines and certain assets associated with our InfiniBand business (the IB Business). As a result of this divestiture, our condensed consolidated statements of income for all periods present the operations of the IB Business as discontinued operations. The following discussion and analysis is based on our continuing operations and excludes any results or discussion of our discontinued operations.

Third Quarter Financial Highlights and Other Information A summary of our financial performance during the third quarter of fiscal 2013 is as follows: • Net revenues increased to $119.4 million in the third quarter of fiscal 2013 from $117.9 million in the second quarter of fiscal 2013. Revenues from Host Products increased to $89.8 million in the third quarter of fiscal 2013 from $89.6 million in the second quarter of fiscal 2013. Revenues from Network Products were $20.0 million for the third quarter of fiscal 2013 and increased sequentially by $2.4 million from the second quarter of fiscal 2013. Revenues from Silicon Products were $9.6 million for the third quarter of fiscal 2013 compared to $10.7 million in the second quarter of fiscal 2013.

• Gross profit as a percentage of net revenues increased to 67.3% in the third quarter of fiscal 2013 from 66.9% in the second quarter of fiscal 2013.

• Operating income as a percentage of net revenues increased to 12.1% in the third quarter of fiscal 2013 from 11.0% in the second quarter of fiscal 2013.

• Income from continuing operations increased to $13.7 million, or $0.15 per diluted share, in the third quarter of fiscal 2013 from $11.8 million, or $0.13 per diluted share, in the second quarter of fiscal 2013.

• Cash, cash equivalents and marketable securities increased to $495.2 million as of December 30, 2012 from $484.4 million as of September 30, 2012.

• Accounts receivable decreased to $69.5 million as of December 30, 2012 from $72.9 million as of September 30, 2012. Days sales outstanding (DSO) in receivables was 53 days as of December 30, 2012.

• Inventories were $23.0 million as of December 30, 2012 compared to $21.8 million as of September 30, 2012. Our annualized inventory turns were 6.8 turns in the third quarter of fiscal 2013.

Results of Operations Net Revenues A summary of our net revenues by product category is as follows: Three Months Ended Nine Months Ended December 30, January 1, December 30, January 1, 2012 2012 2012 2012 (Dollars in millions) Net revenues: Host Products $ 89.8 $ 111.8 $ 280.4 $ 324.2 Network Products 20.0 18.5 57.1 56.2 Silicon Products 9.6 12.5 30.1 43.1 $ 119.4 $ 142.8 $ 367.6 $ 423.5 Percentage of net revenues: Host Products 75 % 78 % 76 % 77 % Network Products 17 13 16 13 Silicon Products 8 9 8 10 100 % 100 % 100 % 100 % 11 -------------------------------------------------------------------------------- Table of Contents Historically, the global marketplace for network infrastructure solutions has expanded in response to the information requirements of enterprise data centers, cloud computing, Web 2.0 and other environments dependent on high performance, reliable data networking. The markets we serve have been characterized by rapid advances in technology and related product performance, which has generally resulted in declining average selling prices over time.

The United States and other countries around the world have experienced, and may continue to experience, economic weakness and uncertainty. Economic uncertainty has adversely affected, and in the future may adversely affect, information technology spending rates, which has negatively impacted our revenue and operating results. Accordingly, it is extremely difficult for us to forecast future sales levels and historical information may not be indicative of future trends.

Our net revenues are derived from the sale of Host Products, Network Products and Silicon Products. Net revenues of $119.4 million for the three months ended December 30, 2012 decreased from $142.8 million for the three months ended January 1, 2012. The decrease in net revenues was primarily the result of a $22.0 million, or 20%, decrease in revenue from Host Products and a $2.9 million, or 23%, decrease in revenue from Silicon Products. The decrease in revenue from Host Products was primarily due to a decrease in the quantity of adapters sold. The decrease in revenue from Silicon Products was due to a decrease in the quantity of chips sold. Revenue from Silicon Products can vary from quarter to quarter based on the purchasing cycles of our customers for these long-lead time products.

Net revenues of $367.6 million for the nine months ended December 30, 2012 decreased from $423.5 million for the nine months ended January 1, 2012. The decrease in net revenues was primarily the result of a $43.8 million, or 14%, decrease in revenue from Host Products and a $13.0 million, or 30%, decrease in revenue from Silicon Products. The decrease in revenue from Host Products was primarily due to a decrease in the quantity of adapters sold. The decrease in revenue from Silicon Products was primarily due to a decrease in the quantity of chips sold.

A small number of our customers account for a substantial portion of our net revenues, and we expect that a small number of customers will continue to represent a substantial portion of our net revenues for the foreseeable future.

Our top ten customers accounted for 84% and 86% of net revenues during the nine months ended December 30, 2012 and January 1, 2012, respectively.

We believe our major customers continually evaluate whether or not to purchase products from alternative or additional sources. Accordingly, there can be no assurance that a major customer will not reduce, delay or eliminate its purchases from us. Any such reduction, delay or loss of purchases could have a material adverse effect on our business, financial condition or results of operations.

Net revenues by geographic area are as follows: Three Months Ended Nine Months Ended December 30, January 1, December 30, January 1, 2012 2012 2012 2012 (In millions) United States $ 51.5 $ 59.5 $ 159.8 $ 182.6 Asia-Pacific and Japan 40.5 46.6 122.1 134.7 Europe, Middle East and Africa 21.3 29.5 67.3 84.8 Rest of world 6.1 7.2 18.4 21.4 $ 119.4 $ 142.8 $ 367.6 $ 423.5 Revenues by geographic area are presented based upon the ship-to location of the customer, which is not necessarily indicative of the location of the ultimate end-user of our products. The United States and China are the only countries that represented 10% or more of net revenues for the periods presented. Net revenues from customers in China were $17.0 million and $50.9 million for the three and nine months ended December 30, 2012, respectively, and $19.8 million and $54.9 million for the three and nine months ended January 1, 2012, respectively.

12 -------------------------------------------------------------------------------- Table of Contents Gross Profit Gross profit represents net revenues less cost of revenues. Cost of revenues consists primarily of the cost of purchased products, assembly and test services; costs associated with product procurement, inventory management, logistics and product quality; and the amortization of purchased intangible assets. A summary of our gross profit and related percentage of net revenues is as follows: Three Months Ended Nine Months Ended December 30, January 1, December 30, January 1, 2012 2012 2012 2012 (Dollars in millions) Gross profit $ 80.3 $ 97.0 $ 246.2 $ 289.6 Percentage of net revenues 67.3 % 67.9 % 67.0 % 68.4 % Gross profit for the three months ended December 30, 2012 decreased $16.7 million, or 17%, from gross profit for the three months ended January 1, 2012. The gross profit percentage for the three months ended December 30, 2012 was 67.3% compared to 67.9% for the corresponding quarter in the prior year. The decrease in gross profit percentage was primarily due to lower volumes to absorb manufacturing costs.

Gross profit for the nine months ended December 30, 2012 decreased $43.4 million, or 15%, from gross profit for the nine months ended January 1, 2012. The gross profit percentage for the nine months ended December 30, 2012 was 67.0% compared to 68.4% for the corresponding period in the prior year. The decrease in gross profit percentage was primarily due to an unfavorable product mix.

Our ability to maintain our current gross profit percentage may be significantly affected by factors such as manufacturing volumes over which fixed costs are absorbed, sales discounts and customer incentives, component costs, the mix of products shipped, the transition to new products, competitive price pressures, the timeliness of volume shipments of new products, our ability to achieve manufacturing cost reductions, and amortization and impairments of purchased intangible assets. We anticipate that it will continue to be difficult to reduce manufacturing costs. As a result of these and other factors, our gross profit percentage may decline in future periods.

Operating Expenses Our operating expenses are summarized in the following table: Three Months Ended Nine Months Ended December 30, January 1, December 30, January 1, 2012 2012 2012 2012 (Dollars in millions) Operating expenses: Engineering and development $ 38.4 $ 34.2 $ 115.9 $ 104.2 Sales and marketing 19.3 19.9 57.9 58.1 General and administrative 8.2 8.8 25.0 26.8 $ 65.9 $ 62.9 $ 198.8 $ 189.1 Percentage of net revenues: Engineering and development 32.2 % 24.0 % 31.5 % 24.6 % Sales and marketing 16.2 13.9 15.8 13.7 General and administrative 6.8 6.1 6.8 6.3 55.2 % 44.0 % 54.1 % 44.6 % Engineering and Development. Engineering and development expenses consist primarily of compensation and related employee benefit costs, service and material costs, occupancy and equipment costs and related computer support costs. During the three months ended December 30, 2012, engineering and development expenses increased to $38.4 million from $34.2 million for the three months ended January 1, 2012. The increase was primarily due to a $2.9 million increase in cash compensation and related employee benefit costs, principally due to an increase in headcount related to our planned incremental investments to drive future revenue growth, a $0.7 million increase in service and material costs related to new product development, and a $0.7 million increase in equipment depreciation and maintenance costs.

During the nine months ended December 30, 2012, engineering and development expenses increased to $115.9 million from $104.2 million for the nine months ended January 1, 2012. The increase was primarily due to a $6.5 million increase in cash 13 -------------------------------------------------------------------------------- Table of Contents compensation and related employee benefit costs, principally due to an increase in headcount related to our planned incremental investments to drive future revenue growth, a $3.9 million increase in service and material costs related to new product development, and a $1.6 million increase in equipment depreciation and maintenance costs.

We believe continued investments in engineering and development activities are critical to achieving future design wins, expansion of our customer base and revenue growth opportunities.

Sales and Marketing. Sales and marketing expenses consist primarily of compensation and related employee benefit costs, sales commissions, promotional activities and travel for sales and marketing personnel. During the three months ended December 30, 2012, sales and marketing expenses decreased to $19.3 million from $19.9 million for the three months ended January 1, 2012.

During the nine months ended December 30, 2012, sales and marketing expenses decreased to $57.9 million from $58.1 million for the nine months ended January 1, 2012. Cash compensation and related employee benefit costs increased $1.2 million primarily due to an increase in headcount. This increase was offset by decreases in promotional expenses and outside services.

We believe continued investments in our sales and marketing organizational infrastructure and related marketing programs are critical to the success of our strategy of expanding our customer base and enhancing relationships with our existing customers.

General and Administrative. General and administrative expenses consist primarily of compensation and related employee benefit costs for executive, finance, accounting, human resources, legal and information technology personnel. Non-compensation components of general and administrative expenses include accounting, legal and other professional fees, facilities expenses and other corporate expenses. General and administrative expenses decreased to $8.2 million for the three months ended December 30, 2012 from $8.8 million for the three months ended January 1, 2012.

General and administrative expenses decreased to $25.0 million for the nine months ended December 30, 2012 from $26.8 million for the nine months ended January 1, 2012. The decrease was primarily due to a $1.0 million decrease in cash compensation and related employee benefit costs.

Income Taxes Our provision for income taxes from continuing operations was $1.6 million and $6.5 million for the three and nine months ended December 30, 2012, respectively, and $5.7 million and $13.5 million for the three and nine months ended January 1, 2012. Our effective tax rate from continuing operations was 13% for each of the nine-month periods ended December 30, 2012 and January 1, 2012.

On January 2, 2013, the federal research tax credit was retroactively reinstated as part of the American Taxpayer Relief Act of 2012. We expect to record an income tax benefit of approximately $6 million in the fourth quarter of fiscal 2013 as a result of the retroactive reinstatement of this tax credit.

As of December 30, 2012, we have a deferred tax asset, net of federal benefit, of $10.1 million related to state research tax credits. These state tax credits have no expiration date and may be carried forward indefinitely. The determination of whether it is more likely than not that we will realize the full benefit of our deferred tax assets, including the deferred tax asset related to the state research tax credits, requires significant judgment and estimates. These estimates may include projections of future taxable income by tax jurisdiction and the amount of tax credits to be generated in future periods. Such estimates are subject to uncertainty due to various factors, including the economic environment, industry and market conditions, and the length of time of the projections included in the analyses. If our actual results, or estimates used in future analyses related to deferred tax assets, are less favorable than current estimates, or we conclude that we expect to generate more state research tax credits than we can utilize for the indefinite future, a valuation allowance may be required related to this deferred tax asset with a corresponding adjustment to earnings in the period in which such determination is made. As of December 30, 2012, based upon our estimates, we believe it is more likely than not that we will realize the full benefit of the existing deferred tax asset related to these state research tax credits and accordingly have not recorded a valuation allowance.

Our federal consolidated income tax returns for fiscal years 2008 and 2009 are currently under examination by the Internal Revenue Service. We do not believe that the results of these examinations will have a material impact on our financial condition or results of operations.

14-------------------------------------------------------------------------------- Table of Contents Given the global scope of our operations and the complexity of global tax and transfer pricing rules and regulations, it is difficult to estimate earnings within each tax jurisdiction. If actual earnings within each tax jurisdiction differ materially from our estimates, we may not achieve our expected effective tax rate. Additionally, our effective tax rate may be impacted by other items, including the tax effects of acquisitions, dispositions, newly-enacted tax legislation, examinations by tax authorities, stock-based compensation, uncertain tax positions and changes in the realizability of deferred tax assets.

Liquidity and Capital Resources Our combined balances of cash, cash equivalents and marketable securities decreased to $495.2 million as of December 30, 2012 from $538.0 million as of April 1, 2012. As of December 30, 2012 and April 1, 2012, our international subsidiaries held $396.1 million and $351.0 million, respectively, of our total cash, cash equivalents and marketable securities. These holdings by our international subsidiaries as of December 30, 2012 consisted primarily of debt securities due from U.S. issuers, including the U.S. government and related agencies, and U.S. dollar denominated cash and money market funds. Certain foreign regulations could impact our ability to transfer funds to the United States. We currently intend to reinvest the funds held outside of the United States in our international operations and, as a result, do not intend to repatriate these funds. Should we decide to repatriate funds held outside of the United States, we may incur a significant tax obligation.

We believe that existing cash, cash equivalents, marketable securities and expected cash flow from operations will provide sufficient funds to finance our operations for at least the next twelve months. However, it is possible that we may need to supplement our existing sources of liquidity to finance our activities beyond the next twelve months or for the future acquisition of businesses, products or technologies and there can be no assurance that sources of liquidity will be available to us at that time.

Cash provided by operating activities decreased to $101.5 million for the nine months ended December 30, 2012 from $134.1 million for the nine months ended January 1, 2012. Operating cash flow for the nine months ended December 30, 2012 consisted of our net income of $43.5 million, net non-cash expenses of $43.7 million and net cash provided as a result of changes in operating assets and liabilities of $14.3 million. The changes in operating assets and liabilities included a $14.4 million increase in accrued taxes, net, and a $7.2 million decrease in accounts receivable, partially offset by a $3.3 million increase in inventories and a $2.5 million decrease in accounts payable. The increase in accrued taxes, net, is primarily due to a tax refund received during the period.

The decrease in accounts receivable was primarily due to the timing of cash collections and a decrease in net revenues. The increase in inventories was primarily due to advanced purchases of silicon chips to maintain flexibility due to long lead times for these products. The decrease in accounts payable was primarily due to the timing of payment obligations.

Cash provided by operating activities of $134.1 million for the nine months ended January 1, 2012 consisted of our net income of $91.1 million and net non-cash expenses of $51.1 million, partially offset by net cash used as a result of changes in operating assets and liabilities of $8.1 million. The changes in operating assets and liabilities included a $12.2 million increase in accounts receivable, partially offset by a $4.5 million increase in accrued taxes. The increase in accounts receivable was primarily due to the timing of cash collections. The increase in accrued taxes was primarily due to the timing of payment obligations.

Cash used in investing activities was $55.6 million for the nine months ended December 30, 2012 and consisted of $23.9 million of net purchases of available-for-sale securities and $31.7 million of purchases of property and equipment. During the nine months ended January 1, 2012, cash used in investing activities was $111.6 million and consisted of $88.1 million of net purchases of available-for-sale securities and $23.5 million of purchases of property and equipment.

We expect capital expenditures to increase in the future as we continue to invest in machinery and equipment, more costly engineering and production tools for new technologies, and enhancements to our corporate information technology infrastructure.

Cash used in financing activities of $110.6 million for the nine months ended December 30, 2012 consisted of $111.7 million for purchases of common stock under our stock repurchase program and $5.6 million for minimum tax withholdings paid on behalf of employees for restricted stock units that vested during the period, partially offset by $6.7 million of proceeds from the issuance of common stock and excess tax benefits from stock-based awards. During the nine months ended January 1, 2012, cash used in financing activities of $96.1 million consisted of $103.9 million for purchases of common stock under our stock repurchase program and $5.4 million for minimum tax withholdings paid on behalf of employees for restricted stock units that vested during the period, partially offset by $13.2 million of proceeds from the issuance of common stock and excess tax benefits from stock-based awards.

Since fiscal 2003, we have had various stock repurchase programs that authorized the purchase of up to $1.95 billion of our outstanding common stock. As of December 30, 2012, we had repurchased a total of 120.4 million shares of common stock under our stock repurchase programs for an aggregate purchase price of $1.87 billion. Pursuant to the existing stock repurchase program, we are authorized to repurchase shares with an aggregate cost of up to $79.1 million as of December 30, 2012.

15 -------------------------------------------------------------------------------- Table of Contents We have certain contractual obligations and commitments to make future payments in the form of non-cancelable purchase orders to our suppliers and commitments under operating lease arrangements. A summary of our contractual obligations as of December 30, 2012, and their impact on our cash flows in future fiscal years, is as follows: 2013 (Remaining three months) 2014 2015 2016 2017 Thereafter Total (In millions) Operating leases $ 2.3 $ 8.9 $ 5.7 $ 1.9 $ 1.9 $ 2.1 $ 22.8 Non-cancelable purchase obligations 22.2 2.4 - - - - 24.6 Total $ 24.5 $ 11.3 $ 5.7 $ 1.9 $ 1.9 $ 2.1 $ 47.4 The amount of unrecognized tax benefits, including related accrued interest and penalties, was $67.0 million as of December 30, 2012. We are not able to provide a reasonable estimate of the timing of future tax payments related to these obligations.

Critical Accounting Policies and Estimates The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenues and expenses during the reporting period. We base our estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances, including the current economic environment, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We believe the accounting policies described below to be our most critical accounting policies. These accounting policies are affected significantly by judgments, assumptions and estimates used in the preparation of the financial statements and actual results could differ materially from the amounts reported based on these policies.

Revenue Recognition We recognize revenue from product sales when all of the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price to the customer is fixed or determinable and (iv) collection of the resulting accounts receivable is reasonably assured.

For all sales, we use a binding purchase order or a signed agreement as evidence of an arrangement. Delivery occurs when goods are shipped and title and risk of loss transfer to the customer, in accordance with the terms specified in the arrangement with the customer. The customer's obligation to pay and the payment terms are set at the time of delivery and are not dependent on the subsequent resale of the product. However, certain of our sales are made to distributors under agreements that contain a limited right to return unsold product and price protection provisions. These return rights and price protection provisions limit our ability to reasonably estimate product returns and the final price of the inventory sold to distributors. As a result, the price to the customer is not fixed or determinable at the time products are delivered to distributors.

Accordingly, we recognize revenue from these distributors based on the sell-through method using inventory information provided by the distributor. At times, we provide standard incentive programs to our customers. We account for our competitive pricing incentives and rebates as a reduction of revenue in the period the related revenue is recorded based on the specific program criteria and historical experience. In addition, we record provisions against revenue and cost of revenue for estimated product returns in the same period that revenue is recognized. These provisions are based on historical experience as well as specifically identified product returns. Service and other revenue is recognized when earned and receipt is reasonably assured.

For those sales that include multiple deliverables, we allocate revenue based on the relative selling price of the individual components. When more than one element, such as hardware and services, are contained in a single arrangement, we allocate revenue between the elements based on each element's relative selling price, provided that each element meets the criteria for treatment as a separate unit of accounting. When applying the relative selling price method, we determine the selling price for each deliverable using vendor-specific objective evidence (VSOE) of the selling price, if it exists. In order to establish VSOE of the selling price, we must regularly sell the product and/or service on a standalone basis with a substantial majority of the sales priced within a relatively narrow range. If VSOE of the selling price cannot be determined, we then consider third party evidence (TPE) of the selling price. Generally, we are not able to determine TPE due to the lack of similar products and services sold by other companies within the industry. If neither VSOE nor TPE exists, we determine the estimated selling price based on multiple factors including, but not limited to, cost, gross margin, market conditions and pricing practices.

Revenue allocated to each element is then recognized when the basic revenue recognition criteria is met for each deliverable.

16-------------------------------------------------------------------------------- Table of Contents We sell certain software products and related post-contract customer support. We recognize revenue from software products when all of the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price to the customer is fixed or determinable and (iv) collection of the resulting accounts receivable is probable. Revenue is allocated to undelivered elements based upon VSOE of the fair value of the element. VSOE of the fair value 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 are met for each element. If we are unable to determine VSOE of fair value for an undelivered element, the entire amount of revenue from the arrangement is deferred and recognized over the service period or when all elements have been delivered.

Stock-Based Compensation We recognize compensation expense for all stock-based awards made to employees and non-employee directors, including stock options, restricted stock units and stock purchases under our Employee Stock Purchase Plan (the ESPP), based on estimated fair values on the measurement date, which is generally the date of grant. Stock-based compensation is recognized for the portion of the award that is ultimately expected to vest. Forfeitures are estimated at the time of grant based on historical trends and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We recognize stock-based compensation expense for awards that are subject to only a service condition on a straight-line basis over the requisite service period for the entire award, which is the vesting period for stock options and restricted stock units, and the offering period for the ESPP. For all other stock-based awards, stock-based compensation is recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. The determination of fair value of stock-based awards on the date of grant using an option-pricing model is affected by our stock price, as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards and actual and projected employee stock option exercise behaviors. In estimating expected stock price volatility, we use a combination of both historical volatility, calculated based on the daily closing prices of our common stock over a period equal to the expected term of the option, and implied volatility, utilizing market data of actively traded options on our common stock. We believe that the historical volatility of the price of our common stock over the expected term of the option is a strong indicator of the expected future volatility. We also believe that implied volatility takes into consideration market expectations of how future volatility will differ from historical volatility. Accordingly, we believe a combination of both historical and implied volatility provides the best estimate of the future volatility of the market price of our common stock. Changes in the subjective assumptions can materially affect the estimated fair value of stock-based awards.

Income Taxes We utilize the asset and liability method of accounting for income taxes. Income tax positions taken or expected to be taken in a tax return should be recognized in the first reporting period that it is more likely than not the tax position will be sustained upon examination. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. Previously recognized income tax positions that fail to meet the recognition threshold in a subsequent period are derecognized in that period. Differences between actual results and our assumptions, or changes in our assumptions in future periods, are recorded in the period they become known. We record potential accrued interest and penalties related to unrecognized tax benefits in income tax expense.

Deferred income taxes are recognized for the future tax consequences of temporary differences using enacted statutory tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Temporary differences include the difference between the financial statement carrying amounts and the tax bases of existing assets and liabilities and operating loss and tax credit carryforwards. The effect on deferred taxes of a change in tax rates is recognized in earnings in the period that includes the enactment date.

A valuation allowance is recorded when it is more likely than not that some or all of a deferred tax asset will not be realized. Significant judgment and estimates are required in determining whether a valuation allowance is recorded.

In assessing the need for a valuation allowance, we consider all available evidence, including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. Our estimates and projections require significant judgment and are subject to uncertainty due to various factors, including the economic environment, industry and market conditions, and the length of time of the projections included in the analyses. If our actual results, or estimates used in future analyses related to deferred tax assets, are less favorable than current estimates, a valuation allowance may be required with a corresponding adjustment to earnings in the period in which such determination is made.

17 -------------------------------------------------------------------------------- Table of Contents As a multinational corporation, we are subject to complex tax laws and regulations in various jurisdictions. The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws themselves are subject to change as a result of changes in fiscal policy, changes in legislation, evolution of regulations and court rulings. Therefore, the actual liability for U.S. or foreign taxes may be materially different from our estimates, which could result in the need to record additional liabilities or potentially to reverse previously recorded tax liabilities. Differences between actual results and our assumptions, or changes in our assumptions in future periods, are recorded in the period they become known.

Investment Securities Investment securities include available-for-sale securities, trading securities and other investment securities. Our investment securities are classified in the consolidated balance sheets based on the nature of the security and the availability for use in current operations.

Available-for-sale securities are recorded at fair value based on quoted market prices or other observable inputs. Unrealized gains and losses, net of related income taxes, on available-for-sale securities are excluded from earnings and reported as a separate component of accumulated other comprehensive income until realized.

Trading securities are recorded at fair value with unrealized holding gains and losses included in earnings and reported in interest and other income, net. In the absence of quoted market prices, these securities are valued based on an income approach using an estimate of future cash flows.

Other investment securities are accounted for under the cost method and recorded at the lower of fair value or cost.

We recognize an impairment charge on available-for-sale securities when the decline in the fair value of an investment below its cost basis is judged to be other-than-temporary. If we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, we would recognize the entire impairment in earnings. If we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment is separated into (a) the amount representing the credit loss and (b) the amount related to all other factors. The amount of the other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the other-than-temporary impairment related to other factors is recognized in other comprehensive income, net of applicable taxes.

Significant judgment is required in determining the fair value of investment securities in inactive markets as well as determining when declines in fair value constitute an other-than-temporary impairment and the portion of any impairment that is due to a credit loss. We consider various factors in determining whether to recognize an impairment charge, including the current financial and credit market environment, the financial condition and near-term prospects of the issuer of the security, the magnitude of the unrealized loss compared to the cost of the investment, the length of time the investment has been in a loss position and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery of market value.

Realized gains or losses are determined on a specific identification basis and reported in interest and other income, net, as incurred.

Inventories Inventories are stated at the lower of cost (first-in, first-out) or market. We write down the carrying value of our inventory to estimated net realizable value for estimated excess and obsolete inventory based upon assumptions about future demand and market conditions. These assumptions are based on economic conditions and trends (both current and projected), anticipated customer demand and acceptance of our current products, expected future products and other assumptions. If actual market conditions are less favorable than those projected by management, additional write-downs may be required. Once we write down the carrying value of inventory, a new cost basis is established. Subsequent changes in facts and circumstances do not result in an increase in the newly-established cost basis.

Goodwill and Other Intangible Assets Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. The amounts and useful lives assigned to intangible assets acquired, other than goodwill, impact the amount and timing of future amortization. The amount assigned to in-process research and development is capitalized and accounted for as an indefinite-lived intangible asset until the underlying projects are completed or abandoned.

Goodwill is not amortized but instead is tested at least annually for impairment, or more frequently when events or changes in circumstances indicate a potential impairment, by comparing the carrying value to the fair value of the reporting unit to which the 18 -------------------------------------------------------------------------------- Table of Contents goodwill is assigned. A two-step test is used to identify the potential impairment and to measure the amount of impairment, if any. The first step is to compare the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit is less than its carrying amount, goodwill is considered impaired and the loss is measured by performing step two. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. We perform the annual test for impairment as of the first day of our fourth fiscal quarter.

The initial recording and subsequent evaluation for impairment of goodwill and purchased intangible assets requires the use of significant management judgment regarding the forecasts of future operating results. It is possible that our business plans may change and our estimates used may prove to be inaccurate. If our actual results or estimates used in future impairment analyses are lower than current estimates, we could incur impairment charges.

Long-Lived Assets Long-lived assets, including property and equipment and purchased intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Significant judgment is required in determining whether a potential indicator of impairment of our long-lived assets exists. Recoverability of assets to be held and used is measured by the comparison of the carrying amount of an asset or asset group to future undiscounted net cash flows expected to be generated by the asset or asset group. If such an asset or asset group is considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the asset or asset group exceeds the fair value of the asset or asset group. Assets to be disposed of are reported at the lower of their carrying amount or fair value less costs to sell. Estimating future net cash flows and determining proper asset groupings for the purpose of this impairment test requires the use of significant management judgment. If our actual results, or estimates used in future impairment analyses, are lower than our current estimates, we could incur impairment charges.

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