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ARUBA NETWORKS, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read together with our Consolidated Financial Statements and related notes included elsewhere in this report. Overview Aruba Networks, Inc. is a leading global provider of enterprise mobility solutions. We develop, market and sell solutions that help solve our customers' secure mobility requirements through our Mobility-Defined Networks™, a fundamentally new network architecture designed to automatically optimize infrastructure-wide performance and trigger security actions that previously required manual intervention by information technology ("IT") departments. Mobility-Defined Networks™ gather and correlate contextual data about user roles, device types, application flows and location, which is critical in dynamic, ever-changing mobility environments where end-users roam. This self-healing, self-optimizing approach to mobility can greatly reduce IT helpdesk tickets and offer stronger data protection. We believe the market for mobility solutions is changing and that the explosive growth of mobile devices, in part as a result of the bring-your-own-device ("BYOD") phenomenon, is forcing IT departments to radically revise the way they approach provisioning and supporting these devices. Our goal is to provide simplified, dependable solutions that enable our customers to quickly, securely and cost-effectively meet their mobility and BYOD needs. Our Aruba Mobility-Defined Network are designed for the all-wireless workplace and an increasingly mobile universe of end-users, whom we refer to as GenMobile, who rely on mobile devices for nearly every aspect of worklife and personal communication and demand to stay connected to everything virtually all the time, no matter where they are. Aruba Mobility-Defined Networks are comprised of three major components. The first component consists of our mobility-centric network infrastructure, including Mobility Controllers with ArubaOS™ operating system software, value-added security software modules, controller-less and controller-managed wireless access points, Mobility Access Switches, Remote Access Points, virtual private network ("VPN") client software, and our AirWave™ and cloud-based Aruba Central® management solutions. The second component is our Aruba ClearPass Access Management System™, our next-generation access management system, which is designed to simplify and automate policy management, guest network access, mobile device onboarding, and mobile device health checks. The third component consists of our mobility applications, including application programming interfaces ("APIs") for location and analytics applications as well as our Meridian™-powered mobile applications, which engage visitors through their mobile devices by providing indoor way-finding with turn-by-turn directions and targeted location-aware push notifications. We conduct business in three primary geographic regions: Americas, Europe, Middle East and Africa ("EMEA"), and Asia Pacific ("APAC"). Our solutions have been sold to more than 40,000 customers worldwide, including some of the largest and most complex global organizations. Our customer base spans major industries and verticals, including general enterprise, high tech enterprise, industrial enterprise, higher education, K-12 education, health care, retail, federal/state/local government, financial services and hospitality. We typically sell to and support these customers through a two-tier distribution model in most areas of the world, including the United States. Our Value Added Distributors ("VADs") and Original Equipment Manufacturers ("OEMs") sell our portfolio of products, including a variety of our support services, to a diverse number of Value Added Resellers ("VARs"), systems integrators and service providers. Also, certain of our OEMs sell directly to end customers. Critical Accounting Policies Our Consolidated Financial Statements are prepared in accordance with U.S. GAAP. These accounting principles require us to make estimates and judgments that 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 expenses 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 these estimates and judgments are made. 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 include revenue recognition, stock-based compensation, inventory valuation, allowance for doubtful accounts, impairment of goodwill and intangible assets, and accounting for income taxes. Revenue Recognition Total revenue is derived primarily from the sale of products and services, including support and professional services. The following revenue recognition policies define the manner in which we account for our sales transactions. 42 -------------------------------------------------------------------------------- We recognize revenue when all of the following criteria have occurred: (1) we have entered into a legally binding arrangement with a customer; (2) delivery has occurred or the title and risk of loss has passed; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is reasonably assured. Our fees are typically considered to be fixed or determinable at the inception of an arrangement, generally based on specific products and quantities to be delivered. Substantially all of our contracts do not include rights of return or acceptance provisions. To the extent that agreements contain such terms, we recognize revenue once the customer has accepted, or once the acceptance provisions or right of return lapses. Payment terms to customers generally range from net 30 to 90 days. In the event payment terms are provided that differ from our standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payments are received, provided the remaining criteria for revenue recognition have been met. We assess the ability to collect from our customers based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. If the customer is not deemed credit worthy, we defer revenue from the arrangement until payment is received and all other revenue recognition criteria have been met. We record estimated sales returns as a reduction to revenue upon shipment based on our contractual obligations and historical returns experience. In cases where we are aware of circumstances that will likely result in a specific customer's request to return purchased equipment, we record a specific sales returns reserve. Our revenue recognition policies provide that, when a sales arrangement contains multiple elements, such as hardware and software licenses and/or services, we allocate revenue to each element based on a selling price hierarchy. The selling price for a deliverable is based on its vendor specific objective evidence ("VSOE") of selling price if available, third party evidence ("TPE") of selling price, if VSOE is not available, or best estimated selling price ("BESP"), if neither VSOE nor TPE is available. In multiple element arrangements where non-essential software deliverables are included, revenue for these multiple-element arrangements is allocated to the software deliverable and the non-software deliverables based on the relative selling prices of all of the deliverables in the arrangement using the hierarchy in the applicable accounting guidance. We limit the amount of revenue recognition for delivered elements to the amount that is not contingent on the future delivery of products or services, future performance obligations or subject to customer-specified return or refund privileges. We establish VSOE of selling price using the price charged for a deliverable based upon the normal pricing and discounting practices when sold separately. VSOE for support services, professional services, and training is measured by the stand-alone renewal rate offered to the customer. In determining VSOE, we require that a substantial majority of the selling prices for an element falls within a reasonably narrow pricing range, generally evidenced by a substantial majority of such historical stand-alone transactions falling within a reasonably narrow range of the median rates. In addition, we consider major service groups, geographies, customer classifications, and other variables in determining VSOE. TPE of selling price is established by evaluating largely similar and interchangeable competitor products or services in standalone sales to similarly situated customers. We are typically not able to determine TPE for our products or services. Generally, our go-to-market strategy differs from that of our peers and our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, we are unable to reliably determine selling prices of competitor products and services on a stand-alone basis. When we are unable to establish the selling price of our non-software elements using VSOE or TPE, we use BESP in the allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine BESP for a product or service by considering multiple factors including, but not limited to, cost of products, gross margin objectives, pricing practices, geographies, customer classes and distribution channels. We regularly review estimated selling price of the product offerings and maintain internal controls over the establishment and updates of these estimates. We currently do not expect a material impact in the near term from changes in estimated selling prices, including VSOE of selling price. Products Product revenue consists of revenue from sales of our hardware appliances, perpetual software licenses, and software as a service. The majority of our products are hardware appliances containing software components that function together to provide the essential functionality of the product. Therefore, our hardware appliances are considered non-software elements and are not subject to the industry-specific software revenue recognition guidance. For these appliances, delivery occurs upon transfer of title and risk of loss, which is generally upon shipment. It is our practice to ensure an end-user has been identified by the channel partner prior to shipment to a channel partner. For end-users and channel partners, we generally have no significant obligations for future performance such as rights of return or pricing credits. 43 -------------------------------------------------------------------------------- For sales to direct end-users and certain channel partners, including value-added resellers ("VARs"), we recognize product revenue upon delivery, assuming all other revenue recognition criteria are met. We also sell through value-added distributors ("VADs"). A significant portion of our sales are made through VADs under agreements allowing for stocking of our products in their inventory, pricing credits and limited rights of return for stock rotation. Product revenue on sales made through these VADs is initially deferred and revenue is recognized upon sell-through as reported by the VADs to us. Our product revenue also includes revenue from the sale of stand-alone software products. Stand-alone software products may operate on our hardware appliance but are not considered essential to the functionality of the hardware. Sales of stand-alone software generally include a perpetual license to our software. For sales of stand-alone software, we recognize revenue based on software revenue recognition guidance. Under the software revenue recognition guidance, we use the residual method to recognize revenue when a product agreement includes one or more elements to be delivered at a future date and VSOE of the fair value of all undelivered elements exists. In the majority of our contracts, the only element that remains undelivered at the time of delivery of the product is support services. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the contract fee is recognized as product revenue. If evidence of the fair value of one or more undelivered elements does not exist, all revenue is generally deferred and recognized when delivery of those elements occurs or when fair value can be established. When the only undelivered element for which we do not have VSOE of selling price is support, revenue for the entire arrangement is bundled and recognized ratably over the support period. Product revenue for our software as a service is recognized ratably over the contractually committed service delivery period. Services Service revenue consists of revenue from support agreements, professional services, and training. Support services include repair and replacement of defective hardware appliances, software updates and access to technical support personnel. Software updates provide customers with rights to unspecified software product upgrades and to maintenance releases and patches released during the term of the support period. Revenue for support services is recognized on a straight-line basis over the service contract term, which is typically one to five years. Revenue for professional services is recognized upon delivery or completion of performance. Professional service arrangements are typically short-term in nature and are largely completed within 90 days from the start of service. Revenue for training services is recognized upon delivery of the training. Costs associated with these service offerings are expensed as incurred. Post-contractual services ("PCS") that we provide to our channel partners differ from PCS that we provide to our end customers in that we are only obligated to provide support services to the channel partner directly, while the channel partner is obligated to provide support services directly to the end customer. The channel partner is obligated to provide to the end customer first level troubleshooting assistance as well as second level support for high-level technical and product diagnosis which might include returned merchandise fulfillment. Our obligations are only to provide software upgrades and, in the unusual scenario in which the channel partner is unable to provide the technical support that the end customer requires, a third level technical diagnosis and support. As discussed in Note 1, The Company and its Significant Accounting Policies, of the Notes to Consolidated Financial Statements, ratable product and related support and professional services revenue and the related cost of revenue in fiscal 2012 has been reclassified to support and professional services revenue and related cost of revenue to conform to current presentation. Shipping and Handling Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue. Stock-Based Compensation We measure and recognize compensation expense for all stock-based awards made to employees and non-employees under the fair value method. Our stock-based awards include stock options, restricted stock units and awards, employee stock purchase plan, and performance-based awards. We calculate the fair value of restricted stock and performance-based awards, which are paid in restricted stock, based on the fair market value of our common stock on the date of grant. We calculate the fair value of stock options and employee stock purchase plan shares on the date of grant using the Black-Scholes option-pricing model. This methodology requires the use of subjective assumptions, such as expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rates and expected dividends. This fair value is then amortized on a straight-line basis over the requisite service period of the awards, which is generally the vesting period. We determine the amount of stock-based compensation expense based on awards that we ultimately expect to vest, reduced for estimated forfeitures. In addition, compensation expense includes the effects of awards modified, repurchased or cancelled. 44 --------------------------------------------------------------------------------Inventory Inventory consists of hardware and related component parts and is stated at the lower of cost or market. Cost is computed using the standard cost, which approximates actual cost, on a first-in, first-out basis. We record inventory write-downs for potentially excess inventory based on forecasted demand, economic trends, and technological obsolescence of our products and transition of inventory related to new product releases. At the point of loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. Inventory write-downs are reflected as cost of product revenue and amounted to approximately $4.3 million, $5.6 million, and $4.1 million for fiscal 2014, 2013, and 2012, respectively. Allowance for Doubtful Accounts We record an allowance for doubtful accounts based on historical experience and a detailed assessment of the collectability of our accounts receivable. In estimating the allowance for doubtful accounts, we consider, among other factors, (i) the aging of the accounts receivable, including trends within and ratios involving the age of the accounts receivable, (ii) our historical write-offs, (iii) the credit-worthiness of each customer, (iv) the economic conditions of the customer's industry, and (v) general economic conditions. In cases where we are aware of circumstances that may impair a specific customer's ability to meet their financial obligations to us, we record a specific allowance against amounts due from the customer, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected. Charges to operations relating to allowance for doubtful accounts were $(0.1) million, $0.8 million, and $0.1 million for fiscal 2014, 2013, and 2012, respectively. Impairment of Goodwill and Intangible Assets Goodwill represents the excess cost of a business acquisition over the fair value of the net assets acquired. We perform impairment testing on goodwill at least annually, during our fourth fiscal quarter, and sooner if indicators of impairment exist at the reporting unit level. We perform the impairment testing by first assessing qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of its reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, we determine it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we perform a two-step impairment test. The first step requires the identification of the reporting units and comparison of the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit is less than its carrying value, an indication of goodwill impairment exists for the reporting unit and the second step of the impairment test is performed to compute the amount of the impairment. Under the second step, an impairment loss is recognized for any excess of the carrying amount of the reporting unit's goodwill over the implied fair value of that goodwill. We have determined that we have only one reporting unit. We did not recognize any impairment charges related to goodwill during fiscal 2014, 2013, and 2012. Purchased intangible assets with finite lives are amortized using the straight-line method over the estimated economic lives of the assets, which range from one to 13 years. Amortization expense is recorded in the Consolidated Statements of Operations in cost of revenue and sales and marketing expenses. Long-lived assets, including intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Some factors we consider important which could trigger an impairment review include the following: • significant under performance relative to estimated results; • significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and • significant negative industry or economic trends. Determination of recoverability of purchased intangible assets is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of an impairment loss is based on the fair value of the asset. We did not record any impairment charges in any of the periods presented. Screening for and assessing whether impairment indicators exist or if events or changes in circumstances have occurred, including market conditions, operating fundamentals, competition and general economic conditions, requires significant judgment. Additionally, changes in the technology industry occur frequently and quickly. Therefore, there can be no assurance that a charge to operating expenses will not occur as a result of future goodwill and intangible impairment tests. Income Taxes We are subject to income taxes in the United States and numerous foreign jurisdictions. In the ordinary course of a global business, there are many transactions and calculations where the ultimate tax outcome is uncertain. Some of these uncertainties 45 -------------------------------------------------------------------------------- arise as a consequence of cost reimbursement arrangements among related entities and the segregation of foreign and domestic earnings and expenses to avoid double taxation. Significant judgment is required in determining our worldwide income tax provision. Although we believe that our estimates are reasonable, the final tax outcome of these matters could be different from that which is reflected in our historical income tax provisions and accruals. Such differences could have a material effect on our income tax provision and net income in the period in which such determination is made. Our effective tax rate includes the impact of certain undistributed foreign earnings for which zero U.S. taxes have been provided because such earnings are planned to be indefinitely reinvested outside the U.S. We plan any remittances of foreign earnings to the U.S. based on projected cash flow, working capital and investment needs of our foreign and domestic operations. Based on these assumptions, we estimate the amount that will be distributed to the United States and provide U.S. federal taxes on these amounts. As of July 31, 2014, we estimate that all foreign earnings are permanently reinvested outside the U.S. and therefore have excluded a U.S. tax provision on these earnings. Material changes in our estimates as to how much of our foreign earnings will be distributed to the United States or tax legislation that limits or restricts the amount of undistributed foreign earnings that we consider indefinitely reinvested outside the U.S. could materially impact our income tax provision and effective tax rate. Conversely, changes to the U.S. or other tax law that changes the way in which our foreign earnings are taxed if held outside the U.S. or taxed if distributed to the U.S. may lead us to reevaluate whether to distribute foreign earnings. We estimate our current tax liability and assess temporary differences that result from differing treatments of certain items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which we show on our balance sheet. We must then assess the likelihood that our deferred tax assets will be realized. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. In order for us to realize our deferred tax assets, we must be able to generate sufficient taxable income in those jurisdictions where the deferred tax assets are located. In determining the need for a valuation allowance, we consider future growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate, historical earnings, taxable income in prior years, if carryback is permitted under the law, carry-forward periods, and prudent and feasible tax planning strategies. In the event we were to determine that not all or part of our net deferred tax assets are not more likely than not to be realized in the future, an adjustment to the deferred tax assets valuation allowance would be charged to earnings in the period in which we make such a determination, or goodwill would be adjusted if the valuation allowance related to deferred tax assets acquired in a business combination and the adjustment is within the measurement period. If we later determine that it is more likely than not that the deferred tax assets would be realized, we would reverse the previously provided valuation allowance as an adjustment to earnings at such time. Based on an evaluation of the above factors, we recorded a valuation allowance to reflect uncertainties about whether we will be able to utilize certain California research credit carryforwards. While we have considered future taxable income in assessing the need for a valuation allowance, we could in the future be required to increase the valuation allowance to take into account additional deferred tax assets that we may be unable to realize. An increase in the valuation allowance would have an adverse impact, which could be material, on our income tax provision and net income in the period in which we record the increase. The Company believes that its California tax research credit carryforwards are not more likely than not to be realized. As a result, in the fiscal year ended 2013, the Company recorded a partial valuation allowance on certain California tax research credit carryforwards generated in fiscal years before 2013. A full valuation allowance was recorded on credits earned in fiscal years ending July 31, 2014 and 2013. The amount of income tax we pay is subject to ongoing audits by federal, state and foreign tax authorities, which often result in proposed assessments. Our estimate of the potential outcome for any uncertain tax issue involves substantial judgment. We recognize and measure benefits for uncertain tax positions using a two-step approach. The first step is to evaluate the tax position taken or expected to be taken in a tax return by determining if the weight of available evidence indicates that it is more likely than not that the tax position will be sustained upon audit, including resolution of any related appeals or litigation processes. For tax positions that are more likely than not of being sustained upon audit, the second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement. Significant judgment is required to evaluate uncertain tax positions. We evaluate our uncertain tax positions on a quarterly basis. Our evaluations are based upon a number of factors, including changes in facts or circumstances, changes in tax law or guidance, correspondence with tax authorities during the course of audits and effective settlement of audit issues. Changes in the recognition or measurement of uncertain tax positions could result in material increases or decreases in our income tax expense in the period in which we make the change, which could have a material impact on our effective tax rate and operating results. Recent Accounting Pronouncements Refer to Recent Accounting Pronouncements, under Note 1, The Company and its Significant Accounting Policies, of the Notes to Consolidated Financial Statements for recent accounting pronouncements that could have an effect on us. 46 -------------------------------------------------------------------------------- Major Trends Affecting Our Financial Results Revenue Our ability to increase our revenue will depend significantly on, among other things, continued growth in the market for enterprise mobility and remote networking solutions, continued acceptance of our products in the marketplace, our ability to continue to attract and retain new customers and distribution partners, our ability to compete, the willingness of customers to displace wired networks with wireless LANs, and our ability to continue to sell into our installed base of existing customers. We believe that Aruba Mobility-Defined Networks, including our 802.11ac WLAN, ClearPass and Aruba Instant offerings, and software as a service solutions, will enable broader networking initiatives by both our current and potential customers. Our growth in support revenue is tied to increasing the number of products under support contracts, which is dependent on growing our installed base of customers, maintaining or improving the attach rate of support offerings to product sales and renewing existing support contracts. While we rely primarily on our partners to deliver professional services associated with our products, we sometimes deliver professional services directly to end customers, especially as we introduce new products. Our future profitability and rate of growth, if any, will also be directly affected by the timing and size of orders, product and channel mix, relative amount of professional services, seasonality of demand and sales patterns, average selling prices, costs of our products, our ability to effectively manage our multi-tier distribution model, general economic conditions, timing and impact of product transitions, and the extent to which we invest in our sales and marketing, research and development, and general and administrative resources. The revenue growth that we have experienced has been driven primarily by an expansion of our customer base coupled with increased purchases from existing customers, which we believe reflects the need of business enterprises and other organizations to provide secure mobility to their users in a manner that is more cost effective than the traditional approach of using port-centric networks. Our revenue grew 21.5% in fiscal 2014 as compared to fiscal 2013. Our ability to meet our product revenue expectations is dependent upon (1) new orders received, shipped, and recognized in a given quarter, (2) the amount of orders booked but not shipped in prior quarters that are shipped and recognized in the current quarter, and (3) the amount of deferred revenue entering a given quarter that is recognized as revenue in the quarter. We typically ship products within 10 days after the receipt of an order. Our product deferred revenue is comprised of: • product orders that have shipped but where the terms of the agreement, typically with our large customers, contain acceptance terms and conditions or other terms that require that the revenue be deferred until all revenue recognition criteria are met; and • product orders shipped to our VADs and OEMs for which we have not yet received persuasive evidence of sell-through from the VADs or OEMs. Product Transitions We are currently in the midst of an access point product transition cycle from the 802.11n standard to the new 802.11ac standard, which we expect to continue into fiscal 2015. These types of product transitions present both an opportunity to increase our market share (as occurred during the last transition from 802.11abg to 802.11n) as well as opposing risks. Our new 802.11ac access points are the fastest ramping access points in our history and their demand exceeded our expectations of the market during the second half of fiscal 2014. We often introduce new premium products, such as our AP-225 802.11ac access point, for early adopter segments, and subsequently introduce value-priced products for larger market segments, such as our AP-205 802.11ac access point. These early premium products generally require higher initial production costs than existing products. Although we expect production costs to decrease over time, we have experienced, and may experience in the future, pressures on our gross margins when our customers adopt the new standard earlier than we expect and purchase the new higher cost products at a rate faster than we forecast, before we are able to lower our production costs. Product transitions may offer opportunities to capture market share, which can compound these early market pressures. In addition, we have faced and we may face in the future competition on pricing that could impact our ability to capture market share at this standard-changing inflection point or otherwise continue to pressure our gross margins. On August 26, 2014, we announced a restructuring plan that will reduce certain positions, and shift other positions to lower-cost, talent-rich locations, providing the foundation for scaling the Company to an efficient global infrastructure, improving our cost structure. 47 -------------------------------------------------------------------------------- Costs and Expenses The substantial majority of our cost of product revenue consisted of payments to third parties to manufacture our products, including Wistron NeWeb Corp. ("WNC"), Sercomm, Accton Technology Corporation ("Accton"), and Flextronics International Ltd. ("Flextronics"), who were our largest contract manufacturers for fiscal 2014. Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. The largest component of our operating expenses in each of these categories is personnel costs. Personnel costs consist of salaries, benefits and incentive compensation for our employees, including commissions for sales personnel and stock-based compensation expense for employees. Due to changes we have made in our stock issuance practices, if fiscal 2015 we expect our stock-based compensation expense will decrease on absolute dollar basis and decrease as a percentage of revenue compared with fiscal 2014, with continued reductions expected in fiscal 2016 and fiscal 2017. As of July 31, 2014, we had 1,754 employees worldwide compared to 1,473 employees at July 31, 2013. The increase in employees is the most significant driver behind the increase in costs and operating expenses in fiscal 2014. Even though we have recently adopted a cost optimization plan that will reduce certain positions and shift other positions to lower-cost, talent-rich locations, we expect to continue hiring additional employees as we continue building the foundation for scaling the Company with a global optimized structure. Subsequent Events - Restructuring Plan On August 26, 2014, we announced a restructuring plan to optimize the administrative costs of our operations by realigning our workforce to better reflect our business operations. We expect this optimization plan will reduce our current workforce by approximately 3.7%, or 66 positions, as well as relocate approximately 4.2% of our current workforce, or 75 positions, from our facilities in Sunnyvale, California, to our facilities in Portland, Oregon, Bangalore, India, and Cork, Ireland. We estimate that we will incur pre-tax restructuring charges of between approximately $6.0 million to $8.0 million, substantially all of which would result in cash expenditures for employee termination benefits and related costs, as well as between $2.3 million and $4.3 million in other pre-tax costs related to these restructuring charges, including temporary, redundant personnel and facility costs, recruiting costs and other travel and personnel-related costs associated with employee transitions to lower cost operating locations. We expect that these pre-tax charges will be expensed over the first three quarters of fiscal 2015, with the majority of the charges expected to be expensed in the first half of fiscal 2015. Stock Repurchase As of July 31, 2014, our Board of Directors had authorized a stock repurchase program for an aggregate amount of up to $500.0 million (consisting of an original $100.0 million authorization on June 13, 2012, plus subsequent authorizations of $100.0 million on July 15, 2013, $100.0 million on October 9, 2013, and $200.0 million on February 20, 2014). We are authorized to make repurchases in the market until our Board of Directors terminates the program or until such repurchases reach the authorized amount, whichever occurs first. Any repurchases under the program will be funded either from available working capital or external financing. The number of shares repurchased and the timing of repurchases are based on the price of our common stock, general business and market conditions, and other investment considerations. Shares are retired upon repurchase. Our policy related to repurchases of our common stock is to charge any excess of cost over par value entirely to additional paid-in capital. During fiscal 2014 and 2013, we repurchased a total of 14,729,540 shares and 5,311,332 shares, respectively, for a total of purchase price of $263.0 million and $86.2 million, respectively. At July 31, 2014, $130.9 million remains authorized for repurchase under our stock repurchase program. Significant Events Business Combinations On May 13, 2013, the Company acquired Meridian Apps, Inc. ("Meridian"), a privately-held mobile-software company providing software for visitor engagement through indoor way-finding and targeted location-based messaging. As a result of this acquisition, the Company is offering indoor location-based services by combining its unique, network-based contextual information about users, devices and applications with Meridian's Wi-Fi based visitor engagement solution for smart phones and tablets. The purchase price consideration was $16.8 million, consisting of cash consideration. In addition, we are obligated to pay additional cash compensation of up to $10.2 million to certain former Meridian employees who became our employees, which is payable over a period of approximately three years from the closing date, subject to continued employment. For fiscal 2014 and 2013, we recorded compensation costs of $3.5 million and $0.8 million, respectively, in research and development expenses associated with this additional cash compensation. See Note 2, Business Combinations, of the Notes to Consolidated Financial Statements. 48 -------------------------------------------------------------------------------- Legal Settlement During the fourth quarter of our fiscal 2013, we reached a settlement resolving the lawsuit filed against us by Nomadix, Inc. As part of the settlement, we agreed to pay Nomadix an amount in consideration for, among other things, a perpetual non-exclusive license to the patent asserted by Nomadix. The settlement amount was recorded in the fourth quarter of fiscal 2013. The terms of the settlement are confidential. Although the settlement did have a material impact to our Consolidated Statements of Operations, it did not have a material adverse effect on our consolidated financial position or cash flows for fiscal 2013. Revenue, Cost of Revenue and Operating Expenses Revenue We derive our revenue primarily from sales of our ArubaOS operating system, controllers and gateways, wireless access points, switches, application software modules, access management solution, multi-vendor management solution software, and support and professional services. We sell our products to channel partners and end customers located in the United States, EMEA, APAC, and other parts of the world. We continue to expand into international locations and introduce our products in new markets. For fiscal 2015, we expect international revenue to increase in absolute dollars and remain in the approximate percentage range of recent years. For more information about our international revenue, see Note 11, Segment Information and Significant Customers, of the Notes to Consolidated Financial Statements. Support services consist of software updates, on a when-and-if available basis, and telephone and Internet access to technical support personnel and hardware support. We provide customers with rights to unspecified software product upgrades and to maintenance releases and patches released during the term of the support period. Professional services consist of consulting and training services. Consulting services primarily consist of design as well as onsite and remote support services. Training services are typically instructor-led or online courses on the use of our products. Cost of Revenue Cost of product revenue consists primarily of manufacturing costs for our products, shipping and logistics costs, charges for inventory obsolescence, amortization of existing technology and warranty obligations. We utilize third parties to manufacture our products and perform shipping logistics. We have outsourced the substantial majority of our manufacturing, repair and supply chain operations. Accordingly, the substantial majority of our cost of product revenue consists of payments to our contract manufacturers. Our contract manufacturers produce our products in Asia using quality assurance programs and standards that we jointly established. Manufacturing, engineering and documentation controls are conducted at our facilities in Sunnyvale, California, Bangalore, India and Beijing, China. Cost of product revenue also includes amortization expense from our purchased intangible assets. Cost of support and professional services revenue is primarily comprised of personnel costs, including stock-based compensation expense, for providing technical support. In addition, we engage third-party support vendors to complement our internal support resources, the costs of which are included within costs of support and professional services revenue. Gross Margin Our gross margin has been, and will continue to be, affected by a variety of factors, including: • changes in the mix of products and services sold or manner in which products are sold in our channel; • the percentage of revenue from international regions; • changes in price competition and discounting pressures; • changes in material, labor or other manufacturing-related costs; • excess product component or obsolescence charges from our contract manufacturers; • write-downs for obsolete or excess inventory; • changes in costs due to changes in component pricing or charges incurred due to component holding periods if our forecasts do not accurately anticipate product demand; • timing of revenue recognition and revenue deferrals; • warranty-related issues; • freight charges; • timing and pricing with regard to the introduction of new products or new product platforms and the related transition from older products to newer products; 49--------------------------------------------------------------------------------• entry into new markets with different pricing and cost structures; • amortization expense from our intangible assets which is mainly existing technology; • amortization of capitalized software development costs; • support attach rates and customer renewal rate; and • timing of investments in headcount and resources to support our professional service offerings. Due to higher net effective discounts for products sold through our indirect channels, our overall gross margin for indirect channel sales are typically lower than those associated with direct sales. We expect product revenue from our indirect channels to continue to be a significant majority of our future revenue. Further, we expect that within our indirect channels, sales through our VADs and OEMs will continue to be significant, which will negatively impact our gross margins as VADs and OEMs generally experience a larger net effective discount than our other channel partners. Research and Development Expenses Research and development expenses primarily consist of personnel costs and facilities costs. We expense research and development expenses as incurred. We are devoting substantial resources to the continued development of additional functionality for existing products and the development of new products. We intend to continue to invest significantly in our research and development efforts because we believe it is essential to maintaining our competitive position. For fiscal 2015, we expect research and development expenses to increase on an absolute dollar basis and decrease as a percentage of revenue compared to fiscal 2014. Sales and Marketing Expenses Sales and marketing expenses represent the largest component of our operating expenses and primarily consist of personnel costs, sales commissions, marketing programs and facilities costs. A portion of the amortization expense related to our intangible assets is also included in sales and marketing expenses. Marketing programs are intended to generate revenue from new and existing customers and are expensed as incurred. We plan to continue to invest strategically in sales and marketing with the intent to add new customers and increase penetration within our existing customer base, expand our domestic and international sales and marketing activities, build brand awareness and sponsor additional marketing events. We expect sales and marketing expenses will continue to be our most significant operating expense. Generally, new sales personnel are not as productive as existing personnel, and thus, the increase in sales and marketing expenses that we experience as we hire additional sales personnel is not expected immediately to result in increased revenue. Some of our sales personnel may never become as productive as anticipated or may not become as productive in the time frame originally expected. As a result, these expenses will reduce our operating margin unless and until the new sales personnel become equally productive and generate the amount of revenue expected. Accordingly, the timing of sales personnel hiring and the rate at which they become productive will affect our future performance. For fiscal 2015, we expect sales and marketing expenses will continue to be our most significant operating expense and will increase on an absolute dollar basis as we continue to invest strategically in this area and decrease as a percentage of revenue compared to fiscal 2014. General and Administrative Expenses General and administrative expenses primarily consist of personnel and facilities costs related to our executive, finance, human resources, information technology and legal organizations, as well as insurance, investor relations, and IT infrastructure costs related to our enterprise resource planning ("ERP") and other systems. Further, our general and administrative expenses include professional services consisting of outside legal, audit, tax, Sarbanes-Oxley and IT consulting costs, and non-income tax reserves. We have incurred in the past, and may continue to incur, significant legal costs defending ourselves against claims made by third parties. These expenses are expected to continue as part of our ongoing operations and, depending on the timing and outcome of lawsuits and the legal process, legal costs and any resulting damages or settlements could have a significant impact on our financial statements. For fiscal 2015, we expect general and administrative expenses to increase in absolute dollars and decrease as a percentage of revenue compared to fiscal 2014. However, third-party professional services are subject to material fluctuations given the needs of the business, which may cause our expected expenditures in absolute dollars and as a percentage of revenue to differ from our forecasted expectations. Other Income, net Other income, net includes interest income primarily from cash equivalents and short-term investments, accretion of discount or amortization of premium on short-term investments, losses or gains from foreign exchange rate changes, and changes in the valuation of our contingent rights liability associated with our acquisition of Azalea Networks, Inc. in September 2010. 50 -------------------------------------------------------------------------------- Results of Operations The following table presents our historical operating results as a percentage of total revenue for the periods indicated: Years ended July 31, 2014 2013 2012 Revenue: Product 81.7 % 82.7 % 84.1 % Support and professional services 18.3 % 17.3 % 15.9 % Total revenue 100.0 % 100.0 % 100.0 % Cost of revenue: Product 25.7 % 24.8 % 25.2 % Support and professional services 5.2 % 4.6 % 4.1 % Total cost of revenue 30.9 % 29.4 % 29.3 % Gross margin 69.1 % 70.6 % 70.7 % Operating expenses: Research and development 23.2 % 23.3 % 21.2 % Sales and marketing 37.7 % 38.5 % 38.4 % General and administrative 8.2 % 8.5 % 9.0 % Legal settlements - % 2.3 % - % Total operating expenses 69.1 % 72.6 % 68.6 % Operating income (loss) margin - % (2.0 )% 2.1 % Other income, net Interest income 0.1 % 0.2 % 0.2 % Other income, net - % 0.1 % 0.3 % Income (loss) before provision for income taxes 0.1 % (1.7 )% 2.6 % Provision for income taxes 4.0 % 3.6 % 4.3 % Net loss (3.9 )% (5.3 )% (1.7 )% 51-------------------------------------------------------------------------------- Revenue Years ended July 31, 2014 2013 2012 (in thousands) Total revenue $ 728,933 $ 600,044 $ 516,769 Type of revenue: Product $ 595,375 $ 496,343 $ 434,733 Support and professional services 133,558 103,701 82,036 Total revenue $ 728,933 $ 600,044 $ 516,769 Percentage revenue by type: Product 81.7 % 82.7 % 84.1 % Support and professional services 18.3 % 17.3 % 15.9 % Revenue by geography: United States $ 476,114 $ 379,447 $ 323,331 Europe, the Middle East and Africa 132,847 106,427 89,540 Asia Pacific 102,666 94,361 89,677 Rest of World 17,306 19,809 14,221 Total revenue $ 728,933 $ 600,044 $ 516,769 Percentage revenue by geography: United States 65.3 % 63.2 % 62.6 % Europe, the Middle East and Africa 18.2 % 17.7 % 17.3 % Asia Pacific 14.1 % 15.7 % 17.5 % Rest of World 2.4 % 3.3 % 2.8 % Total revenue by sales channel: Indirect $ 666,251 $ 560,313 $ 477,974 Direct 62,682 39,731 38,795 Total revenue $ 728,933 $ 600,044 $ 516,769 Percentage revenue by sales channel: Indirect 91.4 % 93.4 % 92.5 % Direct 8.6 % 6.6 % 7.5 % Fiscal 2014 revenue compared to fiscal 2013 revenue For fiscal 2014, total revenue increased $128.9 million, or 21.5%, compared to fiscal 2013. The revenue growth was driven primarily by an expansion of our customer base coupled with incremental purchases from existing customers as a result of ongoing strength in the enterprise mobility market, which continues to benefit from BYOD initiatives and strong uptake of our 802.11ac access points, as well as positive results from our significant investments in sales efforts during fiscal 2014. For fiscal 2014, compared with fiscal 2013 and fiscal 2012, revenue growth was partially offset by a decline in certain large service provider sales in APAC. Product revenue increased $99.0 million, or 20.0% during fiscal 2014 compared to fiscal 2013. The increase in product revenue was primarily driven by a combination of strong demand for our Access Points, particularly our Instant access points and our 802.11ac products and increasing demand for our ClearPass and switching solutions. The rapid proliferation of Wi-Fi enabled mobile devices, the increase in demand for multimedia-rich mobility applications, and the rise of both server and desktop virtualization are driving the increase in demand for our products. Our mobility solutions, further enhanced by the introduction of ClearPass and our Instant access point solutions, continue to gain momentum as companies move toward a next generation Mobility-Defined Network. We continue to add new customers each fiscal year. Support and professional services revenue increased $29.9 million, or 28.8%, during fiscal 2014 compared to fiscal 2013. The increase in support revenue was primarily a result of increased initial sales and renewals of post-contract support agreements boosted by higher product sales, higher professional services, and a larger customer installed base. The increase in professional service revenue was primarily a result of stronger overall demand for our ClearPass, AirWave and Public Facing Enterprise ("PFE") solutions, leveraged by an expansion of our internal professional services team and our installation services partners. 52 -------------------------------------------------------------------------------- As a percentage of total revenue, U.S. revenue increased $96.7 million, or 25.5%, during fiscal 2014 compared to fiscal 2013. Revenue from shipments to locations outside the U.S. increased $32.2 million, or 14.6%, during fiscal 2014 compared to fiscal 2013. The increase in revenue in the United States and locations outside the United States was primarily due to overall market growth and increased market penetration led by a significantly larger sales organization in fiscal 2014 than fiscal 2013. Revenue from our indirect sales channel increased $105.9 million, or 18.9%, during fiscal 2014 compared to fiscal 2013. Going forward, we expect to continue to derive a significant majority of our total revenue from indirect channels as we continue to focus on expanding our channels and improving the efficiency of marketing and selling our products through these channels. Fiscal 2013 revenue compared to fiscal 2012 revenue For fiscal 2013, total revenue increased $83.3 million, or 16.1%, over fiscal 2012, primarily due to an increase in product revenue. Product revenue increased $61.6 million, or 14.2% during fiscal 2013 compared to fiscal 2012. Our increased product revenue was primarily driven by higher sales of Access Point and Controller hardware, as well as related software solutions. We also saw higher switching revenue in fiscal 2013 compared to 2012. Support and professional services revenue increased $21.7 million, or 26.4%, during fiscal 2013 compared to fiscal 2012. This increase is primarily a result of increased initial sales and renewals of post-contract support agreements resulting from higher product sales and a larger customer install base, as well as higher professional service revenue. Revenue from our indirect sales channel increased $82.3 million during fiscal 2013 compared to fiscal 2012 and increased slightly as a percentage of revenue from 92.5% to 93.4%. Revenue from shipments to locations outside the U.S. increased $27.2 million, or 14.0%, during fiscal 2013 compared to fiscal 2012 due to stronger demand across all of our geographies. As a percentage of total revenue, U.S. revenue was slightly up during fiscal 2013 compared to 2012, from 62.6% to 63.2%. In fiscal 2013, ratable product and related professional services and support revenue and the related cost of revenue in fiscal 2012 have been reclassified to support and professional services revenue and related cost of revenue in the Consolidated Statements of Operations, respectively. We believe the ratable product and related support and professional services revenue and related cost of revenue are not material to the total consolidated revenue and cost of revenue, and their nature is consistent with support and professional services revenue and related cost of revenue. Cost of Revenue and Gross Margin Years ended July 31, 2014 2013 2012 (in thousands) Total revenue $ 728,933 $ 600,044 $ 516,769 Cost of product revenue $ 186,976 $ 149,113 $ 130,446 Cost of support and professional services revenue 37,805 27,366 20,992 Total cost of revenue 224,781 176,479 151,438 Gross profit $ 504,152 $ 423,565 $ 365,331 Gross margin 69.1 % 70.6 % 70.7 % Fiscal 2014 cost of revenue and margin compared to fiscal 2013 cost of revenue and margin For fiscal 2014, our total cost of revenue increased $48.3 million, or 27.4%, compared to fiscal 2013. This increase was primarily due to the corresponding increase in our product revenue. The substantial majority of our cost of product revenue consisted of payments to WNC, Sercomm, Accton, and Flextronics, our largest contract manufacturers. For fiscal 2014, payments to WNC, Sercomm, Accton, and Flextronics constituted approximately 36%, 23%, 17%, and 5%, respectively, of our cost of product revenue. Additionally, cost of product revenue was impacted by an increase of $2.9 million in amortization of intangible assets during fiscal 2014, compared to fiscal 2013, primarily as a result of a full year of amortization expense related to intangible assets acquired in our acquisition of Meridian Apps, Inc. (in May 2013) compared with two months of amortization in fiscal 2013, and the acceleration of amortization of certain intangible assets deemed to have reached their end of life during the fourth quarter of fiscal 2014. 53 -------------------------------------------------------------------------------- For fiscal 2014, our total cost of support and professional services revenue increased $10.4 million, or 38.1%, compared to fiscal 2013. For fiscal 2014, cost of support and professional services was primarily impacted by an increase of $4.4 million, $1.7 million, $2.6 million, and $1.1 million in personnel compensation, stock-based compensation, outside services, and facilities and IT-related expenses, respectively, as compared to fiscal 2013. These increases are primarily the result of an increase in headcount and outside services to support the corresponding increase in support and professional service revenue, including increased costs associated with our initiative to increase professional services delivery capabilities to accelerate the expansion of our solutions and increased costs for outside services, as we expanded our customer support call centers during fiscal 2014. On August 26, 2014, we announced a restructuring plan that will reduced certain positions, and shift other positions to lower-cost, talent-rich locations, providing the foundation for scaling the Company to an efficient global infrastructure, improving our cost structure. Our total gross margin decreased 150 basis points to 69.1% for fiscal 2014, compared to 70.6% in fiscal 2013. The decrease in gross margin was primarily due to product mix changes and increases in our professional services business. The changes in product mix were due, in part, to stronger demand for our switch solutions and the timing of the transition to our new 802.11ac products (both primarily in the third quarter of fiscal 2014), and stronger demand for our Instant access points throughout fiscal 2014. As we expand internationally, we will likely incur additional costs to conform our products to comply with local laws or local product specifications. In addition, we plan to continue hiring additional professional services personnel to support various product initiatives and our international customer base, which would increase our cost of support and professional services. Fiscal 2013 cost of revenue and margin compared to fiscal 2012 cost of revenue and margin For fiscal 2013, our total cost of revenue increased $25.0 million, or 16.5%, as compared to fiscal 2012. This increase was primarily due to the corresponding increase in our product revenue. The substantial majority of our cost of product revenue consisted of payments to Sercomm, WNC, Accton, and Flextronics, our largest contract manufacturers. For fiscal 2013, payments to Sercomm, WNC, Accton, and Flextronics constituted approximately 35%, 28%, 13%, and 12%, respectively, of our cost of product revenue. Additionally, cost of product revenue was impacted by an increase of $1.3 million in freight costs due to increased material flows and new product introductions and stock-based compensation which increased by $1.0 million during fiscal 2013 compared to fiscal 2012. Our cost of support and professional services revenue increased $6.4 million, or 30.4%, during fiscal 2013 as compared to fiscal 2012. This increase was primarily due to the corresponding increase in our service revenue, as well as increased costs associated with our initiative to increase professional services delivery capabilities and increased outside services as we expanded our customer support call centers. Our gross margin decreased 10 basis points to 70.6% for fiscal 2013 as compared to 70.7% for fiscal 2012, primarily due to changes in our product and geographical mix, as well as decreased gross margins on services revenue. Research and Development Expenses Years ended July 31, 2014 2013 2012 (in thousands) Research and development expenses $ 169,328 $ 139,746 $ 109,448 Percent of total revenue 23.2 % 23.3 % 21.2 % For fiscal 2014, research and development expenses increased $29.6 million, or 21.2%, compared to fiscal 2013. The increase was primarily due to an increase in headcount-related expenses and product development, as we continued to enhance our technology solutions, develop new products and support our business growth strategy. For fiscal 2014, personnel compensation and related expenses increased $18.0 million, or 18.5%, compared to fiscal 2013, primarily as a result of increased headcount, including an increase in stock-based compensation expense of $7.6 million, or 20.9%. Depreciation expense and expensed equipment increased $4.0 million, or 32.9%, for fiscal 2014 compared to fiscal 2013, as we continued to invest in lab equipment and prototypes to support our product development efforts. Facilities and IT-related expenses in connection with our worldwide research and development efforts also increased $4.9 million, or 33.3%, as the result of an increase in personnel during fiscal 2014 compared to fiscal 2013. Product certification fees to support the introduction and worldwide expansion of our new product releases and existing products increased $1.3 million, or 50.9%, for fiscal 2014 compared to fiscal 2013. 54 -------------------------------------------------------------------------------- For fiscal 2013, research and development expenses increased $30.3 million, or 27.7%, compared to fiscal 2012. As a result of the increase in employee and contractor headcount, personnel compensation and related expenses and contractor expenses increased $18.1 million, or 22.1%, including an increase in stock-based compensation of $5.2 million, or 16.5%, and an increase in contractor expenses of $1.7 million, or 172.7%, for fiscal 2013 compared to fiscal 2012, as we supported the development of new products, refreshed our ArubaOS, and upgraded our hardware platforms. For fiscal 2013, depreciation expense increased $3.8 million, or 73.4%, compared to fiscal 2012, as we invested in additional lab equipment and related infrastructure to support the expansion of our research and development efforts in international locations. For fiscal 2013, facilities and IT-related expenses in connection with our worldwide research and development efforts increased $5.2 million, or 54.5%, compared to fiscal 2013, as we expanded our infrastructure to support our research and development efforts and increased in personnel. Sales and Marketing Expenses Years ended July 31, 2014 2013 2012 (in thousands) Sales and marketing expenses $ 274,835 $ 230,805 $ 198,373 Percent of total revenue 37.7 % 38.5 % 38.4 % For fiscal 2014, sales and marketing expenses increased $44.0 million, or 19.1%, compared to fiscal 2013. The increase was primarily as a result of expanding our headcount and higher sales commission expense in support of our go-to-market strategy. As a result of increased headcount, personnel compensation and related expenses increased $34.6 million, or 20.5%, in fiscal 2014 compared to fiscal 2013, including an increase in stock-based compensation expense of $4.3 million, or 11.5%. Marketing expenses increased $2.9 million, or 22.2%, during fiscal 2014 compared to fiscal 2013, primarily due to field marketing efforts and programs to introduce and promote our new and existing products, including an expansion of our partner and customer conferences. Additionally, as a result of increased headcount, recruiting, travel and entertainment, equipment, and other headcount supporting expenses increased $3.1 million, or 17.2% during fiscal 2014 compared to fiscal 2013. Facilities and IT-related expenses increased $2.9 million, or 31.1%, during fiscal 2014 compared to fiscal 2013, as we expanded our infrastructure to support our sales and marketing efforts and increase in personnel. For fiscal 2013, sales and marketing expenses increased $32.4 million, or 16.3%, compared to fiscal 2012. As a result of an increase in headcount, personnel compensation and related expenses increased $22.3 million, or 15.3%, including an increase in stock-based compensation of $3.1 million, or 9.0%. Marketing expenses increased $2.1 million, or 18.5%, primarily due to increased participation in trade shows to introduce and promote our new products. Additionally, as a result of increased headcount, recruiting, travel and entertainment, equipment, and other headcount supporting expenses increased $2.5 million, or 16.3% during fiscal 2013 compared to fiscal 2012. Facilities and IT-related expenses increased $4.4 million, or 91.2%, during fiscal 2013 compared to fiscal 2012, as we expanded our sales and marketing infrastructure, including increasing headcount, to support our business growth. General and Administrative Expenses Years ended July 31, 2014 2013 2012 (in thousands) General and administrative expenses $ 60,004 $ 51,030 $ 46,775 Percent of total revenue 8.2 % 8.5 % 9.0 % For fiscal 2014, general and administrative expenses increased $9.0 million, or 17.6%, compared to fiscal 2013. The increase was primarily a result of expanding our headcount to support our business growth. For fiscal 2014, personnel compensation and related expenses increased $5.5 million, or 18.0%, including an increase in stock-based compensation expense of $1.0 million, or 6.3%, as a result of increased headcount and higher compensation incentives compared to fiscal 2013. Outside services increased $2.0 million, or 15.9%, in fiscal 2014 compared to fiscal 2013, primarily due to higher patent-related legal expenses as a result of dealing with a higher volume of legal matters. Facilities and IT-related expenses increased $1.3 million, or 40.1%, during fiscal 2014 compared to fiscal 2013, as we continued to expand our general and administrative infrastructure, including increasing headcount, to support our business growth. The aforementioned increases were partially offset by a decrease of the bad debt expense of $0.8 million, or 113.7%, as a result of lower reserves for accounts receivable required in fiscal 2014 compared to fiscal 2013. 55 -------------------------------------------------------------------------------- For fiscal 2013, general and administrative expenses increased $4.3 million, or 9.1%, compared to fiscal 2012, primarily as a result of the expansion of our general and administrative infrastructure, including an increase in headcount, to support our business growth. As a result of the increase in employee headcount, personnel compensation and related expenses increased $3.6 million, or 13.2%, including an increase in stock-based compensation of $2.8 million, or 21.8%, for fiscal 2013 compared to fiscal 2012. In fiscal 2013, we also incurred higher headcount support expenses and facilities and IT-related expenses of $0.3 million, or 24.3%, and $0.8 million, or 33.5%, respectively, compared to fiscal 2012, to support our headcount increase and growth of our general and administrative organization. The aforementioned increases in expenses were partially offset by lower professional services of $0.7 million, or 5.4%, in fiscal 2013 compared to fiscal 2012, primarily due to lower spending on patent legal services as a result of a lower volume of legal matters. Legal Settlements Years ended July 31, 2014 2013 2012 (in thousands) Legal settlements $ 250 $ 14,000 $ - Percent of total revenue - % 2.3 % - % For fiscal 2014, legal settlement expenses related to patent infringement assertions decreased $13.8 million, or 98.2%, compared to fiscal 2013. In the first quarter of fiscal 2014, we made full payment of a patent infringement legal settlement of $14.0 million, which had been recorded in the fourth quarter of fiscal 2013, which accounted for the decrease in fiscal 2014. Although this legal settlement had a material impact to our Consolidated Statements of Operations for fiscal 2013, it did not have a material adverse effect on our consolidated financial position or cash flows for fiscal 2013. In the fourth quarter of fiscal 2014, we recorded a patent infringement legal settlement of $0.3 million that is expected to be paid in full in the first quarter of fiscal 2015. In fiscal 2012, there were no legal settlements. Other Income, Net Years ended July 31, 2014 2013 2012 (in thousands) Interest income $ 843 $ 1,138 $ 1,194Other income (expense), net (173 ) 653 1,631 Total other income, net $ 670 $ 1,791 $ 2,825 Percent of total revenue 0.1 % 0.3 % 0.5 % For fiscal 2014, total other income, net decreased $1.1 million, or 62.6%, compared to fiscal 2013. For fiscal 2014, interest income decreased $0.3 million, or 25.9%, primarily due to lower invested balances in short-term investments, our primary source of our interest income. Our average short-term investments balance for fiscal 2014 was $185.4 million compared with $244.5 million in fiscal 2013. For fiscal 2014, other income (expense), net decreased $0.8 million or 126.5%, compared to fiscal 2013, primarily as a result of a change in valuation and a gain totaling $1.7 million recognized in fiscal 2013 from our contingent rights liability associated with our acquisition of Azalea Networks, Inc. ("Azalea"), which expired in December 2012 ($1.3 million gain recognized upon expiration). This change in valuation and gain were partially offset by losses of $0.7 million from changes in foreign exchange rates and $0.2 million from other miscellaneous expenses during fiscal 2014 compared to fiscal 2013. For further information on Azalea refer to Note 3, Contingent Rights Liability Arising from Business Combinations, of the Notes to Consolidated Financial Statements. For fiscal 2013, total other income, net decreased $1.0 million, or 36.6%, compared to fiscal 2012, primarily as a result of a decrease in other income of $0.7 million from the change in valuation of our contingent rights liability associated with Azalea, and an increase in losses of $0.3 million related to changes in foreign exchange rates. The decrease in interest income in fiscal 2013 compared to fiscal 2012 was not material. 56 -------------------------------------------------------------------------------- Provision for Income Taxes Years ended July 31, 2014 2013 2012 (in thousands)Income (loss) before income taxes $ 405 $ (10,225 ) $ 13,560 Provision for income taxes 29,370 21,383 22,411 Net loss $ (28,965 ) $ (31,608 ) $ (8,851 ) Effective tax rate 7,251.9 % 209.1 % 165.3 % Our effective tax rate in all periods is the result of a mix of income earned in various tax jurisdictions that apply a broad range of income tax rates. The provision for income taxes differs from the tax computed at the U.S. federal statutory income tax rate due primarily to the fixed amortization of tax capitalized in connection with an international restructuring in fiscal 2012, state taxes, nondeductible stock-based compensation, research and development tax credits, the difference between foreign tax rates and the U.S. tax rate, and an increase in the valuation allowance for deferred tax assets. Future effective tax rates could be adversely affected if earnings are lower than anticipated in countries where we have lower statutory tax rates or by unfavorable changes in tax laws and regulations or their interpretation. Our effective tax rate for fiscal 2014 differed from the effective tax rate for fiscal 2013 primarily due to a decrease in U.S. research and development credits, an increase in uncertain tax positions, and a change in the mix of our earnings or losses in jurisdictions with different tax rates. Our effective tax rate for fiscal 2013 differed from the effective tax rate for fiscal 2012 primarily due to an increase in non-deductible stock-based compensation, an increase in our valuation allowance for deferred tax assets, and a change in the mix of our earnings or losses in jurisdictions with different tax rates, partially offset by an increase in our U.S. research and development credit benefit of approximately $1.9 million, recorded in fiscal 2013, due to the retroactive extension of the credit to fiscal 2012. In fiscal 2012, we implemented a new structure of our corporate organization to more closely align our corporate organization with the international nature of our business activities and to reduce our overall effective tax rate through changes in how we develop and use our intellectual property and the structure of our international procurement and sales, including transfer-price arrangements for intercompany transactions. We recorded a deferred charge during the first quarter of fiscal 2012 related to the deferral of income tax expense on intercompany profits that resulted from the sale of our intellectual property rights outside of North and South America to our Irish subsidiary. We also record deferred charges on other sales of intangible properties as they occur. The deferred charge from these transactions is included in prepaids and other current and other non-current assets on the Consolidated Balance Sheets. As of July 31, 2014, the balance in prepaids and other current assets and other non-current assets was $1.0 million and $1.9 million, respectively. The deferred charge is amortized on a straight-line basis as a component of income tax expense over three to eleven years, based on the economic life of the intellectual property, and will increase our effective tax rate during the amortization period. The deferred charge resulted in a 1,984.5 point increase to our effective tax rate for fiscal 2014 from 5,267.4% to 7,251.9%. While we have yet to realize any tax savings to date, we expect to realize a reduction in our effective tax rate in fiscal 2015 as a result of our corporate reorganization after the deferred charges have been materially amortized. We file income tax returns in the U.S. federal jurisdiction, various U.S. state and local jurisdictions, and in various foreign jurisdictions. Due to our net operating loss and credit carryfowards, substantially all years are subject to examination. There are no major income tax audits currently in progress as of July 31, 2014. For further information, refer to Note 9, Income Taxes, of the Notes to Consolidated Financial Statements. Quarterly Fluctuations in Operating Results The following table sets forth our unaudited quarterly Consolidated Statement of Operations data for each of the eight quarters ended July 31, 2014. In management's opinion, the data has been prepared on the same basis as the audited Consolidated Financial Statements included in this report, and reflects all necessary adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of this data. Our operating results may fluctuate due to a variety of factors, many of which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. Users of the financial statements should not rely on our past results as an indication of our future performance. Net income (loss) per share for the four quarters of each fiscal year may not sum to the total for the fiscal year because of the different number of shares outstanding during each period. 57 -------------------------------------------------------------------------------- For the three months ended FY 2014 July 31, 2014 April 30, 2014 January 31, 2014 October 31, 2013 (in thousands, except per share data) Revenue Product $ 167,588 $ 155,201 $ 141,755 $ 130,831 Support and professional services 35,274 33,587 34,601 30,096 Total revenue 202,862 188,788 176,356 160,927 Cost of revenue Product 53,127 50,428 43,303 40,118 Support and professional services 9,856 9,466 10,050 8,433 Total cost of revenue 62,983 59,894 53,353 48,551 Gross profit 139,879 128,894 123,003 112,376 Operating expenses Research and development 43,376 42,922 42,585 40,445 Sales and marketing 72,071 70,151 69,569 63,044 General and administrative 15,719 15,302 14,468 14,515 Legal settlement 250 - - - Total operating expenses 131,416 128,375 126,622 118,004 Operating income (loss) 8,463 519 (3,619 ) (5,628 ) Other income (expense), net Interest income 182 183 217 261 Other income (expense), net (165 ) (198 ) (81 ) 270 Total other income (expense), net 17 (15 ) 136 531 Income before provision for (benefit 8,480 504 (3,483 ) (5,097 ) from) income taxes Provision for income taxes 12,566 6,855 7,219 2,730 Net loss $ (4,086 ) $ (6,351 ) $ (10,702 ) $ (7,827 ) Shares used in computing net loss per common share, basic 107,339 107,293 107,153 112,011 Net loss per common share, basic $ (0.04 ) $ (0.06 ) $ (0.10 ) $ (0.07 ) Shares used in computing net loss per common share, diluted 107,339 107,293 107,153 112,011 Net loss per common share, diluted $ (0.04 ) $ (0.06 ) $ (0.10 ) $ (0.07 ) 58-------------------------------------------------------------------------------- For the three months ended FY 2013 July 31, 2013 April 30, 2013 January 31, 2013 October 31, 2012 (in thousands, except per share data) Revenue Product $ 125,025 $ 121,195 $ 130,901 $ 119,222 Support and professional services 28,039 25,941 24,461 25,260 Total revenue 153,064 147,136 155,362 144,482 Cost of revenue Product 38,505 36,782 37,665 36,161 Support and professional services 7,228 7,190 6,991 5,957 Total cost of revenue 45,733 43,972 44,656 42,118 Gross profit 107,331 103,164 110,706 102,364 Operating expenses Research and development 38,112 34,983 34,688 31,963 Sales and marketing 62,289 57,199 57,398 53,919 General and administrative 13,275 13,405 12,399 11,951 Legal settlement 14,000 - - - Total operating expenses 127,676 105,587 104,485 97,833 Operating income (loss) (20,345 ) (2,423 ) 6,221 4,531 Other income (expense), net Interest income 263 266 293 316 Other income (expense), net (487 ) (114 ) 978 276 Total other income (expense), net (224 ) 152 1,271 592 Income (loss) before provision for income taxes (20,569 ) (2,271 ) 7,492 5,123 Provision for (benefit from) income taxes (4,988 ) 17,920 2,502 5,949 Net income (loss) $ (15,581 ) $ (20,191 ) $ 4,990 $ (826 ) Shares used in computing net income (loss) per common share, basic 114,202 114,411 112,584 111,976 Net income (loss) per common share, basic $ (0.14 ) $ (0.18 ) $ 0.04 $ (0.01 ) Shares used in computing net income (loss) per common share, diluted 114,202 114,411 123,270 111,976 Net income (loss) per common share, diluted $ (0.14 ) $ (0.18 ) $ 0.04 $ (0.01 ) Prior Period Adjustments In the fourth quarter of fiscal 2014, we recorded certain out-of-period adjustments to correct errors that reduced revenue by $1.5 million in the three months ended July 31, 2014, of which $0.7 million relates to the three months ended January 31, 2014 and $0.8 million relates to fiscal 2011. The impact of this correction resulted in an increase in our net loss of $0.9 million in the three months ended July 31, 2014 and $0.4 million in fiscal 2014. We have assessed the impact of these adjustments for the three months ended July 31, 2014 and fiscal 2014, and on previously reported financial statements and concluded that the adjustments are not material, either individually or in the aggregate, to any of the aforementioned reporting periods, including previously reported Consolidated Financial Statements for the three months ended January 31, 2014 and fiscal 2011. On that basis, we have recorded the adjustments in the three months ended July 31, 2014. In the first quarter of fiscal 2013, we recorded an out-of-period adjustment to correct an error that increased the provision for income taxes by $1.8 million which related to the fourth quarter of fiscal 2012. The impact of this correction would have resulted in an increase in net loss of $1.8 million for the fourth quarter of fiscal 2012 and fiscal 2012. We have assessed the impact of this adjustment on previously reported financial statements and for fiscal 2013 and concluded that the adjustment was not material, either individually or in the aggregate to previously reported Consolidated Financial Statements. On that basis, we have recorded the adjustment in the first quarter of fiscal 2013. 59 --------------------------------------------------------------------------------Liquidity and Capital Resources July 31, July 31, 2014 2013 (in thousands) Working capital $ 244,004 $ 368,760 Cash and cash equivalents $ 118,594 $ 144,919 Short-term investments $ 166,359 $ 269,882 Years ended July 31, 2014 2013 2012 (in thousands) Cash provided by operating activities $ 112,692 $ 153,213 $ 112,861 Cash provided by (used in) investing activities $ 79,453 $ (98,831 ) $ (96,327 ) Cash provided by (used in) financing activities $ (218,470 ) $ (43,111 ) $ 36,467 As of July 31, 2014, our principal sources of liquidity were our cash, cash equivalents and short-term investments. Cash and cash equivalents are comprised of cash, sweep funds and money market funds with an original maturity of 90 days or less at the time of purchase. Short-term investments include corporate bonds, U.S. government agency securities, U.S. treasury bills, commercial paper, certificates of deposit, and municipal notes and bonds. Cash, cash equivalents and short-term investments decreased $129.8 million during fiscal 2014 from $414.8 million as of July 31, 2013 to $285.0 million as of July 31, 2014, primarily as a result of repurchases of our common stock (under our stock repurchase program) of $263.0 million in fiscal 2014 and the payment of a legal settlement of $14.0 million in the first quarter of fiscal 2014. As of July 31, 2014, we had $76.0 million of cash and cash equivalents held outside the United States. Refer to Note 9, Income Taxes, of the Notes to Consolidated Financial Statements, for information concerning the potential tax impact of repatriating earnings for certain non-U.S. subsidiaries that are permanently reinvested outside of United States. Historically, we have required capital principally to fund our working capital needs, stock repurchase program and acquisition activities. It is our investment policy to invest excess cash in a manner that preserves capital, provides liquidity and maintains appropriate diversification and optimizes current income within our policy's framework. We are averse to principal loss and attempt to ensure the safety and preservation of our invested funds by limiting default risk, market risk and reinvestment risk. Our investment policy is designed to prevent fluctuations in market value which could materially affect our financial results. Cash Flows from Operating Activities Our cash flows from operating activities will continue to be affected principally by our profitability, working capital requirements, the extent to which we increase spending on personnel and the continued growth in revenue and cash collections. The timing of hiring sales personnel in particular affects cash flows as there is a lag between the hiring of sales personnel and the generation of revenue and related cash flows. In the future, we anticipate achieving cash tax savings and a reduction in our overall tax rate as a result of our corporate organization structure implemented in fiscal 2012 offset by increases in our cash tax obligations after our tax loss and credit carryforwards have been utilized. Our largest source of operating cash flows is cash collections from our customers. Our primary uses of cash from operating activities are for personnel related expenditures, purchases of inventory, purchases of property and equipment, and facilities and IT-related expenditures. During fiscal 2014, net cash provided by operating activities decreased $40.5 million compared to fiscal 2013. This decrease was primarily due to a decrease of $51.4 million from changes in operating assets and liabilities, offset by an increase in cash flows of $10.9 million generated from operations after adjusting our net loss for fiscal 2014 for non-cash items. The increase in cash flows from operations of $10.9 million, as described above, was primarily due to an increase in depreciation and amortization of $5.8 million and an increase of stock-based compensation expense of $15.0 million, which were partially offset by a decrease in the excess tax benefits associated with stock-based compensation of $8.9 million and a decrease of deferred income taxes of $3.5 million. The decrease from changes in operating assets and liabilities of $51.4 million, as described above, was primarily a result of a decrease in accounts payable and other current and noncurrent liabilities of $64.4 million and a decrease in other noncurrent assets of $7.8 million, which were partially offset by an increase in accounts receivable, prepaids and other current assets and income taxes payable of $4.6 million, $2.7 million, and $10.9 million, respectively. The decrease of $64.4 million in accounts payable and other liabilities was primarily due to lower partner rebates balances due to timing of payments and payment of a legal settlement in the first quarter of fiscal 2014. 60 -------------------------------------------------------------------------------- During fiscal 2013, net cash provided by operating activities increased $40.4 million compared to fiscal 2012. The additional cash flows generated from operating activities was primarily due to an increase in cash flows of $16.5 million from operations after adjusting for non-cash items, including depreciation and amortization, and stock-based compensation, and an increase of $46.6 million from the change in operating assets and liabilities. These additional cash flows were partially offset by an increase in our net loss of $22.8 million. The $46.6 million change in operating assets and liabilities was primarily driven by an increase in other current and non-current accrued liabilities. Cash Flows from Investing Activities Cash from investing activities increased $178.3 million during fiscal 2014 compared to fiscal 2013. This increase in investing activities was primarily due to larger sales and maturities, net of purchases, of short-term investments of $161.3 million (primarily to fund purchases of our common stock under our share repurchase program), as well as a decrease in purchases of acquisition and investments in private companies of $18.5 million in fiscal 2014 compared to fiscal 2013. This increase in investing activities was offset by an increase in purchases of long-lived assets of $2.8 million in fiscal 2014 compared to fiscal 2013, primarily to support the growth of our business. Cash used in investing activities increased $2.5 million during fiscal 2013 compared to fiscal 2012. We purchased $98.0 million more short-term investments during fiscal 2013 compared to fiscal 2012 as we reinvested cash flow from operations. Purchases of property and equipment in fiscal 2013 increased $7.6 million compared to fiscal 2012 due to an increase in investments in our research and development infrastructure. The higher level of direct research and development investment was offset by lower acquisition expenditures. We completed one acquisition during fiscal 2013 for a total cash purchase price consideration of $16.8 million, net of cash received, compared to two acquisitions in fiscal 2012 totaling $22.5 million, net of cash received. See Note 2, Business Combinations, of the Notes to Consolidated Financial Statements. Cash Flows from Financing Activities Cash used in financing activities increased by $175.4 million during fiscal 2014 compared to fiscal 2013. This increase in financing activities was primarily due to an increase of $176.8 million in purchases of our common stock under our stock repurchase program, offset by a decrease of cash proceeds from issuance of common stock of $7.5 million in fiscal 2014 compared to fiscal 2013, and an increase of $8.9 million in the excess tax benefits associated with stock-based compensation expense in fiscal 2014 compared to fiscal 2013. Cash provided by (used in) financing activities changed by $79.6 million during fiscal 2013 compared to fiscal 2012 and primarily consisted of the increase of cash used in our stock repurchase program of $66.3 million compared to fiscal 2012, combined with a change in the excess tax benefit associated with stock-based compensation of $11.7 million and by a decrease from cash provided from issuance of common stock of $1.6 million. Based on our current cash, cash equivalents, short-term investments, and cash generated from operations we expect that we will have sufficient resources to fund our operations for the next 12 months. However, we may, in the future, seek to raise additional capital or incur indebtedness to fund our operations or support acquisition activity. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of expansion into new territories, the timing of introductions of new products and enhancements to existing products, the continuing market acceptance of our products and potential future business acquisitions. Contractual Obligations & Commitments Operating leases and purchase obligations The following is a summary of our contractual obligations at July 31, 2014: More Less Than 1 - 3 3 - 5 Than Total 1 Year Years Years 5 Years (In thousands) Operating leases $ 20,979 $ 8,096 $ 11,502 $ 1,381 $ - Purchase obligations (1) 45,429 35,029 8,449 500 1,451 Total contractual obligations $ 66,408 $ 43,125 $ 19,951 $ 1,881 $ 1,451 (1) Purchase obligations represent contractual amounts that will be due to purchase goods and services to be used in our operations and exclude contractual amounts that are cancelable without penalty. These contractual amounts are related principally to inventory, information technology and marketing related purchase agreements. 61-------------------------------------------------------------------------------- Uncertain tax positions Other long term liabilities on our balance sheet include $11.3 million of long-term income taxes payable for uncertain tax positions. We are unable to reliably estimate the timing of future payments related to uncertain tax positions and therefore have excluded them from the preceding table. Off-Balance Sheet Arrangements In the ordinary course of business, we have invested in privately held companies, which we evaluate on an ongoing basis to determine if they should be accounted for as variable interest entities. In fiscal 2014, we evaluated our investments in these privately held companies and concluded that we are not the primary beneficiary of any variable interest on these investments. As a result, we account for these investments on a cost basis and do not consolidate their activity. Certain events may require a reassessment of our investments in these privately held companies to determine if they meet the criteria for variable interest entities and to determine which stakeholders in such entities will be the primary beneficiary. Because we do not control these entities, we do not have the ability to influence these events. In the event of a reassessment, we may be required to make additional disclosures or consolidate these entities in future periods. As of July 31, 2014, we had no off-balance sheet arrangements. 62-------------------------------------------------------------------------------- |