Summary of 3PAR INC. - Yahoo! Finance

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our financial condition and results of operations should be read together with the financial statements and the related notes set forth under "Item 8. Financial Statements and Supplementary Data." In addition to historical information, this report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the "safe harbor" created by those sections. These statements include, among other things, statements concerning our expectations regarding:

• the growth and growth rate of our operations, business, revenues, operating margins, costs and expenses;

• fluctuations in our gross margins;

• the effect of recent accounting pronouncements on our financial position, results of operations, and cash flows;

• our future stock-based compensation charges;

• our foreign exchange risk and our practices related to hedging those risks;

• our future uncertain tax positions;

• the potential impact of our storage solution on the total lifetime cost of storage for our customers;

• the increase of research and development, sales and marketing and general and administrative expenses in the future;

• our future capital expenditures, including investments in our infrastructure and in test and development equipment to support our research and development efforts;

• the availability of individuals with the specific skills required for key positions, as well as our ability to attract, hire and retain sales employees and key personnel;

• our hiring of sales and other key personnel and the impact such hiring may have on our business, growth and competitive position;

• the future yield on our investment portfolio;

• the sufficiency of our existing cash balances to meet our future capital requirements;

• the materiality of our exposure related to contractual guarantees and indemnities;

• the materiality of the exposure of our cash equivalents to changes in value and the projected value of our investment portfolio;

• future changes in competitive practices and landscape in our industry;

• our future reliance on establishing relationships with resellers and authorized service providers to sell, service and support our products in select markets;

• our continued investments in international markets and our expansion strategies in those markets;

• the contribution of international sales as a percentage of our total revenue on an annual basis;

as well as other important statements regarding our future operations, financial condition and prospects and business strategies. Forward-looking statements are based on our management's beliefs and assumptions, and on information currently available to our management, as of the date of this filing. These forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this report, and in particular, the risks discussed under the

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heading "Item 1A. Risk Factors" of this report. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statement.

Overview

We are the leading global provider of utility storage solutions for mid-sized to large enterprises, financial services firms, cloud computing service providers, consumer-oriented Internet/Web 2.0 companies, and government entities. Utility storage provides a foundation upon which organizations are able to build highly virtualized, consolidated IT infrastructures for managing their data. We help organizations build storage infrastructures to meet the performance and high availability demands of the virtual datacenter. Our storage systems are designed to be self-managing (smart), capacity efficient (thin), and resiliently adaptable (ready). We believe our storage systems provide substantial benefits for our customers, including reducing administrative costs and provisioning complexity, improving server and storage utilization, easing power and cooling requirements, scaling efficiently to support continuous growth, and adapting rapidly to meet changing business needs.

Established by engineers with substantial experience in the high-end server and storage markets, we began operations in 1999. From our inception, our corporate and product development objectives have focused on finding ways to use physical storage resources more efficiently and effectively by reducing unused storage and power consumption. Our utility storage solutions are comprised of the 3PAR InServ Storage Servers and the 3PAR InForm Suite, which includes the 3PAR InForm Operating System and other software applications.

We have experienced a history of net losses in each fiscal year since our inception as we have invested significantly in our product development, customer services and sales and marketing organizations to support the growth of our business. While we plan to continue focusing on constraining discretionary operating expenses in light of the general economic downturn, we plan to continue to invest heavily into our sales, customer service, and engineering organizations, which could limit our ability to generate profitability. We believe this strategy will better position us in the market to achieve substantial, long-term growth and market share in our business.

In the United States, United Kingdom and Germany we sell our products primarily through direct sales forces located in those territories. Although we have a direct sales office in Japan, we sell our products indirectly through channel partners and resellers in Asia and selected European markets. Sales in North America represented 84%, 83% and 90%, of our total revenue in fiscal 2009, 2008 and 2007, respectively. We expect that revenue from direct sales, in particular from sales in North America, will continue to contribute a substantial majority of our revenue for the foreseeable future, although it could decrease as a percentage of our total revenue as we expand our international sales through resellers and channel partners. Consequently, we plan to continue to add direct sales personnel in the United States, as well as expand our network of channel partners and resellers internationally, which we believe will be necessary to substantially increase our revenue.

Our revenue growth is driven primarily by increased sales to existing customers. Revenue from repeat business comprised 82%, 79% and 66% of our total revenue in fiscal 2009, 2008 and 2007, respectively. Our customers often follow an initial storage system purchase with subsequent upgrade or additional system purchases within the life cycle of such deployed systems after they have had an opportunity to realize the benefits from its simple usability, efficient performance and scalable architecture. Our revenue growth is also attributable to the expansion of our customer base. Early in our history, our revenue was concentrated with a few customers. While our customer concentration has decreased significantly over the years on an annual basis, we continue to experience sporadic customer concentration on a quarterly basis. For example, in the first and fourth quarters of fiscal 2009, and the first quarter of fiscal 2008, 20%, 12% and 25% of our revenue was attributable to sales to single customers in those periods, respectively.

A typical initial order requires three to six months of selling effort as we educate prospective customers about the technical merits and capabilities and potential cost savings of our products as compared to our

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competitors' solutions. Repeat orders are usually less time-consuming. We generally receive a substantial portion of our orders late in the quarter and the time from order to shipment and revenue recognition can vary substantially. Operational factors affecting the timing of revenue recognition include the time required to build the system to the customer's configuration requirements and the readiness of the customer's physical site with required power, cooling and information technology infrastructure. For new customers, other factors such as meeting technical performance specifications and negotiating contract terms and conditions also affect timing of shipment and revenue recognition.

We assemble our products at a single location in Fremont, California from components and subassemblies supplied to us by a limited number of manufacturers. Some of those components can only be purchased from our current suppliers or would require significant lead time to source from another supplier. We are heavily dependent on the availability of components and the reliability of our current suppliers. We have experienced in the past, and could experience in the future, quality control issues and delivery delays with our suppliers due to factors such as high industry demand and the inability of some suppliers to consistently meet our quality or delivery requirements. Although these problems have not historically adversely affected our revenue, if they occur again in the future, our revenue could be adversely impacted. Additionally, any deterioration in the financial condition of our suppliers and manufacturers, especially given the general economic downturn, could affect their ability to fulfill commitments to us, which could negatively impact our ability to fulfill orders and our research and development efforts and harm our operating results.

During fiscal 2009, we saw overall growth in customer spending commitments in our target markets despite the general economic downturn, which we believe demonstrates an increasing receptivity of our value proposition in those markets. We attribute our fiscal 2009 revenue growth of 57%, in part, to what we believe was increased sales to customers focused on total cost savings and administrative efficiency as they sought to reduce their capital and operating expenses in the midst of the general economic downturn. While we reported what we feel are strong operating results and substantial revenue growth in fiscal 2009, especially given the general economic downturn, our business depends in part on the financial health of our current and prospective customers. Any deterioration in the financial health of our current and prospective customers could result in reductions in sales of our products, longer sales cycles, and increased price competition, which could negatively impact our operating results and slow our revenue growth rate.

Revenue, Cost of Revenue and Operating Expense

Revenue

We derive our revenue from sales of our InServ Storage Servers, licenses of our InForm Suite and other software applications and related support.

Prior to March 2007, we typically sold our products with a three-year basic hardware warranty and software warranty. The software warranty was limited to bug fixes for any non-conforming software products. We generally recognized as product revenue all revenue associated with sales of our products at the time of shipment or installation, depending on the terms of the arrangement, provided that all other revenue recognition criteria were met. During this period, we also offered a premium hardware warranty and an extended hardware and software warranty beyond the initial contract term. Our premium hardware warranty offers faster service response time than our basic hardware warranty. We recognized as support revenue all revenue attributable to these premium and extended warranties on a ratable basis over the contract term, which was typically three years for premium warranty and one year from termination of the basic warranty for extended warranty.

In March 2007, in anticipation of evolving customer requirements for software support, we changed from a software warranty model to a software support model. Under the software support model, the customer receives, in addition to bug fixes, unspecified software upgrades and enhancements, on a when-and-if available basis, over the term of the support period. Commencing in March 2007, we sell all of our systems together with software support.

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During the first quarter of fiscal 2008, we established vendor specific objective evidence, or VSOE of the fair value of our new software support based on the rates we offer to our customers for renewal in our arrangements with them, or stated renewal rates. Accordingly, commencing April 1, 2007, we recognize revenue attributable to our software support as support revenue on a straight-line basis over the software support period. We sell a significant portion of our software support with a one-year term. Support revenue continues to include our premium and extended hardware warranties. We generally recognize the balance of the sale as product revenue at the time of shipment or installation, depending on the terms of the arrangement, provided that all other revenue recognition criteria are met. See "Revenue Recognition" under "Critical Accounting Polices and Estimates" below.

During the month of March 2007, we did not have VSOE of the fair value of our new software support. Therefore, as of March 31, 2007, we had $6.3 million of deferred revenue from product sales with software support that occurred in March 2007, including the hardware, software and support components. We were recognizing this $6.3 million as product revenue on a ratable basis over the applicable software support period until we established VSOE of fair value of PCS for these March 2007 transactions based on renewal rates for separate sales of PCS to other customers. Accordingly, in the first quarter of fiscal 2009 we applied the residual method to the remaining deferred revenue associated with the March 2007 transactions. The implementation of our software support model had an adverse impact on our revenue recognized during the quarter ended March 31, 2007 and resulted in a substantial increase to our deferred revenue at March 31, 2007.

As a result of the implementation of our software support model in March 2007, we expect support revenue to increase significantly in future periods. Therefore, comparing the elements of our revenue on a period-to-period basis may not be meaningful and should not be relied upon as an indication of our future performance.

Cost of Revenue

Cost of product revenue consists primarily of raw materials, manufacturing cost for our products, shipping and logistics cost, expenses for inventory obsolescence and initial warranty obligations. Cost of premium and extended warranty obligations are included in cost of support revenue. We utilize third parties to manufacture subcomponents of our products, which are then shipped to our Fremont, California operations facility for final assembly and testing prior to customer shipment. We outsource onsite support to third-party customer support vendors.

Prior to March 2007, we recognized all our hardware and software warranty costs as cost of product revenue at the time of revenue recognition based on our estimated time and material costs of providing hardware and software warranty support. In March 2007, during the implementation of our software support model, we deferred all hardware related costs associated with product sales bundled with software support for which we had not been able to establish VSOE of fair value at the outset of the arrangement. The hardware related costs associated with these sales are recognized ratably together with the product revenue. We no longer incur software warranty cost beginning March 2007, as this was replaced by our new software support sold together with our systems. For periods subsequent to March 2007, we continue to recognize hardware warranty costs as cost of product revenue at the time of revenue recognition.

Cost of support revenue consists of personnel cost and outside vendor cost to support premium and extended warranty services for all periods presented. Beginning March 2007, cost of support revenue also includes costs associated with providing software support. As a result of the implementation of our software support model in March 2007, we expect cost of support revenue to increase significantly in future periods.

Gross Margin

Gross profit is the difference between revenue and cost of revenue, and gross margin is gross profit expressed as a percentage of revenue. Product mix and system configurations affect our gross margin because our

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software and support margins are higher than our hardware margins. Larger systems tend to have greater software and support components and thereby result in a higher margin. Our gross margin tends to be higher for direct sales than for indirect sales because we generally sell our products to resellers at a discount. Our gross margin has fluctuated in the past, and we expect it will continue to fluctuate in the future primarily as a result of product mix and order size.

Operating Expense

Operating expense consists of research and development, sales and marketing, and general and administrative expense. The largest component of our operating expense in each case is personnel cost. Personnel cost consists of salaries, benefits and incentive compensation for our employees. We grew from 312 employees at March 31, 2007 to 451 employees at March 31, 2008 and to 591 employees at March 31, 2009. We expect to continue to hire additional direct sales and other key personnel to support our growth. The timing of these additional hires could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue, in any particular period.

Research and Development Expense

Research and development expense consists primarily of personnel cost, prototype expense, consulting services and facilities cost associated with personnel. Consulting services generally consist of contracted engineering consulting for specific projects. We recognize research and development expense when incurred. We expect to continue to devote substantial resources to the development of our products. We believe that these investments are necessary to maintain and improve our competitive position. In particular, we anticipate that we will hire substantial additional engineering personnel in future periods.

Sales and Marketing Expense

Sales and marketing expense consists primarily of personnel cost, sales commission, marketing programs and facilities cost associated with sales and marketing and certain customer service and support activities not associated with cost of revenue. We plan to continue to invest in sales and marketing by increasing the number of direct sales personnel we employ. Our sales personnel are not immediately productive and therefore the increase in sales and marketing expense we incur when we add new sales representatives is not immediately offset by increased revenue and may never result in increased revenue. The timing of our hiring of new sales personnel and the rate at which they generate incremental revenue could therefore affect our future period-to-period financial performance.

General and Administrative Expense

General and administrative expense consists primarily of personnel and facilities costs related to our executive, finance, human resources, information technology and legal organizations, as well as fees for professional services. Professional services consist of fees for outside legal, audit, compliance with the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, and information technology consulting.

Other Income (Expense), net

Other income (expense), net includes interest income on cash balances and short-term investments, interest expense on our outstanding debt and borrowings under our revolving line of credit, and losses or gains on our hedging activities and remeasurement of non-United States dollar transactions into United States dollars. If we are successful in growing our international sales we may be subject to increased currency conversion risks because a larger portion of our sales could be denominated in foreign currencies. We have historically invested our available cash balances in money market funds, short-term United States Government and agency obligations, municipal bonds, corporate debt securities and commercial paper.

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Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, or GAAP. These accounting principles require us to make estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements as well as the reported amounts of revenue and expense during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that we make these estimates and judgments. To the extent there are material differences between these estimates and actual results, our consolidated financial statements will be affected. The accounting policies that reflect our more significant estimates and judgments and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results are revenue recognition, stock-based compensation, inventory valuation, warranty provision, allowances for doubtful accounts and income taxes.

Revenue Recognition

We derive our revenue from sales of storage solutions that include hardware, software and related support. Because the embedded software of our storage solution is deemed to be more than incidental to the product as a whole, we account for revenue for the entire sale in accordance with the guidance provided by American Institute of Certified Public Accountants Statement of Position, or SOP 97-2, Software Revenue Recognition, as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions.

We recognize revenue when persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed or determinable, collection of the resulting receivable is reasonably assured and, if applicable, upon satisfaction of evaluation criteria or expiration of the evaluation period, as the case may be. Our fees are considered fixed or determinable at the execution of an agreement, which comprises the final terms of sale including the description, quantity and price of each product purchased. Our sales arrangements with customers and resellers do not include rights of return or rebates and to date, product returns have been negligible. We assess our ability to collect from our customers based on a number of factors, including creditworthiness of the customer and past transaction history.

Prior to March 2007, we typically sold our products with a three-year basic hardware warranty and software warranty. The software warranty was limited to bug fixes for any non-conforming software products. We generally recognized as product revenue all revenue associated with sales of our products at the time of shipment or installation, depending on the terms of the arrangement, provided that all other revenue recognition criteria were met. During this period, we also offered a premium hardware warranty and an extended hardware and software warranty after the initial contract term. Our premium hardware warranty offers faster response time than our basic hardware warranty. In accordance with Financial Accounting Standards Board, or FASB, Technical Bulletin 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts, we recognized revenue relating to our premium hardware warranty and extended hardware and software warranties ratably as support revenue over the warranty period, which was typically three years for premium warranty and one year from termination of the basic warranty for extended warranty.

Our sales are comprised of multiple elements, which include hardware, software and PCS. We allocate revenue to the delivered elements of the sale, typically hardware and software, using the residual method. Under the residual method, we defer revenue from the sale equivalent to the VSOE of the fair value of the PCS and apply any discounts to the delivered elements in accordance with the provisions of SOP 97-2, as amended by

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SOP 98-9. VSOE of the fair value of PCS within a sale is based upon stated renewal rates included within the evidence of the arrangement with the customer. In circumstances where the arrangement does not include stated renewal rates, VSOE of fair value of PCS is based on actual renewal rates for separate sales of PCS to other customers.

During the first quarter of fiscal 2008, we established VSOE of the fair value of our new software support based on stated renewal rates offered to customers within the arrangement. As a result, beginning in the first quarter of fiscal 2008, we defer revenue recognition of the PCS and recognize it as support revenue on a straight-line basis over the support period, which is primarily one year. We allocate the remainder of the revenue associated with the sale to product revenue using the residual method, as allowed by SOP 98-9. Support revenue also continues to include our premium and extended hardware warranties.

During the month of March 2007, we did not have VSOE of fair value for our new software support model. Accordingly, through March 31, 2008, we were recognizing all of the product and support revenue from transactions that included PCS during the month of March 2007 as product revenue ratably over the support period of one to three years. During the first quarter of fiscal 2009, we established VSOE of fair value of PCS for these March 2007 transactions based on renewal rates for separate sales of PCS to other customers. Accordingly, in the first quarter of fiscal 2009 we applied the residual method to the remaining deferred revenue associated with the March 2007 transactions.

We typically recognize product revenue upon installation for transactions sold directly to end users and through certain resellers which require installation by us, provided that the remaining revenue recognition criteria discussed above are satisfied. In cases where the arrangement includes customer-specific acceptance criteria, we recognize revenue upon the earlier of receipt of customer acceptance or the lapse of the acceptance period. For sales through our channel partners, we generally recognize product revenue upon shipment, based on freight terms of FOB Shipping Point or FOB Destination, assuming all other criteria for revenue recognition discussed above have been satisfied.

Stock-Based Compensation . . .