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EMC CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF(Edgar Glimpses Via Acquire Media NewsEdge) OPERATIONS This Management's Discussion and Analysis ("MD&A") of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and notes thereto which appear elsewhere in this Annual Report on Form 10-K. All dollar amounts expressed numerically in this MD&A are in millions. Certain tables may not add up due to rounding.INTRODUCTION We manage our business in two broad categories: EMC Information Infrastructure and VMware Virtual Infrastructure. EMC Information Infrastructure Our EMC Information Infrastructure business consists of three segments: Information Storage, Information Intelligence and RSA Information Security. The objective for our EMC Information Infrastructure business is to simultaneously increase our market share, invest in the business and grow our earnings per share at a rate faster than the rate at which we grow our revenue. During 2012, we continued to innovate and invest in expanding our total addressable market through internal research and development ("R&D") and acquisitions. Our continued investment in new technologies and solutions is reflected in our roadmap for 2013, with numerous innovations, refreshes and brand-new products. We have developed a product portfolio with customers' current and future needs in mind which will continue to evolve as the largest transformation in Information Technology ("IT") history is creating enormous opportunities in Cloud Computing, Big Data and Trust. Cloud Computing leverages an on-demand, self-managed, virtualized infrastructure to deliver IT as a Service in a more efficient, flexible and cost-effective manner. While the fundamental transition to Cloud Computing architectures is gaining traction, customers are increasingly recognizing that their ability to compete is tied to the efficiency, flexibility and agility of their IT operations and that transitioning to a cloud-based architecture will be a key component to their success. We believe our offerings are well-suited to capitalize on this trend as it unfolds over the next several years. Big Data, which is a primary contributor to the pace of overall data growth, refers to the large repositories of corporate and external data, including unstructured information created by new applications (e.g. medical, entertainment, energy and geophysical), social media and other web repositories. It is triggering new approaches for our customers to derive business insight and create new opportunities to expand revenues. The successful transition to a model that leverages Cloud Computing and Big Data is dependent upon both the right infrastructure and the ability to build Trust into that infrastructure. The ability for customers to have and offer Trusted IT is a valuable competitive advantage. We believe we are well-positioned in this market to continue assisting our customers in storing, managing and unlocking the value contained within their information and to enable them to leverage our data-centric approach to security to take full advantage of Cloud Computing and Big Data. Our go to market model, where we continue to leverage our direct sales force and services organization, as well as our channel and services partners and service providers, positions us well to help customers transition to Cloud Computing and benefit from Big Data. We offer three alternatives to help our customers transition to cloud architectures and leverage Big Data: our best of breed infrastructure components, proven infrastructure through VSPEX and converged infrastructure with Vblock from VCE Company LLC, our joint venture with Cisco, and other investors VMware and Intel. Our service provider program is another important part of our strategy to get our customers to the public cloud. Additionally, in December 2012, we announced the Pivotal Initiative ("Pivotal") with VMware, to which both companies plan to commit technology, people and programs from both companies. Pivotal will focus on Big Data Analytics and Cloud Application Platforms in 2013. VMware Virtual Infrastructure VMware's financial focus is on long-term revenue growth to generate free cash flows to fund its expansion of industry segment share and evolve its virtualization-based products for data centers, end-user devices and Cloud Computing through a combination of internal development and acquisitions. VMware expects to grow its business by building long-term relationships with its customers through the adoption of enterprise license agreements ("ELAs"). Additionally, VMware has made, and expects to continue to consider strategic business acquisitions in the future. In January 2013, VMware announced a realignment of their strategy to refocus their resources and investments in support of three growth priorities that focus on their core opportunities as a provider of virtualization technologies that simplify IT infrastructure: the software-defined data center, the hybrid cloud and end-user computing. The software-defined data center ("SDDC") is where increasingly infrastructure is virtualized and delivered as a service, and the control of this data center is entirely 29 -------------------------------------------------------------------------------- automated by software. To further this vision, in the third quarter of 2012, VMware released the VMware vCloud Suite, which is the first integrated solution designed to meet the requirements of the SDDC by pooling industry-standard hardware and running compute, networking, storage and management functions in the data center as software-defined services. For the SDDC, VMware plans to continue to invest in the development and delivery of innovations in networking, security, storage and management as they continue to roll out and enhance the features of their vCloud Suite. For the hybrid cloud, VMware plans to focus on expanding their capabilities to deliver enterprise-class cloud services that are complementary to private clouds in order to enhance their customer's flexibility to run applications on and off premise, as they choose on a compatible, high-quality, secure and resilient hybrid cloud platform. For end-user computing, they plan to enhance their offerings to enable a virtual workspace for both existing PC environments and emerging mobile devices in a secure enterprise environment. On a consolidated basis, our vision, strategy and roadmap allowed us to leverage our strengths through 2012 and position us to capitalize on the evolving trends of Cloud Computing and Big Data and Trust in 2013. As a result, we believe we will grow faster than the markets we serve in 2013 while simultaneously investing in the business and growing earnings per share at a rate faster than the rate at which we will grow our revenue. RESULTS OF OPERATIONS Revenues The following table presents revenue by our segments: Percentage Change 2012 2011 2010 2012 vs 2011 2011 vs 2010 Information Storage $ 15,589.4 $ 14,755.2 $ 12,699.1 5.7 % 16.2 % Information Intelligence Group 640.2 661.4 735.9 (3.2 ) (10.1 ) RSA Information Security 888.7 828.2 729.4 7.3 13.5 VMware Virtual Infrastructure 4,595.6 3,762.9 2,850.7 22.1 32.0 Total revenues $ 21,713.9 $ 20,007.6 $ 17,015.1 8.5 % 17.6 % Consolidated product revenues increased 3.7% to $13,060.5 in 2012. The consolidated product revenues increase was primarily driven by the Information Storage and the VMware Virtual Infrastructure segments' product revenues. The overall growth in product revenue in 2012 was due to a continued higher demand for our portfolio of offerings to address the storage, data analysis and virtualization needs for continued information growth, particularly as customers continue to build out their own data centers to develop and support their private or public cloud infrastructures. The Information Storage segment's product revenues increased 2.6% to $10,362.8 in 2012. Within the networked storage platforms portfolio, which includes our high-end and mid-tier platform products, product revenues increased 5.7%. Within the high-end of the Information Storage segment, product revenues increased 0.8%, primarily due to demand for our scale-out block solution, VMAX, which was refreshed in the second quarter of 2012, as customers continue to purchase VMAX for mission-critical data sets needing to scale. Within the mid-tier of the Information Storage segment, which includes VNX family, Backup and Recovery Systems, EMC Isilon and EMC Atmos, product revenues increased 9.3% in 2012 due to continued performance across each of our mid-tier product groups. Our VNX family, which includes VNX and VNXe, plays an important role in our storage platform because of its simplicity and efficiency with a rich feature set on a unified platform. Within our Backup and Recovery Systems products, deduplication solutions continue to be in demand and our purpose-built back up appliance, Data Domain and our Avamar product delivered strong growth for the year in 2012. Our scale-out file offering from EMC Isilon continues to benefit from the acquisition synergies as it delivers strong revenue growth in new markets while continuing rapid growth in its more traditional verticals. The EMC Atmos object-storage solution ended 2012 with great momentum. Finally, our EMC Greenplum analytics database combined with their Hadoop implementation drove very strong year-over-year growth. The VMware Virtual Infrastructure segment's product revenues increased 13.3% to $2,084.6 in 2012. VMware's license revenues increased in 2012 primarily due to continued demand for its product offerings. ELAs comprised between one-quarter and one-third of their overall sales during 2012 and 2011, with the balance represented by non-ELA, or transactional business. In 2012, their overall sales growth rate declined compared to 2011, with the growth rate in transactional sales lower than the growth rate in ELAs. The RSA Information Security segment's product revenues decreased 6.5% to $412.3 in 2012. The decrease in product revenues was primarily due to the effects of slower global employment growth, especially in Europe and Asia, which negatively impacted 30 --------------------------------------------------------------------------------our Identity and Data Protection business as well as lingering effects from the prior year remediation of tokens which disrupted the normal renewal cycles. The Information Intelligence Group segment's product revenues decreased 4.1% to $200.8 in 2012. The year-over-year decrease in product revenues was primarily attributable to changing customer demand, particularly in the first quarter of 2012. The Information Intelligence Group segment continues to innovate, creating solutions that we believe will be easier to deploy, easier to use and more aligned with customer needs. Consolidated product revenues increased 15.6% to $12,590.7 in 2011. The consolidated product revenues increase was primarily driven by the Information Storage and the VMware Virtual Infrastructure segments' product revenues. The Information Storage segment's product revenues increased 14.5% to $10,100.5 in 2011. The VMware Virtual Infrastructure segment's product revenues increased 31.5% to $1,840.1 in 2011. The RSA Information Security segment's product revenues increased 10.2% to $440.8 in 2011. The increase in product revenues in each of these segments in 2011 was primarily attributable to continued higher demand for our portfolio of offerings to address the storage, virtualization and security needs for continued information growth, particularly as customers continue to build out their own data centers to develop and support their private or public cloud infrastructures. The Information Intelligence Group segment's product revenues decreased 22.2% to $209.3 in 2011 primarily due to changing customer demand. Consolidated services revenues increased 16.7% to $8,653.4 in 2012. The consolidated services revenues increase was primarily driven by the Information Storage and the VMware Virtual Infrastructure segments' services revenues resulting from increased demand for maintenance-related services. In addition, we continue to provide expertise to customers on effective ways to enable Cloud Computing and to leverage their Big Data assets. The Information Storage segment's services revenues increased 12.3% to $5,226.6 in 2012. The increase in services revenues was primarily attributable to higher demand for maintenance-related services associated with a larger installed base as well as increased maintenance renewals. In addition, there has been a growing demand for professional services as we assist with customers' transitions to cloud architectures, transforming IT infrastructures and virtualizing mission-critical applications also contributed to the increase in services revenues. The VMware Virtual Infrastructure segment's services revenues increased 30.6% to $2,511.0 in 2012. The increase in services revenues was primarily attributable to growth in VMware's software maintenance revenues. In 2012, services revenues benefited from strong renewals, multi-year software maintenance contracts sold in previous periods and additional maintenance contracts sold in conjunction with new software license sales. Additionally, VMware experienced increased demand in their professional services driven by the growth in their license sales and installed base. The RSA Information Security segment's services revenues increased 23.0% to $476.5 in 2012. Services revenues increased due to an increase in maintenance revenues and professional services resulting from continued demand for support from our installed base. The Information Intelligence Group segment's services revenues decreased 2.8% to $439.4 in 2012. Consolidated services revenues increased 21.1% to $7,416.8 in 2011. The consolidated services revenues increase was primarily driven by the Information Storage and the VMware Virtual Infrastructure segments' services revenues. The Information Storage segment's services revenues increased 20.1% to $4,654.7 in 2011. The VMware Virtual Infrastructure segment's services revenues increased 32.5% to $1,922.7 in 2011. The RSA Information Security segment's services revenues increased 17.7% to $387.4 in 2011. The Information Intelligence Group segment's services revenues decreased 3.2% to $452.0 in 2011. Services revenues increased across the Information Storage, VMware Virtual Infrastructure and RSA Information Security segments due to an increase in maintenance and professional services resulting from continued demand for support from our installed base. 31 --------------------------------------------------------------------------------Consolidated revenues by geography were as follows: Percentage Change 2012 2011 2010 2012 vs 2011 2011 vs 2010 United States $ 11,510.2 $ 10,549.6 $ 9,152.4 9.1 % 15.3 % Europe, Middle East and Africa 5,908.2 5,667.6 4,942.1 4.2 % 14.7 % Asia Pacific 3,016.5 2,639.4 1,965.2 14.3 % 34.3 % Latin America, Mexico and Canada 1,279.0 1,151.0 955.5 11.1 % 20.5 % Revenues increased in 2012 compared to 2011 and in 2011 compared to 2010 in all of our markets due to greater demand for our products and services offerings. Changes in exchange rates impacted the total revenue increase by 1.1% in 2012 compared to 2011. The impact of the change in rates was most significant in the Euro zone and Latin America markets, and in particular, Brazil. Changes in exchange rates contributed 1.5% to the overall revenue increase in 2011 compared to 2010. The impact of the change in rates was most significant in the Asia Pacific markets, primarily Australia and Japan, Canada and Brazil, partially offset by the Euro and the pound sterling. Costs and Expenses The following table presents our costs and expenses, other income and net income attributable to EMC Corporation. Percentage Change 2012 2011 2010 2012 vs 2011 2011 vs 2010 Cost of revenue: Information Storage $ 6,650.1 $ 6,428.7 $ 5,851.4 3.4 % 9.9 %Information Intelligence Group 208.2 236.6 243.2 (12.0 ) (2.8 ) RSA Information Security 284.5 357.7 221.6 (20.5 ) 61.4 VMware Virtual Infrastructure 542.9 533.3 425.3 1.8 25.4 Corporate reconciling items 389.8 282.3 242.7 38.1 16.3 Total cost of revenue 8,075.5 7,838.6 6,984.1 3.0 12.2 Gross margins: Information Storage 8,939.3 8,326.5 6,890.7 7.4 20.9Information Intelligence Group 432.0 424.7 449.7 1.7 (5.5 ) RSA Information Security 604.3 470.5 507.8 28.4 (7.3 ) VMware Virtual Infrastructure 4,052.7 3,229.5 2,425.5 25.5 33.1 Corporate reconciling items (389.8 ) (282.3 ) (242.7 ) 38.1 16.3 Total gross margin 13,638.4 12,168.9 10,031.0 12.1 21.3 Operating expenses: Research and development(1) 2,559.6 2,149.8 1,888.0 19.1 13.9 Selling, general and administrative(2) 7,004.3 6,479.4 5,375.3 8.1 20.5 Restructuring and acquisition-related charges 110.6 97.3 84.4 13.7 15.3 Total operating expenses 9,674.5 8,726.5 7,347.7 10.9 18.8 Operating income 3,963.9 3,442.4 2,683.3 15.1 28.3 Investment income, interest expense and other expenses, net (160.3 ) (193.2 ) (75.3 ) (17.0 ) 156.6 Income before income taxes 3,803.6 3,249.3 2,608.0 17.1 24.6 Income tax provision 917.6 640.4 638.3 43.3 0.3 Net income 2,886.0 2,608.9 1,969.7 10.6 32.5 Less: Net income attributable to the non-controlling interest in VMware, Inc. (153.4 ) (147.5 ) (69.7 ) 4.0 111.6 Net income attributable to EMC Corporation $ 2,732.6 $ 2,461.3 $ 1,900.0 11.0 % 29.5 % (1) Amount includes corporate reconciling items of $337.9, $322.6 and $287.4 for the years ended December 31, 2012, 2011 and 2010, respectively. (2) Amount includes corporate reconciling items of $640.4, $606.4 and $477.5 for the years ended December 31, 2012, 2011 and 2010, respectively. 32-------------------------------------------------------------------------------- Gross Margins Our gross margin percentages were 62.8%, 60.8% and 59.0% in 2012, 2011 and 2010, respectively. The increase in the gross margin percentage in 2012 compared to 2011 was attributable to the VMware Virtual Infrastructure segment, which increased overall gross margins by 149 basis points, the RSA Information Security segment, which increased overall gross margins by 47 basis points, the Information Storage segment, which increased overall gross margins by 46 basis points and the Information Intelligence Group segment, which increased overall gross margins by 10 basis points. The increase in corporate reconciling items, consisting of stock-based compensation, acquisition-related intangible asset amortization, restructuring and acquisition-related charges and amortization of VMware's capitalized software from prior periods, decreased the consolidated gross margin percentage by 53 basis points. The increase in the gross margin percentage in 2011 compared to 2010 was attributable to the VMware Virtual Infrastructure segment, which increased overall gross margins by 140 basis points, the Information Storage segment, which increased overall gross margins by 126 basis points, partially offset by the RSA Information Security segment, which decreased overall gross margins by 53 basis points, and the Information Intelligence Group segment, which decreased overall gross margins by 4 basis points. The increase in corporate reconciling items, consisting of stock-based compensation, acquisition-related intangible asset amortization and restructuring and acquisition-related charges, decreased the consolidated gross margin percentage by 22 basis points. For segment reporting purposes, stock-based compensation, acquisition-related intangible asset amortization, restructuring and acquisition-related charges and amortization of VMware's capitalized software from prior periods are recognized as corporate expenses and are not allocated among our various operating segments. The increase of $107.5 in the corporate reconciling items in 2012 was attributable to a $61.5 increase in amortization of VMware's capitalized software from prior periods, a $41.9 increase in intangible asset amortization expense and a $1.8 increase in stock-based compensation expense. The $41.9 increase in intangible asset amortization expense is due to a larger intangible asset balance resulting from business acquisitions. The increase of $39.7 in the corporate reconciling items in 2011 was attributable to a $25.4 increase in intangible asset amortization expense and a $15.0 increase in stock-based compensation expense. The $15.0 increase in stock-based compensation expense was primarily attributable to the full-year impact of options exchanged in the acquisition of Isilon, which was acquired in the fourth quarter of 2010. The gross margin percentages for the Information Storage segment were 57.3%, 56.4% and 54.1% in 2012, 2011 and 2010, respectively. The increase in gross margin percentage in 2012 compared to 2011 was primarily attributable to improved product gross margins driven by a shift in mix towards higher margin products and higher sales volume. The increase in gross margin percentage in 2011 compared to 2010 was primarily attributable to improved product and service gross margins driven by a shift in mix towards higher margin products and services, higher sales volume and an improved cost structure. The gross margin percentages for the VMware Virtual Infrastructure segment were 88.2%, 85.8% and 85.1% in 2012, 2011 and 2010, respectively. The increase in gross margin percentage in 2012 compared to 2011 was primarily attributable to improvements in services margins due to growth in maintenance revenue as well as improved license margins resulting from decreased software capitalized amortization expense. The increase in gross margin percentage in 2011 compared to 2010 was primarily attributable to improved license gross margins resulting from decreased software capitalization amortization expense due to VMware's go-to-market strategy and the timing of products reaching technological feasibility. The gross margin percentages for the RSA Information Security segment were 68.0%, 56.8% and 69.6% in 2012, 2011 and 2010, respectively. The increase in the gross margin percentage in 2012 compared to 2011 and the decrease in gross margin percentage in 2011 compared to 2010 was due to an increase in product margins primarily due to the one-time impact of RSA remediation associated with working with customers to implement remediation programs which negatively impacted gross margin in 2011, as well as a release of the residual reserve, which positively impacted gross margins in 2012. The gross margin percentages for the Information Intelligence Group segment were 67.5%, 64.2% and 64.9% in 2012, 2011 and 2010, respectively. The increase in gross margin percentage in 2012 compared to 2011 was attributable to a continued containment of fixed costs and services margin improvement. The decrease in gross margin percentage in 2011 compared to 2010 was attributable to an increase in the mix of service revenue as a percentage of total revenue, slightly offset by an increase in service gross margins. Research and Development As a percentage of revenues, R&D expenses were 11.8%, 10.7% and 11.1% in 2012, 2011 and 2010, respectively. R&D expenses increased $409.8 in 2012 primarily due to an increase in personnel-related costs, which are expenses driven by incremental headcount from strategic hiring and business acquisitions, infrastructure costs and depreciation expense. Personnel-related costs increased by $354.5, infrastructure costs increased by $15.2 and depreciation expense increased by $11.3. Also increasing these 33 -------------------------------------------------------------------------------- costs was a decrease in capitalized software development costs of $23.2. R&D expenses increased $261.8 in 2011 primarily due to an increase in personnel-related costs, including stock-based compensation, infrastructure costs, depreciation expense and travel costs, partially offset by greater levels of software capitalization. Personnel-related costs increased by $274.0, infrastructure costs increased by $20.5, depreciation expense increased by $13.0 and travel costs increased by $10.0. Capitalized software development costs, which reduce R&D expense, increased by $73.6. Corporate reconciling items within R&D, which consist of stock-based compensation and acquisition-related intangible asset amortization, increased $15.3 and $35.2 to $337.9 and $322.6 in 2012 and 2011, respectively. Stock-based compensation expense increased $25.5 and $40.5 in 2012 and 2011, respectively. Acquisition-related intangible asset amortization decreased $6.4 and $7.1 in 2012 and 2011, respectively. The increase in stock-based compensation expense in 2012 was primarily driven by VMware's issuance of restricted stock in connection with the acquisition of Nicira in the third quarter of 2012. The increase in stock-based compensation expense in 2011 was primarily driven by EMC's issuance of stock options in connection with the acquisition of Isilon in the fourth quarter of 2010. R&D expenses within EMC's Information Infrastructure business, as a percentage of EMC's Information Infrastructure business revenues, were 8.4%, 7.6% and 7.9% in 2012, 2011 and 2010, respectively. R&D expenses increased $206.0 in 2012 primarily due to an increase in personnel-related costs, depreciation expense, business development costs and travel costs. Personnel-related costs increased by $221.3, depreciation expense increased by $15.1, business development costs increased by $17.0 and travel costs increased by $5.6. Partially offsetting these increased costs was a increase in capitalized software development costs of $49.5. R&D expenses increased $116.5 in 2011 primarily due to increases in personnel-related costs, depreciation expense, travel costs and infrastructure costs. Personnel-related costs increased by $124.8, depreciation expense increased by $17.8, travel costs increased by $6.1 and infrastructure costs increased by $4.2. Partially offsetting these increased costs was an increase in capitalized software development costs of $60.4. R&D expenses within the VMware Virtual Infrastructure business, as a percentage of VMware's revenues, were 16.9%, 15.6% and 16.8% in 2012, 2011 and 2010, respectively. R&D expenses increased $188.4 in 2012 largely due to an increase in personnel-related costs of $110.2 and to a decrease in VMware's capitalized software development costs of approximately $74.0 in 2012, primarily due to a change in VMware's go-to-market strategy and the timing of products reaching technological feasibility. R&D expenses increased $110.1 in 2011 largely due to increases in personnel-related costs of $106.9. This increase was partially offset by increases in VMware's capitalized software development costs of approximately $13.3 in 2011, primarily due to the timing of products reaching technological feasibility. Following the release of vSphere 5 and the comprehensive suite of cloud infrastructure technologies in the third quarter of 2011, VMware determined that its go-to-market strategy had changed from single solutions to product suite solutions. As a result of this change in strategy, and the related increased importance of interoperability between VMware's products, the length of time between achieving technological feasibility and general release to customers significantly decreased. For future releases, VMware expects its products to be available for general release soon after technological feasibility has been established. Given that the majority of VMware's product offerings are expected to be suites or to have key components that interoperate with VMware's other product offerings, the costs incurred subsequent to achievement of technological feasibility are expected to be immaterial in future periods. Selling, General and Administrative As a percentage of revenues, selling, general and administrative ("SG&A") expenses were 32.3%, 32.4% and 31.6% in 2012, 2011 and 2010, respectively. SG&A expenses increased by $524.9 in 2012 primarily due to increases in personnel-related costs, which are expenses driven by incremental headcount from strategic hiring and business acquisitions, commissions, business development costs, infrastructure costs and depreciation expense. Personnel-related costs increased by $248.6, commissions increased by $131.3, business development costs increased by $67.4, infrastructure costs increased by $29.9 and depreciation expense increased by $22.1 in 2012. SG&A expenses increased by $1,104.1 in 2011 from 2010 primarily due to increases in personnel-related costs, travel costs, commissions, infrastructure costs and depreciation expense. Personnel-related costs increased by $768.0, travel costs increased by $61.8, commissions increased by $51.9, infrastructure costs increased by $43.8 and depreciation expense increased by $29.7 in 2011. Corporate reconciling items within SG&A, which consist of stock-based compensation and acquisition-related intangible asset amortization increased $34.1 to $640.4 in 2012 and increased $128.9 to $606.4 in 2011. In 2012, stock-based compensation expense increased $56.9, somewhat offset by decreases in intangible asset amortization of $12.7. Stock-based compensation expense increased in 2012 primarily due to VMware's issuance of restricted stock in connection with the acquisition of Nicira. In 2011, intangible asset amortization increased $38.2 and stock-based compensation expense increased $95.6. Stock-based compensation expense increased in 2011 primarily due to the Isilon acquisition. 34 -------------------------------------------------------------------------------- SG&A expenses within EMC's Information Infrastructure business, as a percentage of EMC's Information Infrastructure business revenues, were 26.7%, 27.0% and 26.4% in 2012, 2011 and 2010, respectively. SG&A expenses increased $172.3 in 2012 primarily due to increases in personnel-related costs, commissions, business development costs, infrastructure costs and depreciation expense. Personnel-related costs increased slightly due to careful discretionary spending exceeding increases in salary resulting from strategic hiring and business acquisitions. Personnel-related costs increased by $2.7, commissions increased by $100.8, business development costs increased $14.9, infrastructure costs increased by $12.9 and depreciation expense increased by $34.4 in 2012. SG&A expenses increased $655.1 in 2011 primarily due to increases in personnel-related costs, travel costs, commissions, infrastructure costs and depreciation. Personnel-related costs increased by $435.4, travel costs increased by $45.8, commissions increased by $28.7, infrastructure costs increased by $21.2 and depreciation expense increased by $20.7 in 2011. SG&A expenses within the VMware Virtual Infrastructure business, as a percentage of VMware's revenues, were 39.2%, 39.4% and 40.7% in 2012, 2011 and 2010, respectively. SG&A expenses increased $318.6 in 2012 primarily due to growth in personnel-related expenses driven by incremental headcount and by higher commission expense due to increased sales volume as well as an increase in the costs of marketing programs. SG&A as a percentage of revenues decreased in 2012 compared to 2011 due to the increase in revenue outpacing the increase in costs during the period. SG&A expenses increased $320.0 in 2011. The increase in SG&A expenses in 2011 was primarily the result of growth in personnel-related expenses driven by incremental headcount and by higher commission expense due to increased sales volume. Restructuring and Acquisition-Related Charges In 2012, 2011 and 2010, we incurred restructuring and acquisition-related charges of $110.6, $97.3 and $84.4, respectively. In 2012, we incurred $100.9 of restructuring charges, primarily related to our current year restructuring programs and $9.7 of charges in connection with acquisitions for financial, advisory, legal and accounting services. In 2011, we incurred $86.0 of restructuring charges, of which $63.2 primarily related to our 2011 restructuring programs and $11.3 of charges in connection with acquisitions for financial, advisory, legal and accounting services. In 2010, we incurred $76.7 of restructuring charges, of which $37.8 primarily related to our 2010 restructuring program and $7.7 of charges in connection with acquisitions for financial, advisory, legal and accounting services. During 2012, we implemented separate restructuring programs to create further operational efficiencies which will result in a workforce reduction of 1,163 positions. The actions impacted positions around the globe covering our Information Storage, RSA Information Security and Information Intelligence Group segments. All of these actions are expected to be completed within a year of the start of each program. During 2011, we implemented separate restructuring programs to create further operational efficiencies which resulted in a workforce reduction of 787 positions and the vacation of certain facilities. These actions impacted positions around the globe covering our Information Storage, RSA Information Security and Information Intelligence Group segments. All of these actions were completed by the end of 2012. During 2010, we implemented a restructuring program to create further operational efficiencies which resulted in a workforce reduction of approximately 400 positions. These actions impacted positions around the globe covering our Information Storage, RSA Information Security and Information Intelligence Group segments. All of these actions were completed by the end of 2011. During 2012, 2011 and 2010, we recognized $20.8, $26.1 and $31.6, respectively, of lease termination costs for facilities vacated and other contractual obligations in the respective periods as part of all of our restructuring programs. These costs are expected to be utilized by the end of 2015. The remaining cash portion owed for these programs in 2013 is approximately $11.7, plus an additional $12.3 over the period from 2013 and beyond. Investment Income Investment income was $115.0, $129.2 and $142.5 in 2012, 2011 and 2010, respectively. Investment income decreased in 2012 and 2011 primarily due to a decrease in coupon income. Net realized gains were $9.3, $10.1 and $15.8 in 2012, 2011 and 2010, respectively. Interest Expense Interest expense was $78.9, $170.5 and $178.3 in 2012, 2011 and 2010, respectively. Interest expense consists primarily of interest on the $1,725 1.75% convertible senior notes due 2011 (the "2011 Notes"), and our $1,725 1.75% convertible senior notes due 2013 (the "2013 Notes" and, together with the 2011 Notes, the "Notes") which we issued in November 2006. Included in interest expense are non-cash interest charges related to amortization of the debt discount attributable to the conversion feature of $60.6, $115.9 and $114.5 in 2012, 2011 and 2010, respectively. The decrease in interest expense from 2011 to 2012 is due to the 35 -------------------------------------------------------------------------------- settlement of the 2011 Notes in the first quarter of 2012. We are accreting our Notes to their stated values over their terms. See Note E to the consolidated financial statements. Other Income (Expense), Net Other income (expense), net was $(196.3), $(152.0) and $(39.5) in 2012, 2011 and 2010, respectively. Our 2012 other income (expense), net primarily consists of our consolidated share of the losses from our converged infrastructure joint venture, VCE Company LLC, of $244.9 and losses on interest rate swaps, partially offset by our net gains from the sale of strategic investments including a non-recurring gain on our investment in XtremIO of $31.6 as well as the divestiture of a business. Our 2011 other income (expense), net primarily consists of our consolidated share of the losses from VCE of $209.2, partially offset by the non-recurring gain on the sale of VMware's investment in Terremark Worldwide, Inc. of $56.0. Other income (expense), net in 2010 was primarily attributable to our consolidated share of the losses from VCE of $42.8. The VCE joint venture is accounted for under the equity method and our consolidated share of VCE's losses is based upon our portion of the overall funding, which was approximately 63.2%, and represents our share of the net losses of the joint venture net of equity accounting adjustments. The losses recognized from the joint venture exclude our consolidated revenues and gross margins from sales of products and services to VCE, and any additional related selling expenses. See Note J to the consolidated financial statements. Provision for Income Taxes Our effective income tax rate was 24.1%, 19.7% and 24.5% in 2012, 2011 and 2010, respectively. The effective income tax rate is based upon the income for the year, the composition of the income in different countries, effect of tax law changes and adjustments, if any, for the potential tax consequences, benefits or resolutions of audits or other tax contingencies. Our aggregate income tax rate in foreign jurisdictions is lower than our income tax rate in the United States; substantially all of our income before provision for income taxes from foreign operations has been earned by our Irish subsidiaries. We do not believe that any recent or currently expected developments in non-U.S. tax jurisdictions are reasonably likely to have a material impact on our effective rate. Our effective tax rate may be adversely affected by earnings being lower than anticipated in countries where we have lower statutory tax rates and higher than anticipated in countries where we have higher statutory tax rates. In 2012, the lower aggregate income tax rate in foreign jurisdictions reduced our effective rate by 13.6 percentage points compared to our statutory federal tax rate of 35.0%. The net effect of tax credits, state taxes, non-deductible permanent differences, prior year true up adjustments, change in tax contingency reserves and other items collectively increased the rate by 2.7 percentage points. In 2011, the lower aggregate income tax rate in foreign jurisdictions reduced our effective rate by 14.4 percentage points compared to our statutory federal tax rate of 35.0%. The net effect of tax credits, state taxes, non-deductible permanent differences, resolution of income tax audits and reversal of reserves associated with the expiration of statutes of limitations and other items collectively decreased the rate by 0.9 percentage points. In 2010, the lower aggregate income tax rate in foreign jurisdictions reduced our effective rate by 12.2 percentage points compared to our statutory federal tax rate of 35.0%. In 2010, we effected a plan to reorganize our international operations by transferring certain assets of Isilon, Archer Technologies and Bus-Tech entities into a single EMC international holding company. As a result of this reorganization, we incurred an income tax charge which negatively impacted our effective tax rate by 3.2 percentage points. In 2010, we also had a reduction in our valuation allowance which arose from the utilization of a certain subsidiary's foreign net operating loss carryforwards resulting in a benefit to our effective tax rate of 0.6 percentage points. The net effect of tax credits, state taxes, non-deductible permanent differences, resolution of income tax audits and elimination of reserves associated with the expiration of statutes of limitations and other items collectively decreased the rate by 0.9 percentage points. The effective tax rate increased from 2011 to 2012 by 4.4%, from 19.7% to 24.1%, respectively. This increase was principally attributable to the federal tax credit for increasing research activities as well as a decrease in unrecognized tax benefits as a result of various tax audit closures recorded in 2011 with no comparable amounts in 2012. The effective tax rate decreased from 2010 to 2011 by 4.8%, from 24.5% to 19.7%, respectively. This decrease was principally attributable to a higher amount of income earned in foreign jurisdictions during 2011, which was largely due to how certain expenses are allocated to our world-wide subsidiaries. Additionally, the decrease was attributable to the reorganization of our international operations during 2010, and the favorable resolution of income tax audits during 2011, which was partially offset by a decrease in our U.S. tax credits and an increase in other differences. 36 -------------------------------------------------------------------------------- On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law. Some of the provisions were retroactive to January 1, 2012 including an extension of the U.S. federal tax credit for increasing research activities through December 31, 2013. Because the extension was enacted after December 31, 2012, our 2012 effective tax rate does not reflect our estimated 2012 federal tax credit for increasing research activities even though it will be reported on our 2012 federal income tax returns. Had the extension been enacted prior to January 1, 2013, our overall tax provision would have been approximately $66.5 lower reducing our effective tax rate from 24.1% to 22.4%. We expect that our income tax provision for the first quarter of 2013 will include the estimated 2012 federal tax credit for increasing research activities as a discrete tax benefit which will reduce our effective tax rate for the quarter and to a lesser extent our annual effective tax rate for 2013. During the second quarter of 2012, we determined that since VMware's initial public offering in 2007, we have incorrectly recorded deferred tax liabilities on the gains and losses associated with changes in the non-controlling interest. These deferred tax liabilities were recorded as a reduction to additional paid-in capital and therefore had no impact on our previously reported consolidated income statements. The error resulted in an overstatement of our deferred tax liability and an understatement of our additional paid-in capital of $352.6 in our December 31, 2011 consolidated balance sheet. These corrections did not impact our income tax provision in any current or prior period. See Note A to the consolidated financial statements. Non-controlling Interest in VMware, Inc. The net income attributable to the non-controlling interest in VMware was $153.4, $147.5 and $69.7 in 2012, 2011 and 2010, respectively. The increases year over year were due to increases in VMware's net income and increases in the weighted average percentage ownership by the non-controlling interest in VMware. VMware's reported net income was $745.7, $723.9 and $357.4 in 2012, 2011 and 2010, respectively. The weighted-average non-controlling interest in VMware was approximately 20.3%, 20.4% and 19.5% in 2012, 2011 and 2010, respectively. In the first quarter of 2010, we announced a stock purchase program of VMware's Class A common stock to maintain an approximately 80% majority ownership in VMware over the long term. As of December 31, 2012, we have purchased approximately 14.0 million shares for $1,099.1. Financial Condition Cash provided by operating activities was $6,262.4, $5,668.8 and $4,548.8 for 2012, 2011 and 2010, respectively. Cash received from customers was $22,584.8, $21,144.7 and $17,585.4 in 2012, 2011 and 2010, respectively. The increase in cash received from customers from 2010 to 2011 and from 2011 to 2012 was attributable to an increase in sales volume and higher cash proceeds from the sale of multi-year maintenance contracts, which are typically billed and paid in advance of services being rendered. Cash paid to suppliers and employees was $16,018.5, $15,218.7 and $12,830.7 in 2012, 2011 and 2010, respectively. The increase in cash paid to suppliers and employees from 2010 to 2011 and from 2011 to 2012 was primarily due to a general growth in the business to support the increased revenue base. Income taxes paid was $374.4, $323.1 and $232.1 in 2012, 2011 and 2010, respectively. These payments are comprised of estimated taxes for the current year, extension payments for the prior year and refunds or payments associated with income tax filings and tax audits. Cash used in investing activities was $3,905.1, $3,543.5 and $6,476.0 in 2012, 2011 and 2010, respectively. Cash used for business acquisitions, net of cash acquired, was $2,135.8, $536.6 and $3,194.6 in 2012, 2011 and 2010, respectively. The increase in cash used from 2011 to 2012 was due to an increase in acquisition activity with EMC and VMware collectively acquiring seventeen companies during 2012, including the acquisition of Nicira for $1,099.6, compared to the acquisition of seven businesses during 2011. In 2010, we acquired ten companies including the acquisition of Isilon for $2,301.1 net of cash acquired. Net cash used for strategic and other related investments was $46.5 and $300.5 in 2012 and 2011, respectively, and net cash provided by strategic and other related investments was $123.9 in 2010. In 2011, cash used for strategic and other related investments included $112.5 spent on the purchase of patents from Novell. During 2012, we provided funding of $227.9 to our joint ventures, VCE Company LLC, Canopy, our joint venture with Atos, and LenovoEMC, our joint venture with Lenovo Group Limited. In 2011 and 2010, we provided VCE funding of $383.2 and $29.6, respectively. During 2011, VMware purchased a leasehold interest for $151.1. During 2012, we received $58.1 in cash proceeds from the divestiture of our Iomega business. Capital additions were $819.2, $801.4 and $745.4 in 2012, 2011 and 2010, respectively. Capitalized software development costs were $419.1, $442.3 and $363.0 in 2012, 2011 and 2010, respectively. The decrease in 2012 compared to 2011 was primarily attributable to VMware's change in its go-to-market strategy, somewhat offset by EMC Information Infrastructure's efforts on its software development activities. The increase in 2011 was primarily attributable to EMC Information Infrastructure's software development activities. Net purchases of investments were $314.8, $928.4 and $2,267.3 in 2012, 2011 and 2010, respectively. This activity varies from period to period based upon our cash collections, cash requirements and maturity dates of our investments. Cash used in financing activities was $2,149.0, $1,718.5 and $243.8 in 2012, 2011 and 2010, respectively. In 2012, we spent $1,699.8 for payment of our convertible debt. In 2012 , 2011 and 2010, cash used to repurchase 27.1 million, 81.8 and 52.7 million 37 -------------------------------------------------------------------------------- shares of EMC common stock was $684.6, $2,000.0 and $999.9, respectively. Additionally, in 2012, 2011 and 2010, cash used to purchase 3.4 million, 4.6 million and 6.0 million shares of VMware common stock was $290.3, $400.0 and $399.2, respectively. In 2012, 2011 and 2010, VMware spent $467.5, $526.2 and $338.5 to repurchase 5.1 million, 6.0 million and 4.9 million shares of its common stock, respectively. We generated $813.4, $1,011.0 and $1,212.0 in 2012, 2011 and 2010, respectively, from the exercise of stock options and the purchase of shares within the employee stock plans. We generated $260.7, $361.6 and $281.9 in 2012, 2011 and 2010, respectively, of excess tax benefits from stock-based compensation. In 2012 and 2011, we spent $69.9 and $141.0, respectively, on the settlement of interest rate contracts. We expect to continue to generate positive cash flows from operations and to use cash generated by operations as our primary source of liquidity. We believe that existing cash and cash equivalents, together with any cash generated from operations, will be sufficient to meet normal operating requirements for the next twelve months. The 2011 Notes matured and a majority of the noteholders exercised their right to convert the outstanding 2011 Notes at the end of 2011. Pursuant to the settlement terms, the majority of the converted 2011 Notes were not settled until January 9, 2012. At that time, we paid the noteholders $1,699.8 in cash for the outstanding principal and 29.5 million shares for the $661.4 excess of the conversion value over the principal amount, as prescribed by the terms of the 2011 Notes. The remaining $1,710.1 of the 2013 Notes is due in November 2013. Based upon the closing price of our common stock for the prescribed measurement period during the three months ended December 31, 2012, the contingent conversion thresholds on the 2013 Notes were exceeded. As a result, the 2013 Notes are convertible at the option of the holder through March 31, 2013. Upon conversion, we are obligated to pay cash up to the principal amount of the debt converted. We have the option to settle any conversion value in excess of the principal amount with cash, shares of our common stock, or a combination thereof. Approximately $14.9 of the 2013 Notes have been converted as of December 31, 2012. In connection with the issuance of the Notes, we entered into separate convertible note hedge transactions with respect to our common stock (the "Purchased Options"). The Purchased Options allow us to receive shares of our common stock and/or cash related to the excess conversion value that we would pay to the holders of the Notes upon conversion. The Purchased Options will cover, subject to customary anti-dilution adjustments, approximately 215 million shares of our common stock. We paid an aggregate amount of $669.1 of the proceeds from the sale of the Notes for the Purchased Options that was recorded as additional paid-in-capital in shareholders' equity. In the fourth quarter of 2011, we exercised 107.5 million of the Purchased Options in conjunction with the planned settlements of the 2011 Notes, and we received 29.5 million shares of net settlement on January 9, 2012, representing the excess conversion value of the options. The remaining 107.5 million of the Purchased Options expire on December 1, 2013. We also entered into separate transactions in which we sold warrants to acquire, subject to customary anti-dilution adjustments, approximately 215 million shares of our common stock at an exercise price of approximately $19.55 per share of our common stock. We received aggregate proceeds of $391.1 from the sale of the associated warrants. Upon exercise, the value of the warrants is required to be settled in shares. Half of the associated warrants were exercised between February 15, 2012 and March 14, 2012 and the remaining half of the associated warrants have expiration dates between February 18, 2014 and March 18, 2014. During the first quarter of 2012, the exercised warrants were settled with 32.3 million shares of our common stock. We have available for use a credit line of $50.0 in the United States. As of December 31, 2012, we had no borrowings outstanding on the line of credit. The credit line bears interest at the bank's base rate and requires us, upon utilization of the credit line, to meet certain financial covenants with respect to limitations on losses. In the event the covenants are not met, the lender may require us to provide collateral to secure the outstanding balance. At December 31, 2012, we were in compliance with the covenants. As of December 31, 2012, the aggregate amount of liabilities of our subsidiaries was approximately $5,884.5. At December 31, 2012, our total cash, cash equivalents, and short-term and long-term investments were $11,395.7. This balance includes approximately $4,630.8 held by VMware, of which $2,996.7 is held overseas, and $2,743.8 held by EMC in overseas entities. If these overseas funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. 38 --------------------------------------------------------------------------------Use of Non-GAAP Financial Measures and Reconciliations to GAAP Results The financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). EMC uses certain non-GAAP financial measures, which exclude stock-based compensation, amortization of intangible assets, restructuring and acquisition-related charges, amortization of VMware's capitalized software from prior periods, infrequently occurring gains, losses, benefits and charges, and special tax items to measure its gross margin, operating margin, net income and diluted earnings per share for purposes of managing our business. In addition, the benefit of the U.S. research and development ("R&D") tax credit for 2012 is included in the non-GAAP results for the fourth quarter of 2012. EMC also assesses its financial performance by measuring its free cash flow which is also a non-GAAP financial measure. Free cash flow is defined as net cash provided by operating activities, less additions to property, plant and equipment and capitalized software development costs. These non-GAAP financial measures should be considered in addition to, not as a substitute for, measures of EMC's financial performance or liquidity prepared in accordance with GAAP. EMC's non-GAAP financial measures may be defined differently from time to time and may be defined differently than similar terms used by other companies, and accordingly, care should be exercised in understanding how EMC defines its non-GAAP financial measures. EMC's management uses the non-GAAP financial measures to gain an understanding of EMC's comparative operating performance (when comparing such results with previous periods or forecasts) and future prospects and excludes these items from its internal financial statements for purposes of its internal budgets and each reporting segment's financial goals. These non-GAAP financial measures are used by EMC's management in their financial and operating decision-making because management believes they reflect EMC's ongoing business in a manner that allows meaningful period-to-period comparisons. EMC's management believes that these non-GAAP financial measures provide useful information to investors and others (a) in understanding and evaluating EMC's current operating performance and future prospects in the same manner as management does, if they so choose, and (b) in comparing in a consistent manner EMC's current financial results with EMC's past financial results. Our non-GAAP operating results for the three months and year ended December 31, 2012 and 2011 were as follows: For the Three Months Ended For the Year Ended December 31, December 31, December 31, 2012 December 31, 2011 2012 2011 Gross margin $ 3,990.6 $ 3,595.8 $ 14,000.6 $ 12,516.1 Gross margin percentage 66.2 % 64.5 % 64.5 % 62.6 % Operating income 1,656.2 1,467.8 5,397.1 4,784.0 Operating income percentage 27.5 % 26.3 % 24.9 % 23.9 % Income tax provision 358.3 253.4 1,233.5 949.3 Net income attributable to EMC 1,193.6 1,065.2 3,759.5 3,380.5 Diluted earnings per share attributable to EMC $ 0.54 $ 0.49 $ 1.70 $ 1.51 The improvements in the non-GAAP gross margin and non-GAAP gross margin percentage were attributable to higher sales volume and a change in mix attributable to higher margin products. The improvements in the non-GAAP operating income and non-GAAP operating income percentage were primarily attributable to an improved gross margin percentage. The reconciliation of the above financial measures from GAAP to non-GAAP is as follows: For the Three Months Ended December 31, 2012 Restructuring Amortization of and VMware's Intangible acquisition- capitalized Stock-based asset related software from Special tax R&D tax GAAP compensation amortization charges prior periods charge credit Non-GAAP Gross margin $ 3,890.2 $ 30.8 $ 57.1 $ - $ 12.5 $ - $ - $ 3,990.6 Operating income 1,268.6 246.9 98.1 30.0 12.5 - - 1,656.2 Income tax provision 327.0 68.8 29.1 7.3 4.1 (11.5 ) (66.5 ) 358.3 Net income attributable to EMC 869.9 159.6 63.9 22.7 6.7 10.7 60.0 1,193.6 Diluted earnings per share attributable to EMC $ 0.39 $ 0.07 $ 0.03 $ 0.01 $ - $ 0.01 $ 0.03 $ 0.54 39-------------------------------------------------------------------------------- For the Three Months Ended December 31, 2011 Restructuring and Intangible acquisition- Stock-based asset related GAAP compensation amortization charges Non-GAAP Gross margin $ 3,523.3 $ 31.7 $ 40.8 $ - $ 3,595.8 Operating income 1,138.8 213.9 86.2 28.9 1,467.8 Income tax provision 174.9 47.6 27.3 3.7 253.4 Net income attributable to EMC 832.0 151.8 56.1 25.2 1,065.2 Diluted earnings per share attributable to EMC $ 0.38 $ 0.07 $ 0.03 $ 0.01 $ 0.49 For the Twelve Months Ended December 31, 2012 Restructuring Amortization of and VMware's Intangible acquisition- capitalized Stock-based asset related software from RSA special Loss on interest Gain on strategic Special tax R&D tax GAAP compensation amortization charges prior periods charge (release) rate swaps investment charge credit Non-GAAP Gross margin $ 13,638.4 $ 125.5 $ 199.1 $ - $ 61.5 $ (23.8 ) $ - $ - $ - $ - $ 14,000.6 Operating income 3,963.9 920.3 364.7 110.6 61.5 (23.8 ) - - - - $ 5,397.1 Income tax provision 917.6 230.5 112.7 21.5 19.9 (5.7 ) 15.0 - (11.5 ) (66.5 ) 1,233.5 Net income attributable to EMC 2,732.6 622.5 237.6 88.3 33.0 (18.1 ) 24.5 (31.6 ) 10.7 60.0 3,759.5 Diluted earnings per share attributable to EMC $ 1.23 $ 0.28 $ 0.11 $ 0.04 $ 0.02 $ (0.01 ) $ 0.01 $ 0.01 $ 0.01 $ 0.03 $ 1.70 For theTwelve Months Ended December 31, 2011 Restructuring and Intangible acquisition- Stock-based asset related RSA special Gain on strategic GAAP compensation amortization charges charge (release) investment Non-GAAP Gross margin $ 12,168.9 $ 123.7 $ 157.2 $ - $ 66.3 $ - $ 12,516.1 Operating income 3,442.4 836.2 341.8 97.3 66.3 - 4,784 Income tax provision 640.4 194.6 107.9 15.9 10.1 (19.6 ) 949.3 Net income attributable to EMC 2,461.3 587 223.9 80.9 56.2 (28.9 ) 3,380.5 Diluted earnings per share attributable to EMC $ 1.10 $ 0.26 $ 0.10 $ 0.04 $ 0.03 $ (0.01 ) $ 1.51 We also monitor our ability to generate free cash flow in relationship to our non-GAAP net income attributable to EMC over comparable periods. For the year ended December 31, 2012, our free cash flow was $5,024.2, an increase of 14% compared to the free cash flow generated for the year ended December 31, 2011. The free cash flow for the twelve months ended December 31, 2012 exceeded our non-GAAP net income attributable to EMC by $1,264.7. EMC uses free cash flow, among other measures, to evaluate the ability of its operations to generate cash that is available for purposes other than capital expenditures and capitalized software development costs. Management believes that information regarding free cash flow provides investors with an important perspective on the cash available to make strategic acquisitions and investments, fund joint ventures, repurchase shares, service debt and fund ongoing operations. As free cash flow is not a measure of liquidity calculated in accordance with GAAP, free cash flow should be considered in addition to, but not as a substitute for, the analysis provided in the statements of cash flows. 40 --------------------------------------------------------------------------------The reconciliation of the above free cash flow from GAAP to non-GAAP is as follows: For the Three Months Ended For the Year Ended December 31, December 31, December 31, December 31, 2012 2011 2012 2011 Cash Flow from Operations $ 1,899.3 $ 2,184.2 $ 6,262.4 $ 5,668.8 Capital Expenditures (295.7 ) (200.2 ) (819.2 ) (801.4 ) Capitalized Software Development Costs (103.3 ) (100.3 ) (419.1 ) (442.3 ) Free Cash Flow $ 1,500.4 $ 1,883.8 $ 5,024.2 $ 4,425.1 Free cash flow represents a non-GAAP measure related to operating cash flows. In contrast, our GAAP measures of cash flow consist of three components. These are cash flows provided by operating activities of $6,262.4 and $5,668.8 for the years ended December 31, 2012 and 2011, respectively, cash used in investing activities of $3,905.1 and $3,543.5 for the years ended December 31, 2012 and 2011, respectively, and net cash used in financing activities of $2,149.0 and $1,718.5 for the years ended December 31, 2012 and 2011, respectively. All of the foregoing non-GAAP financial measures have limitations. Specifically, the non-GAAP financial measures that exclude the items noted above do not include all items of income and expense that affect EMC's operations or cash flows. Further, these non-GAAP financial measures are not prepared in accordance with GAAP, may not be comparable to non-GAAP financial measures used by other companies and do not reflect any benefit that such items may confer on EMC. Management compensates for these limitations by also considering EMC's financial results as determined in accordance with GAAP. Investments The following table summarizes the composition of our investments at December 31, 2012: Amortized Unrealized Unrealized Aggregate Cost Gains (Losses) Fair Value U.S. government and agency obligations $ 2,187.0 $ 10.2 $ (1.0 ) $ 2,196.2 U.S. corporate debt securities 1,470.8 10.2 (0.5 ) 1,480.5 High yield corporate debt securities 477.0 34.2 (0.8 ) 510.4 Asset-backed securities 2.1 - - 2.1 Municipal obligations 1,020.4 3.0 (0.5 ) 1,022.9 Auction rate securities 73.5 - (3.4 ) 70.1 Foreign debt securities 1,264.2 9.1 (0.3 ) 1,273.0 Total fixed income securities 6,494.9 66.7 (6.4 ) 6,555.2 Publicly traded equity securities 48.5 38.7 (0.7 ) 86.5 Total $ 6,543.4 $ 105.4 $ (7.2 ) $ 6,641.7 Our fixed income and equity investments are classified as available for sale and recorded at their fair market values. At December 31, 2012, with the exception of our auction rate securities, the vast majority of our investments were priced by third-party pricing vendors. These pricing vendors utilize the most recent observable market information in pricing these securities or, if specific prices are not available for these securities, use other observable inputs like market transactions involving identical or comparable securities. In the event observable inputs are not available, we assess other factors to determine the security's market value, including broker quotes or model valuations. Each month, we perform independent price verifications of all of our fixed income holdings. In the event a price fails a pre-established tolerance check, it is researched so that we can assess the cause of the variance to determine what we believe is the appropriate fair market value. For all of our securities where the amortized cost basis was greater than the fair value at December 31, 2012, we have concluded that currently we neither plan to sell the security nor is it more likely than not that we would be required to sell the security before its anticipated recovery. In making the determination as to whether the unrealized loss is other-than-temporary, we considered the length of time and extent the investment has been in an unrealized loss position, the financial condition and near-term prospects of the issuers, the issuers' credit rating, third party guarantees and the time to maturity. 41 -------------------------------------------------------------------------------- Off-Balance Sheet Arrangements, Contractual Obligations, Contingent Liabilities and Commitments Contractual Obligations We have various contractual obligations impacting our liquidity. The following represents our contractual obligations as of December 31, 2012: Payments Due By Period More than Total Less than 1 year 1-2 years* 3-4 years** 4 years Operating leases $ 1,675.7 $ 284.5 $ 448.1 $ 247.7 $ 695.4 Convertible debt 1,710.1 1,710.1 - - - Product warranty obligations 277.9 - - - - Other long-term obligations, including notes payable and current portion of long-term obligations and post retirement obligations 338.9 153.3 1.3 0.7 1.0 Purchase orders 2,370.3 - - - - Uncertain tax positions and related interest 304.9 - - - - Total $ 6,677.8 $ 2,147.9 $ 449.3 $ 248.5 $ 696.4 * Includes payments from January 1, 2014 through December 31, 2015. ** Includes payments from January 1, 2016 through December 31, 2017. As of December 31, 2012, we had $277.9 of product warranty obligations, $182.7 of long-term post retirement obligations, $2,370.3 of purchase orders and $304.9 of liabilities for uncertain tax positions. We are not able to provide a reasonably reliable estimate of the timing of future payments relating to these obligations. The purchase orders are for manufacturing and non-manufacturing related goods and services. While the purchase orders are generally cancellable without penalty, certain vendor agreements provide for percentage-based cancellation fees or minimum restocking charges based on the nature of the product or service. Our operating leases are primarily for office space around the world. We believe leasing such space in most cases is more cost-effective than purchasing real estate. The convertible debt pertains to the 2013 Notes. The holders of the 2013 Notes may convert their 2013 Notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding September 1, 2013 only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the "measurement period") in which the price per Note for each day of that measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such day; (2) during any calendar quarter, if the last reported sale price of our common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or (3) upon the occurrence of certain events specified in the Notes. Additionally, the 2013 Notes will become convertible during the last three months prior to their maturity. Based upon the closing price of our common stock for the prescribed measurement period during the three months ended December 31, 2012, the contingent conversion threshold on the 2013 Notes was exceeded. As a result, the 2013 Notes are convertible at the option of the holder through March 31, 2013. Accordingly, since the terms of the 2013 Notes require the principal to be settled in cash, we reclassified from equity the portion of the 2013 Notes attributable to the conversion feature which had not yet been accreted to its face value and the 2013 Notes have been classified as a current liability. For the holders to be able to continue to convert the 2013 Notes, our closing stock price must exceed $20.90 for 20 out of the last 30 trading days of each future quarter. We have no other off-balance sheet arrangements. 42 -------------------------------------------------------------------------------- Guarantees and Indemnification Obligations EMC's subsidiaries have entered into arrangements with financial institutions for such institutions to provide guarantees for rent, taxes, insurance, leases, performance bonds, bid bonds and customs duties aggregating $151.0 as of December 31, 2012. The guarantees vary in length of time. In connection with these arrangements, we have agreed to guarantee substantially all of the guarantees provided by these financial institutions. EMC and certain of its subsidiaries have also entered into arrangements with financial institutions in order to facilitate the management of currency risk. EMC has agreed to guarantee the obligations of its subsidiaries under these arrangements. We enter into agreements in the ordinary course of business with, among others, customers, resellers, joint ventures, OEMs, systems integrators and distributors. Most of these agreements require us to indemnify the other party against third-party claims alleging that an EMC product infringes a patent and/or copyright. Certain agreements in which we grant limited licenses to specific EMC-trademarks require us to indemnify the other party against third-party claims alleging that the use of the licensed trademark infringes a third-party trademark. Certain of these agreements require us to indemnify the other party against certain claims relating to the loss or processing of data, to real or tangible personal property damage, personal injury or the acts or omissions of EMC, its employees, agents or representatives. In addition, from time to time, we have made certain guarantees regarding the performance of our systems to our customers. We have also made certain guarantees for obligations of affiliated third parties. We have agreements with certain vendors, financial institutions, lessors and service providers pursuant to which we have agreed to indemnify the other party for specified matters, such as acts and omissions of EMC, its employees, agents or representatives. We have procurement or license agreements with respect to technology that is used in our products and agreements in which we obtain rights to a product from an OEM. Under some of these agreements, we have agreed to indemnify the supplier for certain claims that may be brought against such party with respect to our acts or omissions relating to the supplied products or technologies. We have agreed to indemnify the directors, executive officers and certain other officers of EMC and our subsidiaries, to the extent legally permissible, against all liabilities reasonably incurred in connection with any action in which such individual may be involved by reason of such individual being or having been a director or officer. In connection with certain acquisitions, we have agreed to indemnify the current and former directors, officers and employees of the acquired company in accordance with the acquired company's by-laws and charter in effect immediately prior to the acquisition or in accordance with indemnification or similar agreements entered into by the acquired company and such persons. In a substantial majority of instances, we have maintained the acquired company's directors' and officers' insurance, which should enable us to recover a portion of any future amounts paid. These indemnities vary in length of time. Based upon our historical experience and information known as of December 31, 2012, we believe our liability on the above guarantees and indemnities at December 31, 2012 is not material. Pension We have a noncontributory defined benefit pension plan that was assumed as part of the Data General acquisition, which covers substantially all former Data General employees located in the United States. This plan has been frozen resulting in employees no longer accruing pension benefits for future services. The assets for this defined benefit plan are invested in common stocks and bonds. The market related value of the plan's assets is based upon the assets' fair value. The expected long-term rate of return on assets for the year ended December 31, 2012 remains at 6.75%. The Company has begun to shift, and may continue to shift in the future, its asset allocation to lower the percentage of investments in equity securities and increase the percentage of investments in long-duration fixed-income securities. The effect of such a change could result in a reduction to the long-term rate of return on plan assets and an increase in future pension expense consistent with the sensitivity described below. The actual long-term rate of return for the ten years ended December 31, 2012 was 8.40%. Based upon current market conditions, the expected long-term rate of return for 2013 will be 6.75%. A 25 basis point change in the expected long-term rate of return on the plans' assets would have approximately a $1.1 impact on the 2013 pension expense. As of December 31, 2012, the pension plan had a $231.5 unrecognized actuarial loss that will be expensed over the average future working lifetime of active participants. For the year ended December 31, 2012, the discount rate to determine the benefit obligation was 3.71%. The discount rate selected was based on highly rated long-term bond indices and yield curves that match the duration of the plan's benefit obligations. The bond indices and yield curve analyses reflect high quality bond yields in effect at December 31, 2012. The discount rate reflects the rate at which the pension benefits could be effectively settled. A 25 basis point change in the discount rate would have approximately a $0.4 impact on the 2013 pension expense. 43 -------------------------------------------------------------------------------- Critical Accounting Policies Our consolidated financial statements are based on the selection and application of generally accepted accounting principles which require us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to our financial statements. We believe that the areas set forth below may involve a higher degree of judgment and complexity in their application than our other accounting policies and represent the critical accounting policies used in the preparation of our financial statements. If different assumptions or conditions were to prevail, the results could be materially different from our reported results. Our significant accounting policies are presented within Note A to the consolidated financial statements. Revenue Recognition The application of the appropriate guidance within the Accounting Standards Codification to our revenue is dependent upon the specific transaction and whether the sale or lease includes information systems, including hardware storage and hardware-related devices, software, including required storage operating systems and optional value-added software application programs, and services, including installation, professional, software and hardware maintenance and training, or a combination of these items. As our business evolves, the mix of products and services sold will impact the timing of when revenue and related costs are recognized. Additionally, revenue recognition involves judgments, including estimates of fair value and selling price in arrangements with multiples deliverables, assessments of expected returns and the likelihood of nonpayment. We analyze various factors, including a review of specific transactions, the credit-worthiness of our customers, our historical experience and market and economic conditions. Changes in judgments on these factors could materially impact the timing and amount of revenue and costs recognized. Should market or economic conditions deteriorate, our actual return experience could exceed our estimate. Warranty Costs We accrue for systems warranty costs at the time of shipment. We estimate systems warranty costs based upon historical experience, specific identification of system requirements and projected costs to service items under warranty. While we engage in extensive product quality programs and processes, our warranty obligation is affected by product failure rates, material usage and service delivery costs. To the extent that our actual systems warranty costs differed from our estimates by 5 percent, consolidated pre-tax income would have increased/decreased by approximately $13.9 and $12.7 in 2012 and 2011, respectively. Asset Valuation Asset valuation includes assessing the recorded value of certain assets, including accounts and notes receivable, investments, inventories, goodwill and other intangible assets. We use a variety of factors to assess valuation, depending upon the asset. Accounts and notes receivable are evaluated based upon the credit-worthiness of our customers, our historical experience, the age of the receivable and current market and economic conditions. Should current market and economic conditions deteriorate, our actual bad debt experience could exceed our estimate. The market value of our short- and long-term investments is based primarily upon the listed price of the security. At December 31, 2012, with the exception of our auction rate securities, the vast majority of our investments were priced by pricing vendors. These pricing vendors utilize the most recent observable market information in pricing these securities or, if specific prices are not available for these securities, use other observable inputs such as market transactions involving identical or comparable securities. In the event observable inputs are not available, we assess other factors to determine the security's market value, including broker quotes or model valuations. Each month, we perform independent price verifications of all of our fixed income holdings. In the event a price fails a pre-established tolerance check, it is researched so that we can assess the cause of the variance to determine what we believe is the appropriate fair market value. In the event the fair market values that we determine are not accurate or we are unable to liquidate our investments in a timely manner, we may not realize the recorded value of our investments. We hold investments whose market values are below our cost. The determination of whether unrealized losses on investments are other-than-temporary is based upon the type of investments held, market conditions, financial condition and near-term prospects of the issuers, the time to maturity, length of the impairment, magnitude of the impairment and ability and intent to hold the investment to maturity. Should current market and economic conditions deteriorate, our ability to recover the cost of our investments may be impaired. The recoverability of inventories is based upon the types and our levels of inventory held, forecasted demand, pricing, competition and changes in technology. Should current market and economic conditions deteriorate, our actual recovery could be less than our estimate. 44 -------------------------------------------------------------------------------- Other intangible assets are evaluated based upon the expected period the asset will be utilized, forecasted cash flows, changes in technology and customer demand. Changes in judgments on any of these factors could materially impact the value of the asset. We perform an assessment of the recoverability of goodwill, at least annually, in the fourth quarter of each year. Our assessment is performed at the reporting unit level which, for certain of our operating segments, is one step below our segment level. We employ both qualitative and quantitative tests of our goodwill. For several of our reporting units, we performed a qualitative assessment on goodwill impairment to determine whether a quantitative assessment is necessary and determined there was no impairment. For other reporting units we evaluated goodwill using a quantitative model. For all of our goodwill assessments we determined that there was sufficient market value above the carrying value of those reporting units so that we would not expect any near term changes in the operating results that would trigger an impairment. The determination of relevant comparable industry companies impacts our assessment of fair value. Should the operating performance of our reporting units change in comparison to these companies or should the valuation of these companies change, this could impact our assessment of the fair value of the reporting units. Our discounted cash flow analyses factor in assumptions on revenue and expense growth rates. These estimates are based upon our historical experience and projections of future activity, factoring in customer demand, changes in technology and a cost structure necessary to achieve the related revenues. Additionally, these discounted cash flow analyses factor in expected amounts of working capital and weighted average cost of capital. Changes in judgments on any of these factors could materially impact the value of the reporting unit. Restructuring Charges We recognized restructuring charges in 2012, 2011, 2010 and prior years. The restructuring charges include, among other items, estimated employee termination benefit costs, subletting leased facilities and the cost of terminating various contracts. The amount of the actual obligations may be different than our estimates due to various factors, including market conditions, negotiations with third parties and finalization of severance agreements with employees. Should the actual amounts differ from our estimates, the amount of the restructuring charges could be materially impacted. Accounting for Income Taxes As part of the process of preparing our financial statements, we are required to estimate our provision for income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure, including assessing the risks associated with tax audits, together with assessing temporary differences resulting from the different treatment of items for tax and financial reporting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheets. We assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is more likely than not, do not establish a valuation allowance. In the event that actual results differ from these estimates, our provision for income taxes could be materially impacted. Accounting for Stock-Based Compensation For our share-based payment awards, we make estimates and assumptions to determine the underlying value of stock options, including volatility, expected life and forfeiture rates. Additionally, for awards which are performance-based, we make estimates as to the probability of the underlying performance being achieved. Changes to these estimates and assumptions may have a significant impact on the value and timing of stock-based compensation expense recognized, which could have a material impact on our consolidated financial statements. 45-------------------------------------------------------------------------------- |