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BRCD > SEC Filings for BRCD > Form 10-Q on 3-Mar-2017All Recent SEC Filings

Show all filings for BROCADE COMMUNICATIONS SYSTEMS INC

Form 10-Q for BROCADE COMMUNICATIONS SYSTEMS INC


3-Mar-2017

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 Company's 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, 2016. 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 "expects," "anticipates," "assumes," "targets," "projects," "intends," "plans," "believes," "seeks," "estimates," "continues," "may," "should," "could," "depend," "will," "contemplate," "predict," "potential," and variations of such words and similar expressions. 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.


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Overview
We are a leading supplier of networking hardware, software, and services for businesses and organizations of various types and sizes. Our end customers include global enterprises and other organizations that use our products and services as part of their communications infrastructure. In addition, service providers, such as telecommunication firms, cable operators, and mobile carriers, use our products and services as part of their commercial operations. Our business is focused on two key markets. One is Storage Area Networking ("SAN"), where we offer our SAN products, including modular directors, fixed-configuration and embedded switches, and network management and monitoring capabilities. The second is Internet Protocol ("IP") Networking, where we offer IP routers, Ethernet switches, wireless access points and controllers, network security, analytics, and monitoring, as well as products used to manage application delivery. Our IP Networking products are available in modular and fixed hardware-based form factors and can be deployed in both traditional network and next-generation fabric designs. Our IP Networking products also include a wide range of virtualized network software offerings. We also provide product-related customer support and services across all our businesses. Key customer information technology ("IT") initiatives, such as virtualization, enterprise mobility, data center consolidation, cloud computing, and migration to higher performance technologies, such as solid-state storage, continue to rely on our mission-critical SAN-based solutions. We are known as a storage networking innovator and have a leading SAN market share position. Our SAN business strategy is to continue to expand and diversify our partner base and introduce new, innovative solutions for both our large installed base and potential new customers. For example, we recently launched our Gen 6 Fibre Channel SAN platform. This next generation of switches and directors delivers superior performance and scalability designed to support demanding workloads from mission-critical applications. In addition, we continue to add new SAN partners, expand relationships with existing partners, and introduce new products, such as the Brocade Analytics Monitoring Platform. This new platform provides customers the ability to improve operational performance, stability, and security within their storage environments.
Our IP Networking business strategies are designed to support IP networking initiatives and intended to increase new customer accounts and expand our current market share through product innovations, acquisitions, and the development and expansion of our routes to market. Examples include the development of both IP and Ethernet fabric switches, next-generation routers, virtualized software networking products, and the acquisition of Ruckus Wireless, Inc. ("Ruckus"), which was completed on May 27, 2016. The Ruckus acquisition, which provides us access to both the Ruckus product portfolio and Ruckus' channels to market, enhances our scale and competitive positioning in both the enterprise and service provider markets and complements our mobility strategy that we announced in February 2016. In the longer term, we expect the Ruckus acquisition to strengthen our ability to pursue emerging opportunities around 5G mobile services, the Internet of Things, Smart Cities, in-building LTE, and cellular/Wi-Fi convergence.
The success of our IP Networking business, in particular, will depend on customers recognizing the benefits of upgrading their data center networks to fabric-based networking architectures, upgrading their wireline and wireless infrastructure at the network edge, and adopting our virtualized software-based networking solutions as part of the overall digital transformation happening in the marketplace. In particular, our future success in this area would be negatively impacted if the technological transition to virtual software-based solutions does not occur at the anticipated rate or at all. While our software networking license revenues have not been material to date, there is customer interest in software networking products. We plan to continue to support our growth strategy with continuous innovation, leveraging the strategic investments we have made in our core businesses, introducing new products, and enhancing our existing partnerships and forming new partnerships through our various distribution channels.
We continue to face multiple challenges as customers consider moving specific workloads to the cloud, evaluate hyper-converged architectures, and assess new architectures based on software, servers, and a mix of proprietary- and commodity-networking hardware. We also continue to be affected by worldwide macroeconomic conditions and face the possibility that these conditions could deteriorate and create a more cautious capital spending environment in the IT sector. In addition, U.S. federal customers are important to our business, and spending by the U.S. government can be variable and difficult to predict. We are also cautious about the stability and health of certain international markets and current global and country-specific dynamics, such as the drop in the value of the euro and the Chinese yuan versus the U.S. dollar in the past fiscal year, slowing economic growth in China, Russia-related geopolitical uncertainty, and the planned withdrawal of the United Kingdom from the European Union as voted by the British citizens during the June 23, 2016, referendum, also commonly known as "Brexit." These factors may impact our business and those of our partners. Our diversified portfolio of products helps mitigate the effect of some of these challenges, and we expect IT spending levels to generally rise in the long term. However, it is difficult for us to offset the effects of short-term reductions in IT spending.


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We expect our SAN and IP Networking revenues to fluctuate depending on the demand for our existing and future products and services, and the quality of the sales support for our products and services from our distribution and reseller partners, as well as the timing of product and business transitions by our original equipment manufacturer ("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 product mix, and we expect this dynamic to continue.
Our plans for our operating cash flows are to provide liquidity for operations, capital investment, and other strategic initiatives, including investments and acquisitions to strengthen our networking portfolios, and to return capital to stockholders. In the first quarter of fiscal year 2017, our Board of Directors declared and paid a quarterly cash dividend of $0.055 per share of our common stock for a total of $22.3 million. In addition, on February 22, 2017, our Board of Directors declared a quarterly cash dividend of $0.055 per share of our common stock to be paid on April 4, 2017, to stockholders of record as of the close of market on March 10, 2017. Future dividend payments are subject to review and approval on a quarterly basis by our Board of Directors, and are limited under the terms of the Merger Agreement (as defined below). Pending Acquisition by Broadcom Limited
On November 2, 2016, we entered into a merger agreement (the "Merger Agreement") with Broadcom Limited ("Broadcom") under which Broadcom agreed to acquire us. Upon closing of the merger, our stockholders will receive $12.75 in cash, without interest, less any required tax withholding, for each share of Brocade common stock. Our stockholders adopted the Merger Agreement and approved certain related matters at a special meeting of stockholders held on January 26, 2017. Consummation of the merger remains subject to certain other customary closing conditions, including the receipt of certain governmental and regulatory approvals in various jurisdictions. The transaction is not subject to a financing condition.
Assuming timely satisfaction or waiver of the necessary closing conditions, we anticipate that the merger will be completed in the third quarter of fiscal year 2017. For additional information related to the merger, please refer to the Merger Agreement, which is incorporated herein by reference as Exhibit 2.1 to this Form 10-Q. In addition, see Part II, Item 1A. Risk Factors of this Form 10-Q, which is incorporated herein by reference, for a discussion of certain risks due to the announcement and pendency of the proposed acquisition or the failure of the acquisition to be completed that could have a material adverse effect on our business and operating results. These risks include, but are not limited to, the diversion of management and employee attention, potential employee attrition, potential adverse reactions or changes to our business relationships with customers, partners, and suppliers and uncertainty surrounding our future plans and prospects.

Overview of Financial Results
The following table provides an overview of some of our financial results (in
thousands, except percentages):
                                                                  Three Months Ended
                                                             January 28,      January 30,
                                                                 2017             2016
Total net revenues                                          $    581,463     $    574,284
Gross margin                                                $    367,123     $    388,815
Gross margin, as a percentage of total net revenues                 63.1 %           67.7 %
Income from operations                                      $      4,291     $    120,966
Operating income, as a percentage of total net revenues              0.7 %           21.1 %
Net income (loss) attributable to Brocade Communications    $     (5,681 )   $     93,646
Systems, Inc.


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Results of Operations
Our results of operations for the three months ended January 28, 2017, and January 30, 2016, are reported in this discussion and analysis as a percentage of total net revenues, except for gross margin for each reportable segment, which is indicated as a percentage of the respective reportable 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
                              January 28, 2017                January 30, 2016
                                            % of Net                        % of Net                                %
                          Net Revenues      Revenues      Net Revenues      Revenues     Increase/(Decrease)      Change
SAN Products            $      306,873         52.8 %   $      347,058         60.4 %   $           (40,185 )     (11.6 )%
IP Networking Products         173,744         29.9 %          134,109         23.4 %                39,635        29.6  %
Global Services                100,846         17.3 %           93,117         16.2 %                 7,729         8.3  %
Total net revenues      $      581,463        100.0 %   $      574,284        100.0 %   $             7,179         1.3  %

The increase in total net revenues for the three months ended January 28, 2017, compared with the three months ended January 30, 2016, reflects higher sales for our IP Networking products and Global Services offerings, partially offset by lower sales for our SAN products, as further described below.
The decrease in SAN product revenues was caused by lower director and embedded switch product revenues, primarily due to the weaker demand for Fibre Channel-based storage combined with the uncertainty surrounding the pending acquisition of Brocade by Broadcom. While the average selling price per port was flat during the three months ended January 28, 2017, the number of ports shipped decreased by 11.5%;

The increase in IP Networking product revenues primarily reflects $72.1 million in additional revenue from our wireless products due to the May 2016 acquisition of Ruckus, partially offset by a decline in customer orders across our IP product portfolio primarily due to uncertainty surrounding the pending acquisition of Brocade by Broadcom and Broadcom's announcement of its intent to divest the IP Networking business; and

The increase in Global Services revenues was primarily due to growth in support revenue from our wireless products from the acquisition of Ruckus.

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

                                             Three Months Ended
                              January 28, 2017                January 30, 2016
                                            % of Net                        % of Net                                %
                          Net Revenues      Revenues      Net Revenues      Revenues     Increase/(Decrease)      Change
U.S.                    $      272,320         46.8 %   $      316,351         55.1 %   $           (44,031 )     (13.9 )%
Europe, the Middle East        196,558         33.8 %          153,055         26.6 %                43,503        28.4  %
and Africa (1)
Asia Pacific                    82,929         14.3 %           66,578         11.6 %                16,351        24.6  %
Japan                           19,070          3.3 %           24,585          4.3 %                (5,515 )     (22.4 )%
Canada, Central and             10,586          1.8 %           13,715          2.4 %                (3,129 )     (22.8 )%
South America
Total net revenues      $      581,463        100.0 %   $      574,284        100.0 %   $             7,179         1.3  %

(1) Includes net revenues of $106.5 million and $104.2 million for the three months ended January 28, 2017, and the three months ended January 30, 2016, 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. We cannot be certain of the extent to which our domestic and international revenue mix is impacted by the logistics practices of our OEM partners. Unless we receive discrete shipment information from our OEM partners, we account for all domestically delivered OEM shipments as domestic revenue. Therefore, international revenues may comprise a larger percentage of our total net revenues than the attributed revenues above indicate.


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International revenues for the three months ended January 28, 2017, increased to 53.2% as a percentage of total net revenues compared with 44.9% for the three months ended January 30, 2016, primarily due to a shift in the mix of OEM customer delivery locations for our SAN products.
A significant portion of our revenues is concentrated among a relatively small number of OEM customers. For the three months ended January 28, 2017, one customer individually accounted for 19% of our total net revenues. For the three months ended January 30, 2016, two customers individually accounted for 20% and 14% of our total net revenues for a combined total of 34% 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 is summarized as follows (in thousands, except percentages). Gross margin as a percentage of net revenues is indicated as a percentage of the respective reportable segment net revenues, except for total gross margin, which is stated as a percentage of total net revenues.

                                             Three Months Ended
                              January 28, 2017                January 30, 2016
                                            % of Net                        % of Net                             % Points
                          Gross Margin      Revenues      Gross Margin      Revenues     Increase/(Decrease)      Change
SAN Products            $      231,143         75.3 %   $      265,854         76.6 %   $           (34,711 )      (1.3 )%
IP Networking Products          82,819         47.7 %           71,216         53.1 %                11,603        (5.4 )%
Global Services                 53,161         52.7 %           51,745         55.6 %                 1,416        (2.9 )%
Total gross margin      $      367,123         63.1 %   $      388,815         67.7 %   $           (21,692 )      (4.6 )%

The changes in gross margin percentage for each reportable segment for the three months ended January 28, 2017, compared with the three months ended January 30, 2016, were primarily due to the following factors (the percentages below reflect the impact on gross margin):
SAN gross margins relative to net revenues decreased primarily due to lower revenue, as well as an increase in overhead costs from increased incentive compensation and annual merit-based increases in salaries. In addition, the SAN business experienced an increase in certain component costs related to Gen 6 product shipments;

IP Networking gross margins relative to net revenues decreased primarily due to higher amortization of IP Networking-related intangible assets and an increase in excess and obsolete charges for the data center and campus switching business product lines. In addition, overhead costs grew primarily due to increased personnel and the related costs as a result of the Ruckus acquisition in May 2016. This is partially offset by higher product margins due to revenue from the acquired wireless products and reductions in direct product cost; and

Global Services gross margins relative to net revenues decreased primarily due to growth in personnel as a result of the Ruckus acquisition. As a result of these increases in personnel, Global Services has seen an increase in stock-based compensation expense primarily due to the suspension of our employee stock purchase plan ("ESPP") without concurrent replacement awards as required under the terms of the merger agreement with Broadcom, thereby resulting in the need to accelerate the unamortized expense in the first quarter of fiscal year 2017. Stock-based compensation expense also increased primarily due to awards granted to Ruckus employees in connection with the acquisition, higher grant-date fair values of restricted stock units ("RSU"s) granted in the recent past, as well as the lower estimated forfeiture rates used in the first quarter of fiscal year 2017. This is partially offset by an increase in support revenue from the acquisition of Ruckus.


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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 non-recurring 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):

                       January 28, 2017           January 30, 2016
                                  % of Net                   % of Net                    %
R&D expenses:        Expense      Revenues      Expense      Revenues     Increase    Change
Three months ended $   123,503       21.2 %   $    93,257       16.2 %   $  30,246     32.4 %

R&D expenses increased for the three months ended January 28, 2017, compared with the three months ended January 30, 2016, primarily due to the following (in thousands):

                                                                       Increase/(Decrease)
Salaries and other compensation                                       $            18,762
Stock-based compensation expense                                                    6,598
Expenses related to legal, IT, facilities, and other shared functions               3,256
Outside services and other marketing expense                                        1,907
Various individually insignificant items                                             (277 )
Total change                                                          $            30,246

Salaries and other compensation increased primarily due to increased personnel and related costs as a result of the Ruckus acquisition, annual merit-based increases in salaries, and higher incentive compensation. Stock-based compensation expense increased primarily due to the suspension of our ESPP without concurrent replacement awards as required under the terms of the merger agreement with Broadcom, thereby resulting in the need to accelerate the unamortized expense in the first quarter of fiscal year 2017. In addition, RSU expense increased primarily due to awards granted to Ruckus employees in connection with the acquisition, higher grant-date fair values of RSUs granted in the recent past, as well as the lower estimated forfeiture rates used in the first quarter of fiscal year 2017. Expenses related to legal, IT, facilities, and other shared functions increased primarily due to higher overall costs primarily related to the Ruckus acquisition. Outside services and other marketing expense increased primarily due to increased contract workers and consulting services as a result of the Ruckus acquisition, partially offset by a decrease in expense related to product testing and a decrease in country certification expenses due to renewals for existing products rather than new certifications for new products.
Sales and marketing expenses. Sales and marketing ("S&M") expenses consist primarily of salaries, commissions, and related expenses for personnel engaged in sales and marketing functions, costs associated with promotional and marketing programs, travel and entertainment expenses, and allocated expenses related to legal, IT, facilities, and other shared functions.
S&M expenses are summarized as follows (in thousands, except percentages):

                       January 28, 2017           January 30, 2016
                                  % of Net                   % of Net                    %
S&M expenses:        Expense      Revenues      Expense      Revenues     Increase    Change
Three months ended $   180,201       31.0 %   $   151,827       26.4 %   $  28,374     18.7 %


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S&M expenses increased for the three months ended January 28, 2017, compared with the three months ended January 30, 2016, primarily due to the following (in thousands):

                                                                       Increase/(Decrease)
Salaries and other compensation                                       $            24,489
Stock-based compensation expense                                                    5,736
Expenses related to legal, IT, facilities, and other shared functions               2,042
Outside services and other marketing expense                                       (3,088 )
Various individually insignificant items                                             (805 )
Total change                                                          $            28,374

Salaries and other compensation increased primarily due to increased personnel and related costs as a result of the Ruckus acquisition, annual merit-based increases in salaries, increased costs of employment-related benefits, and higher variable incentive compensation. Stock-based compensation expense increased primarily due to the suspension of our ESPP without concurrent replacement awards as required under the terms of the merger agreement with Broadcom, thereby resulting in the need to accelerate the unamortized expense in the first quarter of fiscal year 2017. In addition, RSU expense increased primarily due to awards granted to Ruckus employees in connection with the acquisition, higher grant-date fair values of RSUs granted in the recent past, as well as the lower estimated forfeiture rates used in the first quarter of fiscal year 2017. Expenses related to legal, IT, facilities, and other shared functions allocated to S&M activities increased primarily due to higher overall costs related to the Ruckus acquisition. Outside services and other marketing expense decreased primarily due to lower marketing program spending and decreased investment in the go-to-market strategy for our software business. General and administrative expenses. General and administrative ("G&A") expenses consist primarily of compensation and related expenses for corporate management, finance and accounting, human resources, legal, IT, facilities, and investor relations, as well as recruiting expenses, professional fees, and other corporate expenses, less certain expenses allocated to cost of revenue, R&D, and sales and marketing. . . .

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