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BRCD > SEC Filings for BRCD > Form 10-Q on 6-Jun-2014All Recent SEC Filings

Show all filings for BROCADE COMMUNICATIONS SYSTEMS INC

Form 10-Q for BROCADE COMMUNICATIONS SYSTEMS INC


6-Jun-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis should be read in conjunction with the Condensed Consolidated Financial Statements and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and with Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report filed on Form 10-K with the Securities and Exchange Commission on December 16, 2013. This section and other parts of this Quarterly Report on Form 10-Q contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can also be identified by words such as "anticipates," "expects," "believes," "plans," "predicts," and similar terms. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled "Risk Factors" below.

Overview
We are a leading supplier of networking equipment and software for businesses and organizations of many types and sizes. Our end customers include global enterprises that use our products and services as part of their communications infrastructure, and service providers such as telecommunication firms, cable operators and mobile carriers who use our products and services as part of their production operations. Our products and services are marketed, sold and supported worldwide to end-user customers through distribution partners, including original equipment manufacturer ("OEM") partners, distributors, systems integrators, and value-added resellers, as well as directly to end users by our sales force. Our business model is focused on two key markets: our Storage Area Networking ("SAN") business, where we offer Fibre Channel ("FC") SAN backbones, directors, fixed form factor switches and embedded switches, and our Internet Protocol ("IP") Networking business, where we offer IP routers, Ethernet switches, network security and monitoring, as well as products used to manage application delivery. Our IP products are available in modular, fixed, and virtualized or software form factors and can be deployed in both traditional network designs and full-featured Ethernet fabrics. We also provide product-related customer support and services in both our SAN business and our IP Networking business.
We expect growth opportunities in the SAN market over time to be driven by key customer Information Technology ("IT") initiatives such as server virtualization, enterprise mobility, data center consolidation, and migration to higher performance technologies, such as solid state storage and cloud computing initiatives. Our IP Networking business strategies are intended to increase new customer accounts and expand our market share through product innovation, such as our Ethernet fabric and virtualized software networking products (also known as software-defined networking, or "SDN," and Network Functions Virtualization, or "NFV"), and the development and expansion of our routes to market. The success of Ethernet fabrics, in particular, will depend on customers recognizing the benefits of upgrading their data center networks to fabric-based networking architectures and our future success in this area would be negatively impacted if this technological transition does not occur at the anticipated rate or at all. While our NFV revenues have not been material to date, customer interest in NFV is very high and we believe that customers prefer to buy networking products from suppliers that offer a portfolio of solutions that address their current and future needs. We plan to continue to support our SAN and IP Networking growth plans by continuous innovation, leveraging the strategic investments we have made in our core businesses, developing emerging technologies (such as SDN and NFV), new product introductions, and enhancing our existing partnerships and forming new ones through our various distribution channels.
In the second quarter of fiscal year 2013, we announced that we were making certain changes in our strategic direction by focusing on key technology segments, such as our SAN fabrics, Ethernet fabrics and software networking products, for the data center. As part of this change in focus, we reduced our cost of revenues and other operating expenses by $100 million on an annualized basis when comparing the first quarter of fiscal year 2014 to the first quarter of fiscal year 2013. We achieved our targeted cost reduction opportunities ahead of our previously announced schedule by focusing on the optimization of discretionary spending and rebalancing personnel resources. We previously disclosed that this change in focus will also result in a rebalancing of resources away from certain non-key areas of our business, which has impacted our ability to generate revenue from certain products, markets, geographies and customers. In the second quarter of fiscal year 2014, we made a strategic decision to reduce our investment in the hardware-based ADX products and to increase investment in the software-based ADX products for the Layer 4-7 market. As a result of this change in strategy, we expect hardware-based ADX and related support revenue to be negatively impacted by $20 million to $40 million on an annualized basis. Based on the decrease in the hardware-based ADX revenue forecast, we recognized an $83 million non-cash goodwill impairment charge during the second quarter of fiscal year 2014.
Combined with the other rebalancing actions taken through the first quarter of fiscal year 2014, which, among other actions, included divestiture of our network adapter business and a change in our wireless business strategy, we believe our changes in strategic direction will cause our annualized revenues in fiscal year 2014 to be lower by approximately $80 million to $100 million compared with fiscal year 2013.


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We continue to face multiple challenges, including aggressive price discounting from competitors, new product introductions from competitors, rapid adoption of new technologies by customers, an uneven recovery in the worldwide macroeconomic climate and its impact on IT spending patterns globally, as well as uncertain federal government spending in the United States. We are also cautious about the stability and health of certain international markets, including China, and current global and country-specific dynamics, including inflationary risks in China. These factors may impact our business and that of our partners. While the diversified portfolio of products that we offer helps mitigate the effect of some of these challenges and we expect IT spending levels to generally rise in the long term, it is difficult for us to offset short-term reductions in IT spending, which may adversely affect our financial results and stock price. We expect the number of SAN and IP Networking products we ship to fluctuate depending on the demand for our existing and recently introduced products, and sales support for our products from our distribution and resale partners, as well as the timing of product transitions by our OEM partners. The average selling prices per port for our SAN and IP Networking products have typically declined over time, unless impacted favorably by a new product introduction or mix, and will likely decline in the future.
Our plans for our operating cash flows are to provide liquidity for operations, to repurchase our stock to reduce the dilutive effects of our equity award programs and, from time to time, we may also opportunistically repurchase our stock under our previously announced stock repurchase programs. In addition, we may use our operating cash flows to strengthen our networking portfolios through acquisitions and strategic investments. In September 2013, we announced our intent to return at least 60% of our adjusted free cash flow, which we define as operating cash flow adjusted for the impact of the excess tax benefits from stock-based compensation, less capital expenditures, to investors in the form of share repurchases or dividends. In the third quarter of fiscal year 2014, our Board of Directors initiated a quarterly cash dividend of $0.035 per share of our common stock. The first dividend payment will be made on July 2, 2014, to stockholders of record as of the close of market on June 10, 2014. Future dividend payments are subject to review and approval by our Board of Directors.


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Results of Operations
Our results of operations for the three and six months ended May 3, 2014, and
April 27, 2013, are reported in this discussion and analysis as a percentage of
total net revenues, except for gross margin with respect to each segment, which
is indicated as a percentage of the respective segment net revenues.
Revenues. Our revenues are derived primarily from sales of our SAN and IP
Networking products, and support and services related to these products, which
we call Global Services.
Our total net revenues are summarized as follows (in thousands, except
percentages):
                                           Three Months Ended
                                           % of Net     April 27,      % of Net      Increase/         %
                          May 3, 2014      Revenues        2013        Revenues     (Decrease)       Change
SAN Products            $     321,164         59.8 %   $  319,088         59.2 %   $     2,076         0.7  %
IP Networking Products        121,116         22.6 %      132,658         24.6 %       (11,542 )      (8.7 )%
Global Services                94,630         17.6 %       87,038         16.2 %         7,592         8.7  %
Total net revenues      $     536,910        100.0 %   $  538,784        100.0 %   $    (1,874 )      (0.3 )%



                                              Six Months Ended
                                          % of Net                          % of Net     Increase/         %
                         May 3, 2014      Revenues      April 27, 2013      Revenues     (Decrease)      Change
SAN Products            $    676,620         61.4 %   $        680,822         60.4 %   $   (4,202 )      (0.6 )%
IP Networking Products       240,865         21.9 %            273,171         24.2 %      (32,306 )     (11.8 )%
Global Services              183,960         16.7 %            173,520         15.4 %       10,440         6.0  %
Total net revenues      $  1,101,445        100.0 %   $      1,127,513        100.0 %   $  (26,068 )      (2.3 )%

The decrease in total net revenues for the three months ended May 3, 2014, compared to the three months ended April 27, 2013, primarily reflects lower sales for our IP Networking products, partially offset by increase in sales for our Global Services and SAN products.
The increase in SAN product revenues was caused by an increase in switch and server product revenues, partially offset by a decrease in director product revenue, due to demand changes from our OEM partners. We continue to maintain a positive view of the long-term SAN market despite a soft storage market in the near term. Our average selling price per port decreased by 4.4% during the three months ended May 3, 2014, which was offset by the 5.3% increase in the number of ports shipped during the same period, resulting in higher SAN product revenues for the three months ended May 3, 2014;

The decrease in IP Networking product revenues primarily reflects lower revenues from our IP routing, adapter, and application delivery products due to the divestiture of the network adapter business, our shift in strategy with respect to our ADX product line, our wireless business and certain other product lines. These decreases were partially offset by an increase in our Ethernet switch products for data center and campus customers. Based on our analysis of the information we collect in our sales management system, we estimate that revenues from our U.S. federal government and enterprise end customers, as well as network carrier customers have decreased for the three months ended May 3, 2014, compared with the three months ended April 27, 2013. The decrease in revenues from our U.S. federal government, enterprise end customers, and network carrier customers is due to the current challenging U.S. federal budget environment and due to lower demand from our enterprise and network carrier end customers. As the percentage of our IP Networking products being sold through two-tier distribution has increased, it has become increasingly difficult to quantify our revenues by end customer, and, therefore, these results are based solely on our estimates; and

The increase in Global Services revenues was primarily attributable to an additional week of amortized support revenue from the 14-week quarter in the second quarter of fiscal year 2014 and an increase in the revenue recognized from sales of initial support contracts and renewal support contracts for our SAN products, partially offset by a decrease in the sale of professional services.


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The decrease in total net revenues for the six months ended May 3, 2014, compared with the six months ended April 27, 2013, reflects lower sales of our IP Networking and SAN products, partially offset by higher sales of our Global Services offerings, as further described below.
The decrease in SAN product revenues was caused by a decrease in director product revenue, partially offset by an increase in switch and server product revenues, due to demand changes from our OEM partners. We continue to maintain a positive view of the long-term SAN market despite a soft storage market in the near term. Our average selling price per port decreased by 4.3% during the six months ended May 3, 2014, as compared with the same period in the prior year, which was partially offset by the 3.8% increase in the number of ports shipped during the same period;

The decrease in IP Networking product revenues primarily reflects lower revenues from our IP routing and application delivery products. Based on our analysis of the information we collect in our sales management system, we estimate that revenues from our U.S. federal government and enterprise end customers, as well as network carrier customers, have decreased for the six months ended May 3, 2014, compared with the six months ended April 27, 2013. The decrease in revenues from our U.S. federal government and enterprise end customers is due to the current challenging federal budget environment, and due to lower demand in the United States and Japan. As the percentage of our IP Networking products being sold through two-tier distribution has increased, it has become increasingly difficult to quantify our revenues by end customer, and, therefore, these results are based solely on our estimates; and

The increase in Global Services revenues was primarily attributable to an additional week of amortized support revenue from the 14-week quarter in the second quarter of fiscal year 2014 and an increase in the revenue recognized from sales of initial support contracts and renewal support contracts for both our SAN products and IP Networking products.

Our total net revenues by geographic area are summarized as follows (in thousands, except percentages):

                                           Three Months Ended
                                           % of Net     April 27,      % of Net      Increase/         %
                          May 3, 2014      Revenues        2013        Revenues     (Decrease)       Change
United States           $     314,216         58.5 %   $  314,581         58.4 %   $      (365 )      (0.1 )%
Europe, the Middle East       141,903         26.4 %      145,673         27.0 %        (3,770 )      (2.6 )%
and Africa (1)
Asia Pacific                   41,402          7.7 %       42,001          7.8 %          (599 )      (1.4 )%
Japan                          25,999          4.9 %       27,356          5.1 %        (1,357 )      (5.0 )%
Canada, Central and            13,390          2.5 %        9,173          1.7 %         4,217        46.0  %
South America
Total net revenues      $     536,910        100.0 %   $  538,784        100.0 %   $    (1,874 )      (0.3 )%

(1) Includes net revenues of $89.9 million and $93.4 million for the three months ended May 3, 2014, and the three months ended April 27, 2013, respectively, relating to the Netherlands.

                                              Six Months Ended
                                          % of Net                          % of Net     Increase/         %
                         May 3, 2014      Revenues      April 27, 2013      Revenues     (Decrease)      Change
United States           $    638,131         57.9 %   $        678,633         60.2 %   $  (40,502 )      (6.0 )%
Europe, the Middle East      299,831         27.2 %            288,091         25.5 %       11,740         4.1  %
and Africa (2)
Asia Pacific                  92,458          8.4 %             89,052          7.9 %        3,406         3.8  %
Japan                         46,079          4.2 %             52,835          4.7 %       (6,756 )     (12.8 )%
Canada, Central and           24,946          2.3 %             18,902          1.7 %        6,044        32.0  %
South America
Total net revenues      $  1,101,445        100.0 %   $      1,127,513        100.0 %   $  (26,068 )      (2.3 )%

(2) Includes net revenues of $192.9 million and $177.4 million for the six months ended May 3, 2014, and the six months ended April 27, 2013, respectively, relating to the Netherlands.

Revenues are attributed to geographic areas based on where our products are shipped. However, certain OEM partners take possession of our products domestically and then distribute these products to their international customers. Because we account for all of those OEM revenues as domestic revenues, we cannot be certain of the extent to which our domestic and


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international revenue mix is impacted by the practices of our OEM partners, but end-user location data does indicate that international revenues comprise a larger percentage of our total net revenues than the attributed revenues above may indicate.
International revenues for the three months ended May 3, 2014, were relatively unchanged as a percentage of total net revenues compared to the three months ended April 27, 2013. International revenues for the six months ended May 3, 2014, increased as a percentage of total net revenues compared with the six months ended April 27, 2013, primarily due to lower revenue from IP Networking products sold into the U.S federal market.
A significant portion of our revenues are concentrated among a relatively small number of OEM customers. For the three months ended May 3, 2014, four customers accounted for 17%, 16%, 12%, and 11%, respectively, of our total net revenues for a combined total of 56% of total net revenues. For the three months ended April 27, 2013, three customers accounted for 18%, 16%, and 11%, respectively, of our total net revenues for a combined total of 45% of total net revenues. We expect that a significant portion of our future revenues will continue to come from sales of products to a relatively small number of OEM partners and to the U.S. federal government and its individual agencies through our distributors and resellers. Therefore, the loss of, or significant decrease in the level of sales to, or a change in the ordering pattern of any one of, these customers could seriously harm our financial condition and results of operations.
Gross margin. Gross margin as stated below is indicated as a percentage of the respective segment net revenues, except for total gross margin, which is stated as a percentage of total net revenues.
Gross margin is summarized as follows (in thousands, except percentages):

                                           Three Months Ended
                                           % of Net     April 27,      % of Net      Increase/      % Points
                          May 3, 2014      Revenues        2013        Revenues      (Decrease)      Change
SAN Products            $     236,650         73.7 %   $  231,191         72.5 %   $      5,459         1.2 %
IP Networking Products         63,359         52.3 %       55,956         42.2 %          7,403        10.1 %
Global Services                54,283         57.4 %       46,965         54.0 %          7,318         3.4 %
Total gross margin      $     354,292         66.0 %   $  334,112         62.0 %   $     20,180         4.0 %


                                            Six Months Ended
                                           % of Net     April 27,      % of Net      Increase/       % Points
                          May 3, 2014      Revenues        2013        Revenues      (Decrease)       Change
SAN Products            $     499,165         73.8 %   $  495,972         72.8 %   $      3,193         1.0 %
IP Networking Products        122,422         50.8 %      119,047         43.6 %          3,375         7.2 %
Global Services               105,375         57.3 %       93,018         53.6 %         12,357         3.7 %
Total gross margin      $     726,962         66.0 %   $  708,037         62.8 %   $     18,925         3.2 %

The gross margin percentage for each reportable segment increased for the three months ended May 3, 2014, compared with the three months ended April 27, 2013, primarily due to the following factors (the percentages below reflect the impact on gross margin):
SAN gross margins relative to net revenues increased primarily due to a 1.2% decrease in manufacturing overhead costs primarily due to lower headcount, lower freight costs, and lower outside services spending, partially offset by an increase in variable performance-based compensation and an additional week of payroll expense from the 14-week quarter in the second quarter of fiscal year 2014;

IP Networking gross margins relative to net revenues increased primarily due to a 6.9% decrease in amortization of IP Networking-related intangible assets, as most of these assets were acquired during the acquisition of Foundry Networks, LLC ("Foundry") and were fully amortized prior to the three months ended May 3, 2014. In addition, manufacturing overhead costs decreased 2.3%, relative to net revenues, primarily due to lower overhead labor cost, lower freight costs, and lower outside services spending, partially offset by an increase in variable performance-based compensation and an additional week of payroll expense from the 14-week quarter in the second quarter of fiscal year 2014. Product costs also decreased 1.4%, relative to net revenues, which is mainly attributable to a more favorable mix of IP Networking products as well as product cost reductions resulting from our ongoing efforts to reduce costs with our suppliers; and

Global Services gross margins relative to net revenues increased primarily due to a 3.2% decrease in service and support costs relative to net revenues, due to a decrease in period costs resulting primarily from lower overhead labor cost, and lower rework expenses, partially offset by an increase in variable performance-based compensation for the


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three months ended May 3, 2014. The decrease in service and support costs relative to net revenues was also due to lower legal, IT and facilities expenses allocated to Global Services.
Gross margin percentage for each reportable segment increased for the six months ended May 3, 2014, compared with the six months ended April 27, 2013, primarily due to the following factors (the percentages below reflect the impact on gross margin):
SAN gross margins relative to net revenues increased due to a 0.9% decrease in manufacturing overhead costs primarily due to lower overhead labor cost, lower freight costs and lower outside services spending, partially offset by an increase in variable performance-based compensation and an additional week of payroll expense from the 14-week quarter in the second quarter of fiscal year 2014. In addition, SAN gross margins relative to net revenues increased due to a 0.2% decrease in amortization of SAN-related intangible assets, relative to net revenues. These decreases were partially offset by a 0.2% increase in product and other costs relative to net revenues;

IP Networking gross margins relative to net revenues increased primarily due to a 4.2% decrease in amortization of IP Networking-related intangible assets, as most of these assets were acquired during the acquisition of Foundry and were fully amortized prior to the three months ended May 3, 2014, and a 2.3% decrease in product costs, which is mainly attributable to a more favorable mix of IP Networking products as well as product cost reductions resulting from our ongoing efforts to reduce costs with our suppliers, in each case, relative to net revenues; and

Global Services gross margins relative to net revenues increased primarily due to a 3.3% decrease in service and support costs relative to net revenues, due to a decrease in period costs, primarily resulting from lower overhead labor cost, and lower rework expenses, partially offset by an increase in variable performance-based compensation for the six months ended May 3, 2014. The decrease in service and support costs relative to net revenues was also due to lower legal, IT and facilities expenses allocated to Global Services.

Research and development expenses. Research and development ("R&D") expenses consist primarily of compensation and related expenses for personnel engaged in engineering and R&D activities, fees paid to consultants and outside service providers, engineering expenses, which primarily consist of nonrecurring engineering charges and prototyping expenses related to the design, development, testing and enhancement of our products, depreciation related to engineering and test equipment, and allocated expenses related to legal, IT, facilities and other shared functions.
R&D expenses are summarized as follows (in thousands, except percentages):

                              May 3, 2014               April 27, 2013
Research and                           % of Net                   % of Net     Increase/         %
development expense:      Expense      Revenues      Expense      Revenues     (Decrease)      Change
Three months ended      $  90,554         16.9 %   $  98,429         18.3 %   $   (7,875 )      (8.0 )%
Six months ended        $ 177,710         16.1 %   $ 196,119         17.4 %   $  (18,409 )      (9.4 )%

R&D expenses decreased for the three months ended May 3, 2014, compared with the three months ended April 27, 2013, due to the following (in thousands):

                                                                        Increase
                                                                       (Decrease)
Engineering expense                                                  $      (2,959 )
Expenses related to legal, IT, facilities and other shared functions        (2,450 )
Depreciation and amortization expense                                       (1,121 )
Salaries and other compensation                                               (882 )
Various individually insignificant items                                      (463 )
Total change                                                         $      (7,875 )

. . .
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