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VMW > SEC Filings for VMW > Form 10-Q on 1-Nov-2012All Recent SEC Filings

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Form 10-Q for VMWARE, INC.


1-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

All dollar amounts expressed as numbers in this MD&A (except share and per share amounts) are in millions.
Overview
Our primary source of revenues is the licensing of virtualization and virtualization-based cloud infrastructure solutions and related support and services for use by businesses and organizations of all sizes and across numerous industries in their information technology ("IT") infrastructure. We have developed a multi-channel distribution model to expand our global presence and to reach various segments of our industry. In the third quarter and first nine months of 2012, we derived over 85% of our sales from our channel partners, which include distributors, resellers, system vendors and systems integrators. Sales to our channel partners often involve three tiers of distribution: a distributor, a reseller and an end-user customer. Our sales force works collaboratively with our channel partners to introduce them to customers and new sales opportunities. As we expand geographically, we expect to continue to add additional channel partners.
Although we believe we are currently the leading provider of virtualization infrastructure software solutions, we face competitive threats to our leadership position from a number of companies, some of which have significantly greater resources than we do, which could result in increased pressure to reduce prices on our offerings. As a result, we believe it is important to continue to invest in strategic initiatives related to product research and development, market expansion and associated support functions to expand our industry leadership. We believe that we will be able to continue to meet our product development objectives through continued investment in our existing infrastructure, supplemented with strategic hires and acquisitions, funded through the operating cash flows generated from the sale of our products and services. We believe this is the appropriate priority for the long-term health and growth of our business. We expect to grow our business by broadening our virtualization infrastructure software solutions technology and product portfolio, increasing product awareness, promoting the adoption of virtualization and building long-term relationships with our customers through the adoption of enterprise license agreements ("ELAs"). Since the introduction of VMware vSphere in 2009, we have introduced more products that build on the vSphere foundation, including VMware vSphere 5 and a comprehensive suite of cloud infrastructure technologies, as well as VMware View 5. Additionally, in the third quarter of 2012, we released VMware vCloud Suite 5.1, which integrates our virtualization, cloud infrastructure and management portfolio into a comprehensive solution consisting of cloud infrastructure and management products, expertise and ecosystem support. VMware vCloud Suite 5.1 is our first solution to deliver a software defined data center ("SDDC"). The SDDC architecture abstracts all hardware resources and pools them into aggregate capacity, enabling automation to safely and efficiently parcel it out as needed for applications. The SDDC delivers IT services for cloud computing by extending and simplifying the benefits of virtualization to every domain in the data center: compute, storage, networking, and management functionality. We plan to continue to introduce additional products in the future that expand and promote the use of the vSphere foundation and the SDDC. In addition, we have made acquisitions that strengthen our product offerings or extend our strategy to deliver broader virtualization solutions. For example, in August 2012 we acquired Nicira, Inc. ("Nicira"), a developer of software defined networking solutions, which expands our product portfolio to provide a suite of software defined networking capabilities. Business acquisitions are an important element of our strategy and we expect to continue to consider additional strategic business acquisitions in the future. Our current financial focus is on long-term revenue growth to generate free cash flows to fund our expansion of industry segment share and to evolve our virtualization-based products for data centers, end-user devices and cloud computing through a combination of internal development and acquisitions. See "Non-GAAP Financial Measures" for further information on free cash flows. In evaluating our results, we also focus on operating margin excluding certain expenses which are included in our total operating expenses calculated in accordance with GAAP. The expenses excluded are stock-based compensation, the net effect of the amortization and capitalization of software development costs and certain other expenses consisting of employer payroll taxes on employee stock transactions, amortization of intangible assets and acquisition-related items. We believe this measure reflects our ongoing business in a manner that allows meaningful period-to-period comparisons. We are not currently focused on short-term operating margin expansion, but rather on investing at appropriate rates to support our growth and future product offerings in what may be a substantially more competitive environment.
Although our customers continue to adopt our product platform as a strategic investment that improves efficiency and flexibility for their business and enables substantial cost savings, we remain cautious about the macroeconomic environment. The volatility we are observing in both the world economy and individual sovereign nations may impact IT spending and demand for our products and services for the remainder of 2012. We expect to continue to manage our resources prudently, while making key investments in support of our long-term growth objectives.


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Income Statement Presentation
As we operate our business in one operating segment, our revenues and operating expenses are presented and discussed at the consolidated level. As a consequence of the timing differences in the recognition of license revenues and software maintenance revenues, variability in operating margin can result from differences between when we quote and contract for our services and when the cost is incurred. Variability in operating margin can also result when we recognize previously unearned foreign denominated software maintenance and license revenues in future periods. Due to our use of the U.S. Dollar as our functional currency, unearned revenue remains at its historical rate when recognized into revenue while our operating expenses in future periods are based upon the foreign exchange rates at that time. Sources of Revenues
License revenues
Our license revenues consist of revenues earned from the licensing of our software products. These products are generally licensed on a perpetual basis. License revenues are recognized when the elements of revenue recognition for the licensed software are complete, generally upon electronic shipment of the software. The revenues allocated to the software license included in multiple-element contracts represent the residual amount of the contract after the fair value of the other elements has been determined. While some of our products are licensed on a subscription basis, subscription license revenues are not a material part of our business.
Pricing models have generally been based upon the physical infrastructure, such as the number of physical desktop computers or server processors, on which our software runs. We base pricing for some of our products on virtual, rather than purely physical, entitlements, while continuing to license such products on a perpetual basis. In 2011, we revised the pricing model for VMware vSphere 5 so that while it continued to be licensed perpetually on a per-processor basis, the two physical constraints, number of cores and physical RAM, had been eliminated. These physical constraints were replaced with a single virtualization-based entitlement of virtual memory, or vRAM, which could be shared across a large pool of servers. In the third quarter of 2012, we revised the pricing model again for VMware vSphere when sold on a perpetual basis, continuing to license on a per-processor basis but with no core, vRAM or number of virtual machine limits. The revised pricing model did not impact our revenue recognition policies.
Software maintenance revenues
Software maintenance revenues are recognized ratably over the contract period. Our contract periods typically range from one to five years and include renewals of software maintenance sold after the initial software maintenance period expires. Vendor-specific objective evidence ("VSOE") of fair value for software maintenance services is established by the rates charged in stand-alone sales of software maintenance contracts. Customers receive various types of technical support based on the level of support purchased. Customers who are party to software maintenance agreements with us are entitled to receive product updates and upgrades on a when-and-if-available basis. Professional services revenues
Professional services include solution design, implementation and training. Professional services are not considered essential to the functionality of our products, as these services do not alter the product capabilities and may be performed by our customers or by other vendors. Professional services engagements performed for a fixed fee, for which we are able to make reasonably dependable estimates of progress toward completion, are recognized on a proportional performance basis based on hours incurred and estimated hours of completion. Professional services engagements that are on a time and materials basis are recognized based on hours incurred. Revenues on all other professional services engagements are recognized upon completion. Our professional services may be sold with software products or on a stand-alone basis. VSOE of fair value for professional services is based upon the standard rates we charge for such services when sold separately.
Operating Expenses
Cost of license revenues
Our cost of license revenues principally consist of the amortization of capitalized software development costs and of intangibles, as well as royalty costs in connection with technology licensed from third-party providers and the cost of fulfillment of our software. The cost of fulfillment of our software includes product packaging, personnel costs and related overhead associated with the physical and electronic delivery of our software products. Cost of services revenues
Our cost of services revenues include the costs of personnel and related overhead to deliver technical support for our products and to provide our professional services.


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Research and development expenses
Our research and development ("R&D") expenses include the personnel and related overhead associated with the R&D of new product offerings and the enhancement of our existing software offerings, net of any amounts capitalized. Sales and marketing expenses
Our sales and marketing expenses include personnel costs, sales commissions and related overhead associated with the sale and marketing of our license and services offerings, as well as the cost of product launches. Sales commissions are generally earned and expensed when a firm order is received from the customer and may be expensed in a period other than the period in which the related revenue is recognized. Sales and marketing expenses also include the net impact from the expenses incurred and fees generated by certain marketing initiatives, including our annual VMworld conferences in the U.S. and Europe. General and administrative expenses
Our general and administrative expenses include personnel and related overhead costs to support the overall business. These expenses include the costs associated with our facilities, finance, human resources, IT infrastructure and legal departments, as well as expenses related to corporate costs and initiatives.
Results of Operations
Revenues
Our revenues in the third quarter and first nine months of 2012 and 2011 were as follows:

                         For the Three Months Ended                        For the Nine Months Ended
                                September 30,                                    September 30,
                             2012              2011        % Change           2012             2011        % Change
Revenues:
License               $          491.1     $    443.6          11 %     $      1,490.3     $  1,327.4          12 %
Services:
Software maintenance             550.6          426.8          29              1,562.0        1,176.9          33
Professional services             92.0           71.5          29                259.6          202.5          28
Total services                   642.6          498.3          29              1,821.6        1,379.4          32
Total revenues        $        1,133.7     $    941.9          20       $      3,311.9     $  2,706.8          22

Revenues:
United States         $          553.6     $    443.4          25 %     $      1,589.2     $  1,293.3          23 %
International                    580.1          498.5          16              1,722.7        1,413.5          22
Total revenues        $        1,133.7     $    941.9          20       $      3,311.9     $  2,706.8          22

Total revenues increased by $191.8 or 20% to $1,133.7 in the third quarter of 2012 from $941.9 in the third quarter of 2011. Total revenues increased by $605.1 or 22% to $3,311.9 in the first nine months of 2012 from $2,706.8 in the first nine months of 2011.
In the third quarter and first nine months of 2012 we saw growth in license and services revenues, and growth in the United States and internationally, as compared with the third quarter and first nine months of 2011. License Revenues
Software license revenues increased by $47.5 or 11% to $491.1 in the third quarter of 2012 from $443.6 in the third quarter of 2011. Software license revenues increased by $162.9 or 12% to $1,490.3 in the first nine months of 2012 from $1,327.4 in the first nine months of 2011. License revenues in the third quarter and first nine months of 2012 increased as compared to the third quarter and first nine months of 2011 due to continued demand for our product offerings. In the third quarter of 2012, ELAs comprised 24% of total sales compared with 22% in the third quarter of 2011, and 25% in the first nine months of 2012 compared with 24% in the first nine months of 2011. We have promoted the adoption of virtualization and built long-term relationships with our customers through the adoption of ELAs. ELAs continue to be an important component of our revenue growth and are offered both directly by us and through certain channel partners. ELAs are a core element to our strategy to build long-term relationships with customers as they commit to our virtualization infrastructure software solutions in their data centers. ELAs provide a base from which to sell additional products, such as our application platform products, our end-user computing products and our cloud infrastructure and management products. Under


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a typical ELA, a portion of the revenues is attributed to the license and recognized immediately and the remainder is deferred and primarily recognized as software maintenance revenues in future periods. In addition, the initial maintenance period is typically longer for ELAs than for other types of license sales.
Services Revenues
Services revenues increased by $144.3 or 29% to $642.6 in the third quarter of 2012 from $498.3 in the third quarter of 2011. Services revenues increased by $442.2 or 32% to $1,821.6 in the first nine months of 2012 from $1,379.4 in the first nine months of 2011. The increase in services revenues during the third quarter and first nine months of 2012 was primarily attributable to growth in our software maintenance revenues.
Software maintenance revenues increased by $123.9 or 29% to $550.6 in the third quarter of 2012 from $426.8 in the third quarter of 2011. Software maintenance revenues increased by $385.1 or 33% to $1,562.0 in the first nine months of 2012 from $1,176.9 in the first nine months of 2011. In the third quarter and first nine months of 2012, software maintenance 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. In the third quarter and first nine months of 2012, customers bought, on average, more than 24 months of support and maintenance with each new license purchased, which we believe illustrates our customers' commitment to VMware as a core element of their data center architecture and hybrid cloud strategy.
Professional services revenues increased by $20.4 or 29% to $92.0 in the third quarter of 2012 from $71.5 in the third quarter of 2011. Professional services revenues increased by $57.1 or 28% to $259.6 in the first nine months of 2012 from $202.5 in the first nine months of 2011. Professional services revenues increased as growth in our license sales and installed-base led to additional demand for our professional services. As we continue to invest in our partners and expand our ecosystem of third-party professionals with expertise in our solutions to independently provide professional services to our customers, we do not expect our professional services revenues to constitute an increasing component of our revenue mix. As a result of this strategy, our professional services revenue can vary based on the delivery channels used in any given period as well as the timing of engagements. Revenue Growth in Constant Currency
We invoice and collect in the Euro, the British Pound, the Japanese Yen and the Australian Dollar in their respective regions. As a result, our total revenues are affected by changes in the value of the U.S. Dollar against these currencies. In order to provide a comparable framework for assessing how our business performed excluding the effect of foreign currency fluctuations, management analyzes year-over-year revenue growth on a constant currency basis. Since we operate with the U.S. Dollar as our functional currency, unearned revenues for orders booked in currencies other than the U.S. Dollar are converted into U.S. Dollars at the exchange rate in effect for the month in which each order is booked. We calculate constant currency on license revenues recognized during the current period that were originally booked in currencies other than U.S. Dollars by comparing the exchange rates used to recognize revenue in the current period against the exchange rates used to recognize revenue in the comparable period. For the third quarter of 2012, the year-over-year growth in license revenues measured on a constant currency basis was 14% compared with 11% as reported, and was 14% compared with 12% as reported year-over-year for the first nine months of 2012. We do not calculate constant currency on services revenues, which include software maintenance revenues and professional services revenues.
Unearned Revenues
Our unearned revenues as of September 30, 2012, and December 31, 2011 were as follows:

                                         September 30, 2012      December 31, 2011
Unearned license revenues               $              366.1    $             389.2
Unearned software maintenance revenues               2,415.3                2,133.5
Unearned professional services revenues                211.9                  185.7
Total unearned revenues                 $            2,993.3    $           2,708.4

The complexity of our unearned revenues has increased over time as a result of acquisitions, an expanded product portfolio and a broader range of pricing and packaging alternatives. As of September 30, 2012, total unearned revenues increased by $284.9 or 11% to $2,993.3 from $2,708.4 at December 31, 2011. This increase was primarily due to growth in unearned software maintenance revenues, attributable to our growing base of maintenance contracts.
Unearned license revenues are recognized either ratably or upon the delivery of existing products, future products or services. Future products include, in some cases, emerging products that are offered as part of product promotions where the


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purchaser of an existing product is entitled to receive a promotional product at no additional charge. We regularly offer product promotions as a strategy to improve awareness of our emerging products. To the extent promotional products have not been delivered and VSOE of fair value cannot be established, the revenue for the entire order is deferred until such time as all product delivery obligations have been fulfilled. Increasingly, unearned license revenue may also be recognized ratably, which is generally due to a right to receive unspecified future products or a lack of VSOE of fair value on the software maintenance element of the arrangement. At September 30, 2012, the ratable component represented over half of the total unearned license revenue balance. The amount of total unearned license revenues may vary over periods due to the type and level of promotions offered, as well as due to the portion of license contracts sold with a ratable recognition element. Unearned software maintenance revenues are attributable to our maintenance contracts and are recognized ratably over terms from one to five years with a weighted-average remaining term at September 30, 2012 of approximately 1.9 years. Unearned professional services revenues result primarily from prepaid professional services, including training, and are generally recognized as the services are delivered. We believe our overall unearned revenue balance improves predictability of future revenues and that it is a key indicator of the health and growth of our business. Operating Expenses
Information about our operating expenses for the third quarter and first nine months of 2012 and 2011 is as follows:

                                             For the Three Months Ended September 30, 2012
                                                               Capitalized
                               Core                             Software           Other           Total
                             Operating       Stock-Based       Development       Operating       Operating
                           Expenses (1)     Compensation       Costs, net        Expenses        Expenses
Cost of license revenue    $      25.6     $         0.6     $        14.9     $      19.2     $      60.3
Cost of services revenue         110.1               7.8                 -             1.1           119.0
Research and development         197.8              60.2                 -             1.9           259.9
Sales and marketing              356.3              51.7                 -             3.5           411.5
General and administrative        78.7              11.8                 -             2.1            92.6
Total operating expenses   $     768.5     $       132.1     $        14.9     $      27.8     $     943.3
Operating income                                                                               $     190.3
Operating margin                                                                                      16.8 %



                                            For the Three Months Ended September 30, 2011
                                                               Capitalized
                               Core                             Software          Other           Total
                             Operating       Stock-Based       Development      Operating       Operating
                           Expenses (1)      Compensation      Costs, net       Expenses        Expenses
Cost of license revenue    $      18.5     $          0.4     $      14.4     $      12.8     $      46.1
Cost of services revenue          99.0                6.1               -             1.6           106.7
Research and development         170.9               46.7           (21.1 )           3.2           199.7
Sales and marketing              302.6               24.8               -             4.2           331.6
General and administrative        65.4               10.4               -             1.2            77.0
Total operating expenses   $     656.4     $         88.4     $      (6.7 )   $      23.0     $     761.1
Operating income                                                                              $     180.7
Operating margin                                                                                     19.2 %


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                                             For the Nine Months Ended September 30, 2012
                                                                Capitalized
                                Core                             Software           Other          Total
                             Operating        Stock-Based       Development       Operating      Operating
                            Expenses (1)     Compensation       Costs, net        Expenses        Expenses
Cost of license revenue    $       68.3     $         1.5     $        57.5     $      46.3     $    173.6
Cost of services revenue          331.0              20.7                 -             4.2          355.9
Research and development          575.8             147.6                 -             7.5          730.9
Sales and marketing             1,042.8             110.8                 -            12.8        1,166.4
General and administrative        226.9              34.3                 -             4.5          265.7
Total operating expenses   $    2,244.8     $       314.9     $        57.5     $      75.3     $  2,692.5
Operating income                                                                                $    619.4
Operating margin                                                                                      18.7 %



                                              For the Nine Months Ended September 30, 2011
                                                                  Capitalized
                                 Core                              Software          Other          Total
                               Operating         Stock-Based      Development      Operating      Operating
                             Expenses (1)       Compensation      Costs, net       Expenses        Expenses
Cost of license revenue    $      54.1         $         1.2     $      62.7     $      33.0     $    151.0
Cost of services revenue         281.8                  17.4               -             4.9          304.1
Research and development         486.8                 134.6           (74.0 )          10.7          558.1
Sales and marketing              866.5                  70.6               -            12.0          949.1
General and administrative       189.3                  30.6               -             3.5          223.4
Total operating expenses   $   1,878.5         $       254.4     $     (11.3 )   $      64.1     $  2,185.7
Operating income                                                                                 $    521.1
Operating margin                                                                                       19.3 %


____________________________


(1) Core operating expenses is a non-GAAP financial measure that excludes stock-based compensation, the net effect of the amortization and capitalization of software development costs and certain other expenses from our total operating expenses calculated in accordance with GAAP. The other . . .
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