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EMULEX CORP /DE/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Executive Overview Emulex is a global provider of a broad range of enterprise-class connectivity solutions for servers, networks and storage devices within the data center. The world's leading server and storage Original Equipment Manufacturers (OEMs) depend on our broad range of products to help build high performance, highly reliable, and scalable Fibre Channel Storage Area Networks (SAN) and Ethernet Converged Networking solutions. Our Company operates within a single business segment that has two primary market-focused product lines: Network Connectivity Products (NCP) and Storage Connectivity Products (SCP). Customers in the NCP market use our industry standard Fibre Channel and Ethernet solutions to provide server Input/Output (I/O) and target storage array connectivity to create networks for mission critical enterprise and cloud data centers. These products enable servers to reliably and efficiently connect to Local Area Networks (LANs), SANs, and Network Attached Storage (NAS) by offloading data communication processing tasks from the server as information is delivered and sent to the network. Our products use industry standard protocols including Fibre Channel Protocol (FCP), Internet Protocol (IP), Transmission Control Protocol (TCP)/IP, Internet Small Computer System Interface (iSCSI), NAS, and Fibre Channel over Ethernet (FCoE). Our Ethernet products include Universal Local Area Network on Motherboard application specific integrated circuits (ULOMs), OneConnect ® Universal Converged Network Adapters (UCNAs), and custom form factor solutions for OEM blade servers that enable high performance, scalable networks and convergence. Our Fibre Channel based products include Fibre Channel application specific integrated circuits (ASICs), LightPulse® Host Bus Adaptors (HBAs), and custom form factor solutions for OEM blade servers. SCP includes our InSpeed®, switch-on-a-chip (SOC) or backend connectivity, bridge, and router products. SCP are deployed inside storage arrays, tape libraries, and other storage appliances, and connect storage controllers to storage capacity, delivering improved performance, reliability, and connectivity. Our products use industry standard protocols including Fibre Channel, Serial Attached Small Computer Interface (SAS), and Serial Advanced Technology Attachment (SATA). Our third product line, Advanced Technology and Other Products (ATP), primarily consists of Integrated Baseboard Management Controllers (iBMC), OneCommand® Vision products, certain legacy products and other products and services. We rely almost exclusively on OEMs and sales through distribution channels for our revenue. Our significant OEM customers include the world's leading server and storage providers, including Cisco Systems, Inc. (Cisco), Dell Inc. (Dell), EMC Corporation (EMC), Fujitsu Ltd. (Fujitsu), Hewlett-Packard Company (Hewlett-Packard), Hitachi Data Systems (HDS), Hitachi Limited (Hitachi), Huawei Technologies Company Ltd. (Huawei), Intel Corporation (Intel), International Business Machines Corporation (IBM), NEC Corporation (NEC), Network Appliance, Inc. (NetApp), Oracle Corporation (Oracle), and Xyratex Ltd. (Xyratex). Our significant distributors include ASI Computer Technologies, Inc. (ASI), Avnet, Inc. (Avnet), Digital China Technology Limited, Info X Distribution, LLC (Info X), Ingram Micro Inc. (Ingram Micro), Macnica Networks Corporation (Macnica), Netmarks Inc. (Netmarks), SYNNEX Corporation (SYNNEX), Tech Data Corporation (Tech Data), and Tokyo Electron Device Ltd. (TED). The market for networking infrastructure solutions is concentrated among large OEMs, and as such, a significant portion of our revenues are generated from sales to a limited number of customers. As of December 30, 2012, we had a total of 1,059 employees. Our corporate headquarters are located at 3333 Susan Street, Costa Mesa, California 92626. Our periodic and current reports filed with, or furnished to, the Securities and Exchange Commission pursuant to the requirements of the Securities and Exchange Act of 1934 are available free of charge through our website (www.emulex.com) as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission. References contained herein to "Emulex," the "Company," the "Registrant," "we," "our," and "us" refer to Emulex Corporation and its subsidiaries. Pending Business Combination On December 20, 2012, we issued a formal offer under the terms of New Zealand Takeover Code to acquire Endace Limited (Endace) for cash consideration of 500 pence per share, or approximately £80.7 million (approximately $130.7 million using an exchange rate of 1.62 US Dollars for 1.00 British Pound Sterling) in exchange for 100% of the outstanding equity interests in Endace. The offer period will end at 1p.m., London Time on February 12, 2013. Endace is a network performance management company that provides network monitoring appliances, network analytics software and ultra-high speed network access switching. Emulex's software-defined convergence architecture and Endace's network visibility infrastructure is expected to provide customers with new and innovative ways to solve the challenges of network complexity and ensure application-level performance at speeds of 10Gb and beyond. Endace's ability to record, visualize and monitor network traffic provides customers with the ability to dynamically optimize application delivery across the infrastructure. The combination of Emulex and Endace's technology is expected to provide customers the solutions to connect, monitor and manage high-performance networks. 18 -------------------------------------------------------------------------------- Table of Contents Consolidation of Facilities During fiscal 2011, we commenced the consolidation of certain leased facilities in Colorado and Washington. The consolidation of facilities was completed during the first quarter of fiscal 2012. Total charges related to the facility consolidation and related workforce reductions were approximately $4.2 million, of which $1.1 million was recorded in fiscal 2012 and $3.1 million was recorded in fiscal 2011. The charges consisted primarily of salaries and benefits based on continuous employment of affected employees through the facility closure dates. In fiscal 2012, the charges were comprised of salaries and benefits expense of approximately $0.4 million, acceleration of rent expense of approximately $0.5 million, and other costs of approximately $0.2 million. Patent Litigation Broadcom Corporation (Broadcom) filed a consolidated patent infringement suit against us during fiscal 2010. After a nearly three week trial that ended October 6, 2011, the jury reached a partial verdict involving two out of the six patents. The Court determined that one of the patents (U.S. Patent 7,058,150) [the '150 patent] had been infringed by us, and the jury rendered an advisory verdict on October 12, 2011 to the Court that the '150 patent is not invalid, and awarded approximately $0.4 million in damages related to that patent. The jury reached a unanimous verdict of non-infringement on another patent relating to Emulex Fibre Channel switch products. A mistrial was declared on the remaining four patents (including U.S. Patent 6,424,194 [the '194 patent]) for which no unanimous verdict was reached. Subsequent to the trial, the Court issued orders consistent with the advisory verdicts of invalidity, and issued an order that one additional patent (U.S. Patent 7,471,691) [the '691 patent] had been infringed by us. On March 16, 2012, the Court issued a decision concerning injunctive relief for the '150 and the '691 patents. The decision provided, in part, for a sunset period of 18 months relating to the '150 patent, starting on October 12, 2011. The decision further provided for a sunset period of 18 months relating to the '691 patent, starting on December 16, 2011. The sunset period allows Emulex to sell the affected products to existing customers for specific customer devices, subject to limitations relating to when customers had qualified the products and when certain firm orders had been placed. The decision further provided for Emulex to pay a royalty of nine percent on all sales of such products made during the sunset period. The decision also clarified that foreign sales (outside the U.S.) are beyond the scope of the suit. On April 3, 2012, the Court issued a Permanent Injunction which, with respect to both the '150 and '691 patents, further describe the prohibited activities, contain sunset provision terms including royalty rates and computations, limit the territory to allow sales of products that are manufactured outside the U.S. to customers located outside the U.S., permit design around efforts including modifications and design, development, and testing to eliminate infringement, and permit service and technical support for certain products. On April 4, 2012, we filed a notice of appeal for both the '150 patent and '691 patent infringement findings with the Court of Appeals for the Federal Court, oral arguments for which were heard on December 3, 2012. On May 30, 2012, the Court issued an order requiring the parties to submit an appendix, which identities the permitted sunset sales (Appendix), to the April 3, 2012 Permanent Injunction The current Permanent Injunction permits major OEMs to obtain continued supply beyond the sunset period, providing them time to re-qualify products resulting from the design around efforts. On July 3, 2012, we entered into a Patent License and Release Agreement (Settlement Agreement) with Broadcom pursuant to which both parties agreed to settle and release certain claims related to the patent infringement litigation in exchange for a lump sum payment of $58.0 million. The Settlement Agreement provided for certain amendments to the April 3, 2012 permanent injunction (2012 Permanent Injunction), and dismissals of certain allegations of the lawsuit, including portions of the scheduled re-trial. We also received a worldwide limited license to the '691 patent, the '150 patent, the '194 patent and related families for certain fields of use including Fibre Channel applications. On July 18, 2012, pursuant to the Settlement Agreement, the Court issued an amended permanent injunction with an amended Appendix, and approved a stipulation to dismiss certain allegations in the lawsuit in light of the Settlement Agreement. During the first quarter of fiscal 2013, we made the $58.0 million payment to Broadcom pursuant to the Settlement Agreement, $36.8 million of which was previously expensed in fiscal 2012. The remaining $21.2 million was recorded as prepaid license fees and is being amortized to cost of goods sold over the ten year license term in proportion to the estimated future revenues of such licensed technology. We recognized approximately $1.0 million and $2.0 million of amortization expense related to such prepaid license fees and sunset period royalty expenses during the three and six months ended December 30, 2012. We expect to incur incremental mitigation, product redesign and appeal related expenses during fiscal 2013 and fiscal 2014 related to the unsettled infringement findings in the range of $15 million to $20 million. Engineering and development costs will include expenses for activities to redesign, design around, modify, design, develop, test and requalify certain of our affected products during the sunset period, and to implement our end of life processes in the U.S. for certain other affected products. Sales and marketing costs are likely to include expenses for customer support, pre-production samples, education and 19 -------------------------------------------------------------------------------- Table of Contents training, and other miscellaneous costs. General and administrative costs will include expenses for our appeal of the previous verdicts and judgments. See Note 7 in the accompanying notes to condensed consolidated financial statements under the caption "Litigation" in Part I, Item 1 of this Form 10-Q. Results of Operations The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements included elsewhere herein. Percentage of Net Revenues Percentage of Net Revenues Three Months Ended Six Months Ended December 30, January 1, December 30, January 1, 2012 2012 2012 2012 Net revenues 100 % 100 % 100 % 100 % Cost of sales Cost of goods sold 36 37 37 37 Amortization of core and developed technology intangible assets 4 4 4 6 Patent litigation settlement, damages, sunset period royalties and license fees 1 - 1 - Total cost of sales 41 41 42 43 Gross profit 59 59 58 57 Operating expenses: Engineering and development 33 29 33 33 Selling and marketing 12 12 12 12 General and administrative 9 7 8 8 Amortization of other intangible assets 1 1 1 2 Total operating expenses 55 49 54 55 Operating income 4 10 4 2 Non-operating (expense) income, net - - - - Income before income taxes 4 10 4 2 Income tax (benefit) provision (1 ) (2 ) 2 (1 ) Net income 5 % 12 % 2 % 3 % Three months ended December 30, 2012, compared to three months ended January 1, 2012 Net Revenues. Net revenues for the three months ended December 30, 2012, decreased by approximately $6.5 million, or 5%, to approximately $122.1 million, compared to approximately $128.7 million for the three months ended January 1, 2012. The decrease in revenues was primarily due to weakness in the server and storage technology markets resulting from continuing concern over the global macroeconomic climate. 20 -------------------------------------------------------------------------------- Table of Contents Net Revenues by Product LineNet revenues by product line were as follows: Net Revenues by Product Line Three Months Three Months Ended Percentage Ended Percentage December 30, of Net January 1, of Net Increase/ Percentage (in thousands) 2012 Revenues 2012 Revenues (Decrease) ChangeNetwork Connectivity Products $ 96,132 79 % $ 96,620 75 % $ (488 ) (1 )% Storage Connectivity Products 22,670 18 % 27,583 21 % (4,913 ) (18 )% Advanced Technology & Other Products 3,343 3 % 4,468 4 % (1,125 ) (25 )% Total net revenues $ 122,145 100 % $ 128,671 100 % $ (6,526 ) (5 )% NCP primarily consists of standup HBAs, mezzanine cards, I/O ASICs, ULOMs, and UCNAs. For the three months ended December 30, 2012, Fibre Channel based products accounted for approximately 81% of total NCP revenues, which was comparable to the same period in the prior year. Our NCP revenues for the three months ended December 30, 2012 remained comparable to the three months ended January 1, 2012 but reflect a decrease in units shipped of approximately 7% being offset by an increase in average selling price of approximately 7%. SCP primarily consists of InSpeed®, SOC or backend connectivity, and bridge and router products. Our SCP revenues decreased by approximately 18% for the three months ended December 30, 2012 compared to the three months ended January 1, 2012. The decrease was primarily due to a decline in backend connectivity product shipments as a result of certain products reaching end of life in fiscal 2012. These products typically had higher selling prices compared to other SCP products, therefore, average selling prices for SCP decreased by approximately 25% compared to the same period in the prior year. Our SCP revenue is expected to continue to be lower in fiscal 2013 compared to fiscal 2012. ATP primarily consists of iBMCs, OneCommand® Vision software products, certain legacy products and other products and services. For the three months ended December 30, 2012, iBMC based products accounted for the majority of ATP revenues. The decrease in our ATP revenues for the three months ended December 30, 2012 was primarily due to a decrease in units shipped of approximately 27%, combined with a decrease in average selling price of approximately 11%. Net Revenues by Major Customers In addition to direct sales, some of our larger OEM customers purchase or market products indirectly through distributors, resellers or other third parties. If these indirect sales are purchases of customer-specific models, we are able to track these sales. However, if these indirect sales are purchases of our standard models, we are not able to distinguish them by OEM customer. Customers whose direct net revenues, or total direct and indirect net revenues (including customer-specific models purchased or marketed indirectly through distributors, resellers and other third parties), exceeded 10% of our net revenues were as follows: Net Revenues by Major Customers Direct Revenues Total Direct and Indirect Revenues (2) Three Months Three Months Three Months Three Months Ended Ended Ended Ended December 30, January 1, December 30, January 1, 2012 2012 2012 2012 Net revenue percentage (1): OEM: EMC - - 11 % - Hewlett-Packard 19 % 22 % 22 % 25 % IBM 35 % 37 % 38 % 41 % Hon Hai Precision Industry Co., Ltd. (Foxconn Technology Group) (3) 11 % - - - (1) Amounts less than 10% are not presented. (2) Customer-specific models purchased or marketed indirectly through distributors, resellers, and other third parties are included with the OEM's revenues in these columns rather than as revenue for the distributors, resellers or other third parties. (3) Hon Hai Precision Industry Co., Ltd. is a contract manufacturer that performed manufacturing for some of our OEM customers. 21 -------------------------------------------------------------------------------- Table of Contents Direct sales to our top five customers accounted for approximately 74% of total net revenues for the three months ended December 30, 2012, compared to approximately 73% for the three months ended January 1, 2012. Direct and indirect sales to our top five customers accounted for approximately 83% of total net revenues for the three months ended December 30, 2012, compared to approximately 81% for the three months ended January 1, 2012. Our net revenues from customers can be significantly impacted by changes in our customers' business and their business models. Net Revenues by Sales ChannelNet revenues by sales channel were as follows: Net Revenues by Sales Channel Three Months Three Months Ended Percentage Ended Percentage December 30, of Net January 1, of Net Increase/ Percentage (in thousands) 2012 Revenues 2012 Revenues (Decrease) Change OEM $ 110,174 90 % $ 117,925 92 % $ (7,751 ) (7 )% Distribution 11,896 10 % 10,733 8 % 1,163 11 % Other 75 - 13 - 62 477 % Total net revenues $ 122,145 100 % $ 128,671 100 % $ (6,526 ) (5 )% The decrease in OEM net revenues for the three months ended December 30, 2012 compared to the three months ended January 1, 2012 reflected decreases of approximately 24% in ATP revenues, 19% in SCP revenues, and 2% in NCP revenues generated through our OEMs. The increase in distribution net revenues for the three months ended December 30, 2012 compared to the three months ended January 1, 2012 reflected an increase of approximately 9% in NCP net revenues generated through distribution partners. We believe that our net revenues are being generated primarily as a result of product certifications and qualifications with our OEM customers, which take products directly and indirectly through distribution and contract manufacturers. We view product certifications and qualifications as an important indicator of future revenue opportunities and growth for the Company. However, product certifications and qualifications do not necessarily ensure continued market acceptance of our products by our OEM customers. It is also very difficult to determine the future impact, if any, of product certifications and qualifications on our revenues. Net Revenues by Geographic Territory Our net revenues by geographic territory based on billed-to location were as follows: Net Revenues by Geographic Territory Three Months Three Months Ended Percentage Ended Percentage December 30, of Net January 1, of Net Increase/ Percentage (in thousands) 2012 Revenues 2012 Revenues (Decrease) Change Asia Pacific $ 73,610 60 % $ 80,391 63 % $ (6,781 ) (8 )% United States 31,151 26 % 31,394 24 % (243 ) (1 )% Europe, Middle East, and Africa 15,941 13 % 16,473 13 % (532 ) (3 )% Rest of the world 1,443 1 % 413 - 1,030 249 % Total net revenues $ 122,145 100 % $ 128,671 100 % $ (6,526 ) (5 )% The decrease in net revenues across geographic territories was primarily due to weakness in the server and storage technology markets resulting from continuing concern over the macroeconomic climate. Although Asia Pacific net revenues decreased as a percentage of total net revenues compared to the same period in the prior year, we expect our OEM customers will continue to migrate towards using contract manufacturers that are predominately located in Asia Pacific. However, since we sell to OEMs and distributors who ultimately resell our products to their customers, the geographic mix of our net revenues may not be reflective of the geographic mix of end-user demand or installations. 22-------------------------------------------------------------------------------- Table of Contents Gross Profit. Gross profit consists of net revenues less cost of sales. Our gross profit was as follows (in thousands): Gross Profit Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $71,566 59% $75,423 59% $(3,857) - Cost of sales includes the cost of producing, supporting, and managing our supply of quality finished products. Cost of sales also included approximately $5.1 million of amortization of technology intangible assets for both three months ended December 30, 2012 and January 1, 2012. Approximately $0.2 million and $0.3 million of share-based compensation expenses were included in cost of sales for the three months ended December 30, 2012 and January 1, 2012, respectively. Our gross margin percentage for the three months ended December 30, 2012 remained comparable to the three months ended January 1, 2012 due to favorable product mix that was offset by the sunset period royalty and patent license fee amortization expenses of approximately $1.0 million related to the Settlement Agreement entered into with Broadcom on July 3, 2012. We will continue to recognize patent license fee amortization expenses related to the Settlement Agreement over the remaining patent license term (which expires on July 1, 2020) and sunset period royalty expenses related to the amended 2012 Permanent Injunction through fiscal 2013. Although gross margin remained constant in the current three months ended December 30, 2012, we expect gross margin to trend downward as the portion of our revenues generated from lower margin products increases in the future. Engineering and Development. Engineering and development expenses consist primarily of salaries and related expenses for personnel engaged in the design, development, and support of our products. These expenses also include third-party fees paid to consultants, prototype development expenses, and computer service costs related to supporting computer tools used in the design process. Fluctuations in engineering and development expenses may occur due to the timing of product development cycles and non-recurring engineering costs. Engineering and development expenses were as follows (in thousands): Engineering and Development Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $40,113 33% $37,671 29% $2,442 4% Engineering and development expenses for the three months ended December 30, 2012 compared to the three months ended January 1, 2012 increased by approximately $2.4 million, or 6%. Approximately $2.2 million and $2.4 million of share-based compensation expenses were included in engineering and development costs for the three months ended December 30, 2012 and January 1, 2012, respectively. Engineering and development headcount increased to 687 at December 30, 2012 from 629 at January 1, 2012. The increase in headcount resulted in a net increase in salary and related expenses of approximately $1.0 million. The remaining increase in engineering and development expenses was due to product redesign expenses related to our mitigation activities for the 2012 Permanent Injunction of approximately $0.6 million, an increase in new product development costs of approximately $0.4 million, and system maintenance costs of approximately $0.4 million. We plan to continue to invest in engineering and development costs. In addition, due to the 2012 Permanent Injunction, we expect to continue to incur incremental engineering and development expenses to redesign our impacted products through fiscal 2014. See "Patent Litigation" elsewhere in Part I, Item 2 of this Form 10-Q. Selling and Marketing. Selling and marketing expenses consist primarily of salaries, commissions, and related expenses for personnel engaged in the marketing and sales of our products, as well as trade shows, product literature, promotional support costs, and other advertising related costs. Sales and marketing expenses were as follows (in thousands): Selling and Marketing Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $14,769 12% $15,260 12% $(491) - Selling and marketing expenses for the three months ended December 30, 2012 compared to the three months ended January 1, 2012 decreased by approximately $0.5 million, or 3%. Approximately $0.9 million of share-based compensation expenses were included in selling and marketing costs for both the three month periods ended December 30, 2012 and January 1, 2012. Selling and marketing headcount increased to 158 at December 30, 2012 from 150 at January 1, 2012, resulting in an increase in salary and related expenses of approximately $0.3 million, offset by a decrease in advertising expenses of approximately $0.7 million. We plan to continue to closely manage and target advertising and market promotion expenses to heighten brand awareness of our new and existing products in an effort to provide overall revenue growth. Due to the 2012 Permanent Injunction, we expect to continue to incur incremental sales and marketing expenses to requalify and recertify our impacted products with customers through fiscal 2014. See "Patent Litigation" elsewhere in Part I, Item 2 of this Form 10-Q. 23 -------------------------------------------------------------------------------- Table of Contents General and Administrative. Ongoing general and administrative expenses consist primarily of salaries and related expenses for executives, financial accounting support, human resources, administrative services, professional fees, and other corporate expenses. General and administrative expenses were as follows (in thousands): General and AdministrativeThree Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $10,987 9% $9,123 7% $1,864 2% General and administrative expenses for the three months ended December 30, 2012 compared to the three months ended January 1, 2012 increased by approximately $1.9 million, or 20%. Approximately $2.0 million and $2.5 million of share-based compensation expenses were included in general and administrative costs for the three months ended December 30, 2012 and January 1, 2012, respectively. General and administrative headcount increased to 146 at December 30, 2012 from 139 at January 1, 2012. Although headcount increased during the three months ended December 30, 2012 compared to the three months ended January 1, 2012, salary and related expenses decreased by approximately $0.3 million primarily due a decrease in performance-based compensation. The increase in general and administrative expenses was primarily due to an increase in legal and accounting costs related to our pending acquisition of Endace of approximately $2.1 million and an increase in legal costs related to our mitigation activities for the 2012 Permanent Injunction of approximately $0.4 million. We expect to continue to incur incremental general and administrative expenses related to our mitigation activities for the 2012 Permanent Injunction and our pending acquisition of Endace through fiscal 2014. See "Patent Litigation" and "Pending Business Combination" elsewhere in Part I, Item 2 of this Form 10-Q. Amortization of Other Intangible Assets. Amortization of other intangible assets consists of amortization of intangible assets such as patents, customer relationships, tradenames with estimable lives, covenants not to compete, and backlog. Amortization expense was as follows (in thousands): Amortization of Other Intangible Assets Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $1,365 1% $1,602 1% $(237) - Amortization of other intangible assets for the three months ended December 30, 2012 compared to the three months ended January 1, 2012 decreased by approximately $0.2 million, or 15%. The decrease was primarily due to a lower unamortized intangible assets balance at the beginning of the current three month period as a result of certain intangible assets being fully amortized in fiscal 2012. Non-operating (Expense) Income, net. Non-operating (expense) income, net, consists primarily of interest income, interest expense, and other non-operating income and expense items. Our non-operating (expense) income, net, was as follows (in thousands): Non-operating(Expense) Income, net Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $(17) -% $171 -% $(188) - Our non-operating (expense) income, net, for the three months ended December 30, 2012 compared to the three months ended January 1, 2012 decreased by approximately $0.2 million, or 110%. The net decrease was primarily due to a foreign exchange loss in the three months ended December 30, 2012 of approximately $0.1 million compared to a foreign expense gain in the same period in the prior year of approximately of approximately $0.1 million. Income Taxes. Income taxes were as follows (in thousands): Income Taxes Three Months Ended Percentage of Three Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $(1,268) (1)% $(3,056) (2)% $1,788 1% Income taxes for the three months ended December 30, 2012 compared to the three months ended January 1, 2012 increased by approximately $1.8 million. Our effective tax benefit rate was approximately (29)% and (26)% for the three months ended December 30, 2012 and January 1, 2012, respectively. The increase in our effective tax benefit rate for the three months ended December 30, 2012 compared to the three months ended January 1, 2012 was primarily due to the continuing 24 -------------------------------------------------------------------------------- Table of Contents impact of our previously recorded U.S. deferred tax asset valuation allowance, changes in the mix of earnings in international versus U.S. tax jurisdictions and the use of an actual year-to-date effective tax rate for the three months ended December 30, 2012 versus an annualized effective tax rate. We continue to generate the majority of our earnings in countries other than the U.S. including India, Ireland, and Isle of Man, where such earnings are generally subject to significantly lower tax rates than the U.S. We expect this trend to continue in the future. We have made no provision for U.S. income taxes or foreign withholding taxes on the earnings of our foreign subsidiaries as these amounts are intended to be indefinitely reinvested in operations outside of the U.S. We expect our annual effective tax rate for fiscal 2013 to be substantially higher than the U.S. federal statutory rate primarily due to the continued impact of our previously recorded U.S. deferred tax valuation allowance, including changes in the estimated timing of reversing temporary differences and the resulting amount of deferred tax assets estimated to be recoverable in available carryback periods, and the mix of earnings in international versus U.S. tax jurisdictions. Actual current year originations and reversals of temporary differences that are recoverable in available carryback periods and subject to our U.S. deferred tax valuation allowance could drive significant volatility in our effective tax rate and actual tax expense for fiscal 2013. In addition, changes in the mix of U.S. versus international earnings and changing tax laws could affect our actual tax expense for fiscal 2013. As estimates and judgments are used to project such originations and reversals of temporary differences and the mix of earning in our various tax jurisdictions, the impact to our tax provision could vary significantly if the current planning or assumptions change. We also do not forecast discrete events, such as a settlement of tax audits with governmental authorities or changes in tax laws, due to their inherent uncertainty. Such discrete events could also materially impact our tax expense. As the tax rate is driven by various factors, it is not possible to estimate our future tax rate with a high degree of certainty. Six months ended December 30, 2012, compared to six months ended January 1, 2012 Net Revenues. Net revenues for the six months ended December 30, 2012, decreased by approximately $5.7 million, or 2%, to approximately $241.4 million compared to approximately $247.1 million for the six months ended January 1, 2012. The decrease in revenues was primarily due to weakness in the server and storage technology markets resulting from continuing concern over the global macroeconomic climate. Net Revenues by Product LineNet revenues by product line were as follows: Net Revenues by Product Line Six Months Six Months Ended Percentage Ended Percentage December 30, of Net January 1, of Net Increase/ Percentage (in thousands) 2012 Revenues 2012 Revenues (Decrease) Change Network Connectivity Products $ 192,865 80 % $ 183,209 74 % $ 9,656 5 % Storage Connectivity Products 41,439 17 % 51,465 21 % (10,026 ) (19 )% Advanced Technology & Other Products 7,108 3 % 12,394 5 % (5,286 ) (43 )% Total net revenues $ 241,412 100 % $ 247,068 100 % $ (5,656 ) (2 )% For the six months ended December 30, 2012, Fibre Channel based products accounted for approximately 78% of total NCP revenues, representing an increase of approximately 4% compared to the same period in the prior year. In addition, Ethernet based products revenue within NCP also increased by 10% compared to the same period in the prior year. The increase in NCP revenue for the six months ended December 30, 2012 compared to the six months ended January 1, 2012 was primarily due to an increase in units shipped of approximately 7%, partially offset by a decrease in average selling price of approximately 1%. Our SCP revenues decreased by approximately 20% for the six months ended December 30, 2012 compared to the six months ended January 1, 2012. This decrease was primarily due to a decline in backend connectivity product shipments as a result of certain products reaching end of life in fiscal 2012. These products typically had higher selling prices compared to other SCP products, therefore, average selling prices for SCP decreased by approximately 22% compared to the same period in the prior year. 25-------------------------------------------------------------------------------- Table of Contents For the six months ended December 30, 2012, iBMC based products accounted for the majority of total ATP revenues. The decrease in ATP revenue for the six months ended December 30, 2012 was primarily due to a decrease in units shipped of approximately 26% combined with a decrease in average selling price of approximately 23%. Net Revenues by Major Customers Customers whose direct net revenues, or total direct and indirect net revenues (including customer-specific models purchased or marketed indirectly through distributors, resellers and other third parties), exceeded 10% of our net revenues were as follows: Net Revenues by Major Customers Direct Revenues Total Direct and Indirect Revenues (2) Six Months Six Months Six Months Six Months Ended Ended Ended Ended December 30, January 1, December 30, January 1, 2012 2012 2012 2012 Net revenue percentage (1): OEM: EMC - - 10 % - Hewlett-Packard 21 % 23 % 24 % 26 % IBM 34 % 32 % 38 % 37 % Hon Hai Precision Industry Co., Ltd. (Foxconn Technology Group) (3) 10 % - - - (1) Amounts less than 10% are not presented. (2) Customer-specific models purchased or marketed indirectly through distributors, resellers, and other third parties are included with the OEM's revenues in these columns rather than as revenue for the distributors, resellers or other third parties. (3) Hon Hai Precision Industry Co., Ltd. is a contract manufacturer that performed manufacturing for some of our OEM customers. Direct sales to our top five customers accounted for approximately 74% of total net revenues for the six months ended December 30, 2012, compared to approximately 72% for the six months ended January 1, 2012. Direct and indirect sales to our top five customers accounted for approximately 83% of total net revenues for the six months ended December 30, 2012, compared to approximately 80% for the six months ended January 1, 2012. Our net revenues from customers can be significantly impacted by changes to our customers' business and their business models. Net Revenues by Sales Channel Net revenues by sales channel were as follows: Net Revenues by Sales Channel Six Months Six Months Ended Percentage Ended Percentage December 30, of Net January 1, of Net Increase/ Percentage (in thousands) 2012 Revenues 2012 Revenues (Decrease) Change OEM $ 219,213 91 % $ 221,961 90 % $ (2,748 ) (1 )% Distribution 22,089 9 % 25,049 10 % (2,960 ) (12 )% Other 110 - 58 - 52 90 % Total net revenues $ 241,412 100 % $ 247,068 100 % $ (5,656 ) (2 )% The decrease in OEM net revenues for the six months ended December 30, 2012 compared to the six months ended January 1, 2012 reflected a decrease of approximately 20% in SCP revenues and a decrease of approximately 42% in ATP revenues, partially offset by an increase of approximately 8% in NCP revenues generated through our OEMs. The decrease in distribution net revenues for the six months ended December 26, 2012 compared to the six months ended January 1, 2012 reflected a decrease of approximately 10% in NCP net revenues generated through distribution partners. 26-------------------------------------------------------------------------------- Table of Contents Net Revenues by Geographic Territory Our net revenues by geographic territory based on billed-to location were as follows: Net Revenues by Geographic Territory Six Months Six Months Ended Percentage Ended Percentage December 30, of Net January 1, of Net Increase/ Percentage (in thousands) 2012 Revenues 2012 Revenues (Decrease) Change Asia Pacific $ 150,482 62 % $ 147,054 60 % $ 3,428 2 % United States 58,125 24 % 64,042 26 % (5,917 ) (9 )% Europe, Middle East, and Africa 30,832 13 % 35,348 14 % (4,516 ) (13 )% Rest of the world 1,973 1 % 624 - 1,349 216 % Total net revenues $ 241,412 100 % $ 247,068 100 % $ (5,656 ) (2 )% We believe the increase in Asia net revenues and the decrease in Europe, Middle East, and Africa (EMEA) and United States net revenues for the six months ended December 30, 2012 compared to the six months ended January 1, 2012 was primarily due to our OEM customers continuing to migrate towards using contract manufacturers that are predominately located in Asia Pacific. However, since we sell to OEMs and distributors who ultimately resell our products to their customers, the geographic mix of our net revenues may not be reflective of the geographic mix of end-user demand or installations. Gross Profit. Gross profit consists of net revenues less cost of sales. Our gross profit was as follows (in thousands): Gross Profit Six Months Ended Percentage of Six Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $140,542 58% $140,994 57% $(452) 1% Cost of sales includes the cost of producing, supporting, and managing our supply of quality finished products. Cost of sales also included approximately $10.3 million and $13.7 million of amortization of technology intangible assets for the six months ended December 30, 2012 and January 1, 2012, respectively. Approximately $0.5 million and $0.8 million of share-based compensation expenses were included in cost of sales for the six months ended December 30, 2012 and January 1, 2012, respectively. Our gross margin percentage for the six months ended December 30, 2012 improved slightly primarily due to the decrease in amortization of technology intangible assets, partially offset by the sunset period royalty and patent license fee amortization expenses of approximately $2.0 million related to the Settlement Agreement entered into with Broadcom on July 3, 2012. We will continue to recognize patent license fee amortization expenses related to the Settlement Agreement over the remaining patent license term (which expires on July 1, 2020) and sunset period royalty expenses related to the amended 2012 Permanent Injunction through fiscal 2013. Engineering and Development. Engineering and development expenses were as follows (in thousands): Engineering and Development Six Months Ended Percentage of Six Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $78,583 33% $80,946 33% $(2,363) - Engineering and development expenses for the six months ended December 30, 2012 compared to the six months ended January 1, 2012 decreased by approximately $2.4 million, or 3%. Approximately $4.9 million and $5.3 million of share-based compensation expenses were included in engineering and development costs for the six months ended December 30, 2012 and January 1, 2012, respectively. Engineering and development headcount increased to 687 at December 30, 2012 from 629 at January 1, 2012, resulting in an increase in salary and related expenses of approximately $0.4 million. The decrease in engineering and development expenses were primarily due to a decrease in costs associated with new product development of approximately $2.5 million, a decrease in non-recurring workforce reduction and benefit costs related to consolidation of certain leased facilities in fiscal 2012 of approximately $0.4 million, partially offset by an increase in product redesign expenses related to our mitigation activities for the 2012 Permanent Injunction of approximately $0.5 million. 27-------------------------------------------------------------------------------- Table of Contents Selling and Marketing. Sales and marketing expenses were as follows (in thousands): Selling and Marketing Six Months Ended Percentage of Six Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $28,506 12% $29,877 12% $(1,371) - Selling and marketing expenses for the six months ended December 30, 2012 compared to the six months ended January 1, 2012 decreased by approximately $1.4 million, or 5%. Approximately $1.7 million and $1.9 million of share-based compensation expenses were included in selling and marketing costs for the six months ended December 30, 2012 and January 1, 2012, respectively. Selling and marketing headcount increased to 158 at December 30, 2012 from 152 at January 1, 2012, resulting in a net increase in salary and related expenses of approximately $0.2 million as compared to the same period in the prior year. The decrease in selling and marketing expenses during the six months ended December 30, 2012 was primarily due to a decrease in advertising costs of approximately $0.8 million and other individually insignificant items. We plan to continue to closely manage and target advertising and market promotion expenses to heighten brand awareness of our new and existing products in an effort to provide overall revenue growth. General and Administrative. General and administrative expenses were as follows (in thousands): General and Administrative Six Months Ended Percentage of Six Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $19,495 8% $20,988 8% $(1,493) - General and administrative expenses for the six months ended December 30, 2012 compared to the six months ended January 1, 2012 decreased by approximately $1.5 million, or 7%. Approximately $3.8 million and $4.6 million of share-based compensation expenses were included in general and administrative costs for the six months ended December 30, 2012 and January 1, 2012, respectively. General and administrative headcount increased slightly to 146 at December 30, 2012 from 139 at January 1, 2012. Although headcount increased as of the end of the current six month period ended December 30, 2012, salary and related expenses decreased by approximately $0.7 million compared to the same period in fiscal 2012 due to a reduction in executive headcount in fiscal 2012. The remaining change was primarily due to a decrease in litigation costs related to the on-going patent dispute of approximately $3.0 million, a decrease in performance-based compensation of $0.4 million, partially offset by legal and accounting costs related to our pending acquisition of Endace of approximately $2.1 million and an increase in legal costs related to our mitigation activities for the 2012 Permanent Injunction of approximately $1.0 million. Amortization of Other Intangible Assets. Amortization expense was as follows (in thousands): Amortization of Other Intangible AssetsSix Months Ended Percentage of Six Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $2,888 1% $3,364 2% $(476) (1)% Amortization of other intangible assets for the six months ended December 30, 2012 compared to the six months ended January 1, 2012 decreased by approximately $0.5 million, or 14%. The decrease was primarily due to a lower unamortized intangible assets balance at the beginning of the current six month period as a result of certain intangible assets being fully amortized in fiscal 2012. Non-operating (Expense) Income, net. Non-operating (expense) income, net, was as follows (in thousands): Non-operating Income (Expense), net Six Months Ended Percentage of Six Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $(359) -% $593 -% $(952) - Our non-operating (expense) income, net, for the six months ended December 30, 2012 compared to the six months ended January 1, 2012 decreased by approximately $1.0 million, or 161%. The net decrease was primarily due to a foreign exchange loss in the six months ended December 30, 2012 of approximately $0.4 million compared to a foreign exchange gain in the same period in the prior year of approximately $0.5 million. 28 -------------------------------------------------------------------------------- Table of Contents Income Taxes. Income taxes were as follows (in thousands): Income Taxes Six Months Ended Percentage of Six Months Ended Percentage of Increase/ Percentage December 30, 2012 Net Revenues January 1, 2012 Net Revenues (Decrease) Points Change $4,471 2% $(1,423) (1)% $5,894 3% Income taxes for the six months ended December 30, 2012 compared to the six months ended January 1, 2012 increased by approximately $5.9 million. Our effective tax expense/(benefit) rate was approximately 42% and (22)% for the six months ended December 30, 2012 and January 1, 2012, respectively. The increase in our effective tax expense rate for the six months ended December 30, 2012 compared to the six months ended January 1, 2012 was primarily due to the continuing impact of our previously recorded U.S. deferred tax asset valuation allowance, changes in the mix of earnings in international versus U.S. tax jurisdictions, and the use of an actual year-to-date effective tax rate for the six months ended December 30, 2012 versus an annualized effective tax rate. We continue to generate the majority of our earnings in countries other than the U.S. including India, Ireland, and Isle of Man, where such earnings are generally subject to significantly lower tax rates than the U.S. We expect this trend to continue in the future. We have made no provision for U.S. income taxes or foreign withholding taxes on the earnings of our foreign subsidiaries as these amounts are intended to be indefinitely reinvested in operations outside the U.S. Critical Accounting Policies The preparation of our consolidated financial statements requires estimation and judgment that affect the reported amounts of net revenues, expenses, assets, and liabilities in accordance with accounting principles generally accepted in the United States. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances and which form the basis for making judgments about the carrying values of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the periods presented. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties. Changes in judgments and uncertainties relating to these estimates could potentially result in materially different results under different assumptions and conditions. If these estimates differ significantly from actual results, the impact to the consolidated financial statements may be material. We believe that the critical accounting policies that are the most significant for purposes of fully understanding and evaluating our reported financial results include the following: Revenue Recognition. We generally recognize revenue at the time of shipment when title and risk of loss have passed, evidence of an arrangement has been obtained, pricing is fixed or determinable, and collectability is reasonably assured. We make certain sales through two tier distribution channels using selected distributors and Master Value Added Resellers (collectively, Distributors). These Distributors are subject to distribution agreements that may be terminated upon written notice by either party and that generally provide privileges to return a portion of inventory and to participate in price protection and cooperative marketing programs that limit our ability to reasonably estimate product returns and the final price of inventory sold to distributors. Accordingly, we recognize revenue on our standard non-OEM specific products sold to our Distributors based on a sell-through model. OEM specific models sold to our Distributors are generally governed under the related OEM agreements rather than under these distribution agreements; accordingly, we generally recognize revenue at the time of shipment for OEM specific products shipped to our Distributors. We also maintain sales related reserves for our sales incentive programs. Based on the specific program criteria, we classify the costs of these incentive programs as a reduction of revenue, a cost of sale, or an operating expense. Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts based upon historical write-offs as a percentage of net revenues and management's review of outstanding accounts receivable. Amounts due from customers are charged against the allowance for doubtful accounts when management believes that collectibility of the amount is unlikely. Although we have not historically experienced significant losses on accounts receivable, our accounts receivable are concentrated with a small number of customers. Consequently, any write-off associated with one of these customers could have a significant impact on our allowance for doubtful accounts and results of operations. Inventories. Inventories are stated at the lower of cost, on a first-in, first-out basis, or market. We use a standard cost system to determine cost. The standard costs are adjusted periodically to represent actual cost. We regularly compare forecasted demand and the composition of the forecast against inventory on hand and open purchase commitments in an effort to ensure that the carrying value of inventory does not exceed net realizable value. Accordingly, we may have to reduce the carrying value of excess and obsolete inventory if forecasted demand decreases. 29 -------------------------------------------------------------------------------- Table of Contents Intangible Assets and Other Long-Lived Assets. Intangible assets resulting from acquisitions or licensing agreements are carried at cost less accumulated amortization and impairment charges, if any. For assets with determinable useful lives, amortization is computed using the straight-line method over the estimated economic lives of the respective intangible assets, ranging from two to ten years. Furthermore, we assess whether our intangible assets and other long-lived assets should be tested for recoverability periodically and whenever events or circumstances indicate that their carrying value may not be recoverable. The amount of impairment, if any, is measured based on fair value, which is determined using projected discounted future operating cash flows. Assets to be disposed of are reported at the lower of the carrying amount or fair value less selling costs. Goodwill. Goodwill is not amortized, but instead, is tested at least annually for impairment, or more frequently when events or changes in circumstances indicate that goodwill might be impaired. In assessing goodwill impairment, we have the option to first assess the qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, we determine it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if we conclude otherwise, then we are required to perform the first step of the two-step impairment test by comparing the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered impaired; otherwise, 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 goodwill. We also have the option to bypass the qualitative assessment and proceed directly to performing the first step of the two-step goodwill impairment test. We may resume performing the qualitative assessment in any subsequent period. Management considers our business as a whole to be its reporting unit for purposes of testing for impairment. The annual impairment test is performed during the fourth fiscal quarter. See Note 4 in the accompanying notes to condensed consolidated financial statements included in Part I, Item 1 of this Form 10-Q for additional information. Income Taxes. We account for income taxes using the asset and liability method, under which we recognize deferred tax assets and liabilities for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for net operating loss and tax credit carryforwards. Tax positions that meet a more-likely-than-not recognition threshold are recognized in the first reporting period that it becomes more-likely-than-not such tax position will be sustained upon examination. A tax position that meets this more-likely-than-not recognition threshold is recorded at the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. 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. 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. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. A valuation allowance is recorded against any deferred tax assets when, in the judgment of management, it is more likely than not that all of or part of a deferred tax asset will not be realized. In assessing the need for a valuation allowance, we consider all positive and negative evidence, including recent financial performance, scheduled reversals of temporary differences, projected future taxable income, availability of taxable income in carryback periods and tax planning strategies. Based on a review of such information, we believe that insufficient positive evidence exists to support that we will more likely than not be able to realize the majority of our U.S. federal and state deferred tax assets. Therefore, we have recorded a valuation allowance against our deferred tax assets to the extent that they are not expected to be recoverable against taxes previously paid in available carryback periods. Stock-Based Compensation. We account for our stock-based awards to employees and non-employees using the fair value method. Although we grant unvested stock awards, cash-settled stock unit awards and stock options, the majority of the awards granted and stock based compensation recognized consists of unvested stock awards. The fair value of each unvested stock award is determined based on the closing price of our common stock on the grant date. The fair value of each cash-settled unit award is determined based on the closing price of our common stock upon vesting, and therefore, is subject to remeasurement at each reporting period until the award is vested. For stock options, the fair value of each option is based on several criteria including, but not limited to, the valuation model used and associated input factors including principally stock price volatility and, to a lesser extent, expected term, dividend rate, and risk free interest rate. The input factors used in the valuation model are 30-------------------------------------------------------------------------------- Table of Contents based on subjective future expectations combined with management judgment. Stock-based compensation expense is recognized on a straight-line basis over the requisite service period for each separate vesting tranche of the award. A forfeiture rate assumption is applied in determining the fair value of our stock-based compensation related to both unvested stock awards and stock options based on future expectations and may be revised as significant differences become known. In addition, a probability assessment is applied to unvested performance-based stock awards. These adjustments may materially impact our results of operations in the period such changes are made. Litigation Costs. We record a charge equal to at least the minimum estimated liability for a loss contingency or litigation settlement when both of the following conditions are met: (i) information available prior to issuance of the financial statements indicates that it is probable that a liability had been incurred at the date of the financial statements and (ii) the range of loss can be reasonably estimated. Liabilities related to litigation settlements with multiple elements are recorded based on the fair value of each element. Legal and other litigation related costs are recognized as the services are provided. We record insurance and other indemnity recoveries for litigation costs when both of the following conditions are met: (i) the recovery is probable and (ii) collectability is reasonably assured. The insurance recoveries recorded are only to the extent the litigation costs have been incurred and recognized in the financial statements; however, it is reasonably possible that the actual recovery may be significantly different from our estimates. There are many uncertainties associated with any litigation, and we cannot provide assurance that any actions or other third party claims against us will be resolved without costly litigation or substantial settlement charges. If any of those events were to occur, our business, financial condition and results of operations could be materially and adversely affected. See Note 7 in the accompanying notes to condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q. Recently Adopted Accounting Standards See Note 1 in the accompanying notes to condensed consolidated financial statements included in Part I, Item I of this Form 10-Q for a description of recently adopted accounting standards. Liquidity and Capital Resources Our principal sources of liquidity consist of our existing cash balances and investments, as well as funds expected to be generated from operations. At December 30, 2012, we had approximately $274.6 million in working capital and approximately $211.2 million in cash and cash equivalents and current investments as compared to approximately $260.6 million in working capital and approximately $229.9 million in cash and cash equivalents and current investments at July 1, 2012. We maintain an investment portfolio of various security holdings, types, and maturities. We invest in instruments that meet credit quality standards in accordance with our investment guidelines. We limit our exposure to any one issuer or type of investment with the exception of U.S. Government issued or U.S. Government sponsored entity securities. Our investments consisted mostly of marketable certificates of deposit, fixed income securities and corporate bonds as of December 30, 2012 and we did not hold any auction rate securities or direct investments in mortgage-backed securities. Our cash balances and investments are held in numerous locations throughout the world. As of December 30, 2012, our international subsidiaries held approximately 19% of our total cash, cash equivalents and investment securities, the majority of which will be used to repay obligations to U.S. affiliate entities that arise in the normal course of business and would not result in incremental U.S. tax liabilities when paid. Our accounts receivable are primarily with large multinational OEM customers and denominated in U.S. dollars. At December 30, 2012, approximately 10% of our accounts receivable are related to customers with a European billing address. However, we do not believe that the ongoing European Sovereign debt crisis will materially impact the collectability of our accounts receivable or adversely affect our financial position or liquidity. 31-------------------------------------------------------------------------------- Table of Contents Cash Flows The following table summarizes our cash flows: Six Months Ended December 30, January 1, 2012 2012 (in thousands) Net cash provided by (used in): Operating activities $ (11,483 ) $ 38,131 Investing activities 19,741 (13,425 ) Financing activities (515 ) (22,972 ) Effect of foreign currency translation on cash and cash equivalents 161 (554 ) Increase in cash and cash equivalents: $ 7,904 $ 1,180 Operating Activities Cash used in operating activities during the six months ended December 30, 2012 was approximately $11.5 million compared to cash provided by operating activities of approximately $38.1 million during the six months ended January 1, 2012. The decrease in cash flows from operating activities was primarily due to a payment of approximately $58.0 million related to the Settlement Agreement entered into with Broadcom on July 3, 2012. See "Patent Litigation" elsewhere in Part I, Item 2 of this Form 10-Q. The Broadcom payment was partially offset by income tax refunds received of approximately $6.6 million less income taxes paid of approximately $3.2 million. The current period cash used in operating activities resulted from net income of approximately $6.2 million, non-cash adjustments for amortization of intangible assets of approximately $13.2 million, share-based compensation expense of approximately $10.9 million, depreciation and amortization of approximately $8.8 million offset by changes in operating assets and liabilities including a decrease in accounts payable, accrued liabilities and other liabilities of approximately $38.0 million, an increase in prepaid expenses, prepaid income taxes and other assets of approximately $10.9 million and an increase in inventories of approximately $2.8 million. Investing Activities Cash provided by investing activities during the six months ended December 30, 2012 was approximately $19.7 million compared to cash used in investing activities of approximately $13.4 million during the six months ended January 1, 2012. The current period cash provided by investing activities was primarily due to maturities of investments that were not reinvested in anticipation of our pending acquisition of Endace. See "Pending Business Combination" elsewhere in Part I, Item 2 of this Form 10-Q. Financing Activities Cash used in financing activities for the six months ended December 30, 2012 was approximately $0.5 million compared to approximately $23.0 million during the six months ended January 1, 2012. The current period usage of cash was primarily due to payroll tax withholdings on behalf of employees for restricted stock of approximately $3.2 million, partially offset by the proceeds from issuance of common stock under stock plans of approximately $2.6 million. Prospective Capital Needs In early August 2008, our Board of Directors authorized a plan to repurchase up to $100.0 million of our outstanding common stock. In April 2009, upon receipt of an unsolicited takeover proposal and related tender offer of Broadcom to acquire us, our Board of Directors elected to temporarily suspend any activity under the share repurchase plan. In light of Broadcom allowing its tender offer to expire on July 14, 2009, Emulex's Board of Directors elected to reactivate the $100.0 million share repurchase plan effective July 15, 2009. From June 29, 2009 through December 30, 2012, the Company repurchased approximately 9.0 million shares of its common stock for an aggregate purchase price of approximately $78.4 million at an average purchase price of $8.67 per share under this plan. Our Board of Directors has not set an expiration date for the plan. Therefore, we may repurchase additional shares under this plan from time to time through open market purchases or privately negotiated transactions. It is expected that any future share repurchases will be financed by available cash and cash from operations. On December 20, 2012, the Company issued a formal offer under the terms of the New Zealand Takeover Code to acquire Endace for cash consideration of 500 pence per share or approximately £80.7 million (approximately $130.7 million using an exchange rate of 1.62 US Dollars for 1.00 British Pound Sterling) in exchange for 100% of the outstanding equity interests in Endace. The transaction is expected to close in the third quarter of fiscal 2013 at which time the funds will be 32 -------------------------------------------------------------------------------- Table of Contents dispersed to Endace shareholders in exchange for their shares. Any decrease in the value of the U.S. dollar relative to the value of the British pound sterling prior to the closing would increase the effective price of such acquisition. See "Pending Business Combination" elsewhere in Part II, Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations, of this Form 10-Q. We plan to continue our strategic investment in research and development, sales and marketing, capital equipment, and facilities. We may also consider internal and external investment opportunities in order to achieve our growth and market leadership goals, including licensing and product development alignment agreements with our suppliers, customers, and other third parties. We believe that our existing cash and cash equivalents, current investments, and anticipated cash flows from operating activities will be sufficient to support our working capital needs, capital expenditure requirements and stock repurchasing expenditures for at least the next 12 months although we may also consider external financing sources. We currently do not have any outstanding lines of credit or other borrowings. We have disclosed outstanding legal proceedings in Note 7 in the accompanying notes to condensed consolidated financial statements included in Part I, Item 1 of this Form 10-Q, including the consolidated patent infringement lawsuit filed by Broadcom against us. This lawsuit continues to present risks that could have a material adverse effect on our business, financial condition, or results of operations, including loss of patent rights, monetary damages, and injunction against the sale of accused products. We continue to present a vigorous post-trial defense against this lawsuit, and have appealed the trial verdict. On July 3, 2012, we entered into a Settlement Agreement pursuant to which both parties agreed to settle and release certain claims related to the patent infringement litigation. The Settlement Agreement provided for certain amendments to the April 3, 2012 Permanent Injunction, and dismissals of certain allegations of the lawsuit, including portions of the scheduled re-trial. We also received a worldwide limited license to the '691 patent, the '150 patent, the '194 patent and related families for certain fields of use including Fibre Channel applications. We expect to incur incremental costs during fiscal 2013 and fiscal 2014 related to the retrial and to redesign, design around, modify, design, develop, test and requalify certain products that were not covered by the Settlement Agreement and have previously been found to infringe on the '150 and '691 patents in the range of $15 million - $20 million. See "Patent Litigation" in Part I, Item 2 of this Form 10-Q. Also see "Third party claims of intellectual property infringement could adversely affect our business" and "We are dependent on sole source and limited source third party suppliers and EMS providers for our products" in Part II, Item 1A - Risk Factors, of this Form 10-Q for a description of certain risks relating to the litigation with Broadcom that could impact our liquidity and prospective capital needs. 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 December 30, 2012, we did not have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. Contractual Obligations and Commercial Commitments The following summarizes our contractual obligations as of December 30, 2012, and the effect such obligations are expected to have on our liquidity in future periods. The estimated payments reflected in this table are based on management's estimates and assumptions about these obligations. Because these estimates and assumptions are necessarily subjective, the actual cash outflows in future periods will vary, possibly materially, from those reflected in the table. Payments Due by Period (in thousands) Remaining Total 2013 2014 2015 2016 2017 Thereafter Leases (1) $ 18,848 $ 2,621 $ 4,464 $ 3,956 $ 3,471 $ 1,771 $ 2,565 Purchase commitments (2) 46,360 46,360 - - - - - Other commitments (3) 16,805 6,171 6,513 2,472 943 706 - Total (4)(5) $ 82,013 $ 55,152 $ 10,977 $ 6,428 $ 4,414 $ 2,477 $ 2,565 (1) Lease payments include common area maintenance (CAM) charges. (2) Purchase commitments represent an estimate of all open purchase orders and contractual obligations in the ordinary course of business for which we have not received the goods or services as of December 30, 2012. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule and adjust our requirements based on our business needs prior to the delivery of goods or performance of services. 33 -------------------------------------------------------------------------------- Table of Contents (3) Other commitments consist primarily of commitments for software license fees of approximately $7.7 million and non-recurring engineering services of approximately $6.8 million. (4) Excludes approximately $37.4 million of liabilities for uncertain tax positions for which we cannot make a reasonably reliable estimate of the period of payment. See Note 10 in the accompanying notes to condensed consolidated financial statements included in Part I, Item 1 of this Form 10-Q. (5) The expected timing of payments for the obligations discussed above is estimated based on current information. Timing of payment and actual amounts paid may be different depending on the time of receipt of goods or services or changes to agreed-upon amounts for some obligations. Amounts disclosed as contingent or milestone based obligations depend on the achievement of the milestones or the occurrence of the contingent events and can vary significantly. |