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EX-10.67 - STOCK OPTION AGREEMENT WITH GORDON C. BROOKS - BLUE COAT SYSTEMS INCdex1067.htm
EX-32.1 - PEO & PF & ACCOUNTING OFFICER CERTIFICATION PURSUANT TO SECTION 906 - BLUE COAT SYSTEMS INCdex321.htm
EX-31.2 - PF & ACCOUNTING OFFICER CERTIFICATION PURSUANT TO SECTION 302 - BLUE COAT SYSTEMS INCdex312.htm
EX-31.1 - PEO CERTIFICATION PURSUANT TO SECTION 302 - BLUE COAT SYSTEMS INCdex311.htm
EX-10.64 - AMENDED AND RESTATED FORM OF CEO CHANGE IN CONTROL SEVERANCE AGREEMENT - CEO - BLUE COAT SYSTEMS INCdex1064.htm
EX-10.65 - AMENDED AND RESTATED 2007 STOCK INCENTIVE PLAN - BLUE COAT SYSTEMS INCdex1065.htm
EX-10.66 - AMENDED AND RESTATED EMPLOYEE STOCK PURCHASE PLAN - BLUE COAT SYSTEMS INCdex1066.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(MARK ONE)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED OCTOBER 31, 2009

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM                      TO                     

COMMISSION FILE NUMBER 000-28139

 

 

BLUE COAT SYSTEMS, INC.

(Exact Name of Registrant as Specified In Its Charter)

 

 

 

DELAWARE   91-1715963

(State or Other Jurisdiction of

Incorporation or Organization)

 

(IRS Employer

Identification)

420 NORTH MARY AVENUE

SUNNYVALE, CALIFORNIA 94085

(408) 220-2200

(Address, Including Zip Code, of Registrant’s Principal Executive Offices

and Telephone Number, Including Area Code)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES  ¨    NO  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  x       Accelerated filer  ¨    Non-accelerated filer   ¨     Smaller reporting company   ¨
     (Do not check if a smaller
reporting company)
 

Indicate by check mark whether the registrant is a shell company (as determined in Rule 12b-2 of the Exchange Act)    YES  ¨    NO  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

There were 40,577,482 shares of the registrant’s Common Stock, par value $0.0001, issued and outstanding as of November 23, 2009.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page

PART I: FINANCIAL INFORMATION

   4

Item 1:

   Condensed Consolidated Financial Statements    4
   Condensed Consolidated Balance Sheets    4
   Condensed Consolidated Statements of Operations    5
   Condensed Consolidated Statements of Cash Flows    6
   Notes to Condensed Consolidated Financial Statements    7

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    26

Item 3.

   Quantitative and Qualitative Disclosures about Market Risk    43

Item 4.

   Controls and Procedures    43

PART II. OTHER INFORMATION

   44

Item 1.

   Legal Proceedings    44

Item 1A.

   Risk Factors    44

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds    58

Item 3.

   Defaults Upon Senior Securities    58

Item 4.

   Submission of Matters to a Vote of Security Holders    58

Item 5.

   Other Information    59

Item 6.

   Exhibits    59
  

Signatures

   60


Table of Contents

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements include, but are not limited to, statements concerning the following: expectations with respect to future market growth opportunities; changes in and expectations with respect to revenues and gross margins; future operating expense levels and operating margins; the impact of quarterly fluctuations of revenue and operating results; our ability to achieve expected levels of revenues and profit contributions from acquired businesses; the impact of macroeconomic conditions on our business; the adequacy of our capital resources to fund operations and growth; investments or potential investments in acquired businesses and technologies (including our planned acquisition of S7 Software Solutions Pvt.), as well as internally developed technologies; the expansion and effectiveness of our direct sales force, distribution channel, and marketing activities, including the realignment of our sales force and changes in our global fulfillment model; the impact of recent changes in accounting standards and assumptions underlying any of the foregoing. In some cases, forward-looking statements are identified by the use of terminology such as “anticipate,” “expect,” “intend,” “plan,” “predict,” “believe,” “estimate,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” or negatives or derivatives of the foregoing, or other comparable terminology.

The forward-looking statements in this Quarterly Report on Form 10-Q involve known and unknown risks, uncertainties and other factors that may cause industry and market trends, or our actual results, level of activity, performance or achievements, to be materially different from any future trends, results, level of activity, performance or achievements expressed or implied by these statements. For a detailed discussion of these risks, uncertainties and other factors, see the “Risk Factors” section under Part II, Item 1A of this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update forward-looking statements to reflect new information or events or circumstances occurring after the date of this Quarterly Report on Form 10-Q.

 

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PART I: FINANCIAL INFORMATION

Item 1: Condensed Consolidated Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value)

 

     October 31,
2009
    April 30,
2009
 
     (Unaudited)        

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 141,521      $ 114,163   

Accounts receivable, net of allowance of $55 and $1,420 as of October 31, 2009 and April 30, 2009, respectively

     75,677        77,161   

Inventory

     6,869        5,700   

Prepaid expenses and other current assets

     14,247        13,113   

Current portion of deferred income tax assets

     7,941        7,941   
                

Total current assets

     246,255        218,078   

Property and equipment, net

     37,944        34,955   

Restricted cash

     962        850   

Goodwill

     238,082        238,466   

Identifiable intangible assets, net

     42,436        48,774   

Non-current portion of deferred income tax assets

     19,412        19,412   

Other assets

     3,791        1,758   
                

Total assets

   $ 588,882      $ 562,293   
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable

     19,080        24,105   

Accrued payroll and related benefits

     15,553        18,374   

Deferred revenue

     90,710        96,656   

Other accrued liabilities

     8,856        12,299   
                

Total current liabilities

     134,199        151,434   

Deferred revenue, less current portion

     41,877        33,923   

Deferred rent, less current portion

     6,405        5,703   

Long-term income taxes payable

     15,948        12,677   

Other non-current liabilities

     437        600   

Zero Coupon Convertible Senior Notes, due in 2013

     76,794        76,347   

Commitments and contingencies

    

Stockholders’ equity:

    

Preferred stock: $0.0001 par value; issuable in series; 9,958 shares authorized; none issued and outstanding

     —          —     

Common stock: $0.0001 par value; 200,000 shares authorized; 40,550 and 39,713 shares issued and outstanding at October 31, 2009 and April 30, 2009, respectively

     2        2   

Additional paid-in capital

     1,188,125        1,168,106   

Treasury stock, at cost; 375 and 330 shares held at October 31, 2009 and April 30, 2009, respectively

     (2,398     (1,629

Accumulated deficit

     (872,507     (884,870
                

Total stockholders’ equity

     313,222        281,609   
                

Total liabilities and stockholders’ equity

   $ 588,882      $ 562,293   
                

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2009     2008     2009     2008  

Net revenue:

        

Product

   $ 76,502      $ 84,797      $ 150,194      $ 158,726   

Service

     43,934        34,227        86,231        62,801   
                                

Total net revenue

     120,436        119,024        236,425        221,527   

Cost of net revenue:

        

Product

     19,261        25,120        38,744        47,234   

Service

     12,947        12,017        24,984        21,970   
                                

Total cost of net revenue

     32,208        37,137        63,728        69,204   

Gross profit

     88,228        81,887        172,697        152,323   

Operating expenses:

        

Sales and marketing

     45,608        44,952        91,184        88,600   

Research and development

     19,568        20,171        39,404        38,358   

General and administrative

     11,176        13,281        23,892        24,314   

Amortization of intangible assets

     1,822        1,862        3,643        3,024   

Restructuring

     —          —          —          1,546   
                                

Total operating expenses

     78,174        80,266        158,123        155,842   
                                

Operating income (loss)

     10,054        1,621        14,574        (3,519

Interest income

     72        349        173        851   

Interest expense

     (227     (232     (455     (389

Other income (expense), net

     155        (1,353     139        (1,540
                                

Income (loss) before income taxes

     10,054        385        14,431        (4,597

Provision for income taxes

     1,687        636        2,068        1,489   
                                

Net income (loss)

   $ 8,367      $ (251   $ 12,363      $ (6,086
                                

Net income (loss) per share:

        

Basic

   $ 0.19      $ (0.01   $ 0.28      $ (0.16
                                

Diluted

   $ 0.19      $ (0.01   $ 0.28      $ (0.16
                                

Weighted average shares used in computing net income (loss) per share:

        

Basic

     43,777        38,432        43,485        38,224   
                                

Diluted

     45,202        38,432        44,777        38,224   
                                

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

     Six Months Ended
October 31,
 
     2009     2008  

Operating Activities

    

Net income (loss)

   $ 12,363      $ (6,086

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

    

Depreciation

     6,528        4,799   

Amortization

     6,476        5,376   

Stock-based compensation

     10,338        9,343   

Accretion of warrants and issuance costs related to convertible senior notes

     447        372   

Stock-based compensation related to restructuring

     —          88   

Tax benefit of stock option deduction

     235        197   

Excess tax benefit from stock-based compensation

     (792     (156

Loss on disposition of equipment

     474        39   

Changes in operating assets and liabilities:

    

Accounts receivable, net

     1,484        (9,870

Inventory

     (1,169     14,431   

Prepaid expenses and other current assets

     (1,134     604   

Other assets

     (1,420     498   

Accounts payable

     (5,025     4,498   

Accrued payroll and related benefits

     (2,821     (1,994

Accrued restructuring

     (101     200   

Other accrued liabilities

     156        (12,020

Deferred rent

     696        (727

Deferred income taxes

     —          (393

Deferred revenue

     2,008        19,665   
                

Net cash provided by operating activities

     28,743        28,864   

Investing Activities

    

Purchases of property and equipment

     (9,991     (11,300

Restricted cash

     (112     —     

Proceeds from sale and maturities of investment securities

     —          1,204   

Purchase of intangible assets

     (751     —     

Acquisitions, net of cash acquired and prior investment

     —          (169,327
                

Net cash used in investing activities

     (10,854     (179,423

Financing Activities

    

Net proceeds from issuance of common stock

     8,677        6,716   

Excess tax benefit from stock-based compensation

     792        156   

Net proceeds from issuance of convertible senior notes

     —          79,657   
                

Net cash provided by financing activities

     9,469        86,529   
                

Net increase (decrease) in cash and cash equivalents

     27,358        (64,030

Cash and cash equivalents at beginning of period

     114,163        160,974   
                

Cash and cash equivalents at end of period

   $ 141,521      $ 96,944   
                

Supplemental schedule of non-cash investing and financing activities

  

Cash paid for income taxes, net of refunds

   $ 2,701      $ 6,613   

Cash paid for interest

   $ 8      $ 15   

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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Notes to Condensed Consolidated Financial Statements

Note 1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The unaudited condensed consolidated financial statements include the accounts of Blue Coat Systems, Inc. and our subsidiaries, all of which are wholly owned. All inter-company balances and transactions have been eliminated. We record all acquisitions using the purchase method of accounting and, accordingly, include the acquired company’s results of operations in our consolidated results from the date of each acquisition. The consolidated financial statements include the accounts and operating results of Packeteer, Inc. (“Packeteer”) beginning June 6, 2008. In management’s opinion, the accompanying condensed consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of the results for the interim periods presented. The condensed consolidated balance sheet as of April 30, 2009 is derived from the April 30, 2009 audited consolidated financial statements.

The functional currency of our domestic and foreign operations is the U.S. dollar. Accordingly, the effects of foreign currency transactions, and of remeasuring the financial condition and results of operations from local currencies into the functional currency, are included in other income (expense) in the accompanying condensed consolidated statements of operations.

Interim financial results are not necessarily indicative of results anticipated for the full year. These unaudited financial statements should be read in conjunction with our fiscal 2009 audited financial statements and footnotes included in our Annual Report on Form 10-K for the year ended April 30, 2009, as filed with the Securities and Exchange Commission (SEC) on June 22, 2009.

We evaluated subsequent events through the date and time our condensed consolidated financial statements were issued on November 30, 2009.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current period’s presentation. Such reclassifications did not affect net revenues, operating income or net income.

Use of Estimates

The preparation of consolidated financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities, at the dates of the consolidated financial statements, and the reported amounts of net revenue and expenses during the reporting periods. Actual results may differ from these estimates, and such differences could be material to our consolidated financial condition and results of operations.

Restricted Cash

Restricted cash is comprised of $1.0 million in cash and cash equivalents pledged as collateral for two separate irrevocable letters of credit. These letters of credit currently expire in February and May 2010, respectively. The larger letter of credit, which is required by the terms of the lease of our corporate headquarters, is secured by deposits and provides for automatic annual extensions, without amendment, on each successive

 

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expiration date, but no later than the lease expiration of November 30, 2015. The second letter of credit, which relates to an insurance policy, is secured by deposits and provides for automatic extension, without amendment, for one year following the date of expiration. The deposits securing these letters of credit are classified as restricted cash in the accompanying condensed consolidated balance sheets as of October 31, 2009 and April 30, 2009, respectively.

Concentration and Other Risks

Financial instruments that potentially subject us to credit risk consist of demand deposit accounts, money market accounts, commercial paper, corporate securities, U.S. government agency discount notes and trade receivables. We maintain demand deposit and money market accounts with financial institutions of high credit standing. Such deposits may be in excess of insured limits. We invest only in high-quality, investment grade securities and limit investment exposure in any one issue. Investments are classified as cash equivalents in our condensed consolidated balance sheets at October 31, 2009 and April 30, 2009. We believe the financial risks associated with these financial instruments are not material, and have not experienced material losses from our investments in these instruments.

Generally, we do not require collateral for sales to customers. However, we perform on-going credit evaluations of our customers’ financial condition and maintain an allowance for doubtful accounts. During the three and six months ended October 31, 2009, Arrow Enterprise Computing Solutions, Inc. (formerly, Alternative Data Technology, Inc.), a distributor, accounted for 13.8% and 11.9% of our net revenue, respectively. During the three and six months ended October 31, 2008, Arrow Enterprise Computing Solutions, Inc. accounted for 16.0% and 13.3% of our net revenue, respectively. As of October 31, 2009, Arrow Enterprise Computing Solutions, Inc. and Westcon Group European Operations Ltd., a distributor, accounted for 15.8% and 11.2% of our gross accounts receivable balance, respectively. As of April 30, 2009, Arrow Enterprise Computing Solutions, Inc. accounted for 12.4% of our gross accounts receivable balance.

We currently purchase several key parts and components used in the manufacture of our products from a limited number of suppliers. Generally we have been able to obtain an adequate supply of such parts and components. However, an extended interruption in the supply of parts and components currently obtained from our suppliers could adversely affect our financial condition and results of operations.

Supply Chain Liabilities and Valuation of Inventory

We outsource our manufacturing, product fulfillment and repair operations to contract manufacturers and a third party logistics provider, and a significant portion of our cost of net revenue is a result of this activity. Our contract manufacturers procure components and manufacture our products based on demand forecasts that we prepare. These forecasts are based on estimates of future product demand and are adjusted for overall market conditions. If the actual product demand is significantly lower than forecasted, we may be required to write down our inventory or accrue for excess supply chain liability, which could have an adverse impact on our gross margins and profitability.

Inventory consists of raw materials and finished goods. Inventory is recorded at the lower of cost (using the first-in, first-out method) or market, after we give appropriate consideration to obsolescence and inventory in excess of anticipated future demand. In assessing the ultimate recoverability of inventory, we are required to make estimates regarding future customer demand, last time buy decisions, the timing of new product introductions, economic trends and market conditions.

In connection with our acquisition of Packeteer during fiscal 2009, we recorded inventory purchased as part of the acquisition at its approximate fair value, equal to its estimated selling prices less the sum of the costs of disposal and a reasonable profit allowance for the selling effort. This resulted in a $20.3 million write-up of acquired inventory from its carrying value prior to the acquisition, of which approximately $0.5 million remains in inventory at October 31, 2009 and is expected to be sold by the end of the fourth quarter of fiscal 2010.

 

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Inventory, net, consisted of the following:

 

     October 31,
2009
   April 30,
2009
     (in thousands)

Raw materials

   $ 3,398    $ 2,389

Finished goods

     3,471      3,311
             

Total

   $     6,869    $     5,700
             

Guarantees, Indemnifications and Warranty Obligations

Our customer agreements generally include certain provisions for indemnifying such customers against liabilities if our products infringe a third party’s intellectual property rights. We have one customer agreement that contains an indemnification provision for costs that would be incurred in connection with a product recall. To date, we have not incurred any material costs as a result of such indemnification provisions and we have not accrued any liabilities related to such obligations in the accompanying condensed consolidated financial statements.

Our Bylaws provide that we shall indemnify our directors and officers to the fullest extent permitted by Delaware law, including in circumstances in which indemnification is otherwise discretionary under Delaware law. We have also entered into indemnification agreements or other contractual arrangements with current and former executive officers and directors of our company and of certain of our subsidiaries, which contain provisions that may require us, among other things, to indemnify such officers and directors against certain liabilities that may arise by reason of their status or service as directors or officers and to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified. We were required to indemnify certain current and former officers and directors and other employees for their attorneys’ fees and related expenses incurred in connection with the regulatory investigations relating to our historical stock option grant practices, and expect to have indemnification obligations to certain current and former officers and directors and other employees in connection with the derivative litigation relating to our historical stock option granting practices.

We accrue for warranty expenses in our cost of net revenue at the time revenue is recognized and maintain an accrual for estimated future warranty obligations based upon the relationship between historical and anticipated warranty costs and revenue volumes. If actual warranty expenses are greater than those projected, additional charges against earnings would be required. If actual warranty expenses are less than projected, our obligations would be reduced, providing a positive impact on our reported results. We generally provide a one-year warranty on hardware products.

Changes in our warranty obligations, which are included in other accrued liabilities in our condensed consolidated balance sheet for the six months ended October 31, 2009, were as follows (in thousands):

 

Warranty obligation at April 30, 2009

   $ 876   

Warranties issued during the period

     1,340   

Settlements made during the period

     (1,317

Change in estimate of warranty obligation during the period

     (211
        

Warranty obligation at October 31, 2009

   $ 688   
        

Recent Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 166, Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140 (“SFAS 166”). The guidance eliminates the concept of a “qualifying special-purpose entity”

 

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and changes the requirements for derecognizing financial assets. The guidance is effective as of the beginning the first annual reporting period that begins after November 15, 2009. Earlier adoption is prohibited. We will adopt the guidance in our first quarter of fiscal 2011. We do not anticipate this adoption will have a material impact on our consolidated financial statements.

In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R) (“SFAS 167”). The guidance eliminates the quantitative approach previously required for determining the primary beneficiary of a variable interest entity and to require ongoing qualitative reassessments of whether an enterprise is the primary beneficiary of a variable interest entity. It also requires additional disclosures about an enterprise’s involvement in variable interest entities. The guidance is effective as of the beginning of the first annual reporting period that begins after November 15, 2009. Earlier adoption is prohibited. We will adopt the guidance in our first quarter of fiscal 2011. We do not anticipate this adoption will have a material impact on our consolidated financial statements.

In June 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162 (“SFAS 168”). The guidance establishes the FASB Accounting Standards Codification (“ASC”) as the source of authoritative accounting principles recognized by the FASB. The guidance is effective for financial statements issued for interim and annual periods ending after September 15, 2009. We adopted this guidance for our second quarter ending October 31, 2009. There was no change to our consolidated financial statements due to the implementation of this guidance.

In August 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-05, Measuring Liabilities at Fair Value (“ASU 2009-05”). ASU 2009-05 provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value of such liability using one or more of the techniques prescribed by the update. ASU 2009-05 is effective for the first reporting period beginning after issuance. We will adopt ASU 2009-05 in our third quarter of fiscal 2010 and are currently evaluating the impact on our consolidated financial statements.

In October 2009, the FASB issued ASU No. 2009-13, Revenue Recognition (Topic 605)—Multiple Deliverable Revenue Arrangements (“ASU 2009-13”). ASU 2009-13 eliminates the residual method of allocation and requires the relative selling price method when allocating deliverables of a multiple-deliverable revenue arrangement. The determination of the selling price for each deliverable requires the use of a hierarchy designed to maximize the use of available objective evidence including, VSOE, third party evidence of selling price (TPE), or estimated selling price (ESP).

In October 2009, the FASB issued ASU No. 2009-14, Software (Topic 985)—Certain Revenue Arrangements That Include Software Elements (“ASU 2009-14”). ASU 2009-14 amends the scope of software revenue guidance in ASC Subtopic 985-605, Software-Revenue Recognition, to exclude tangible products containing software and non-software components that function together to deliver the product’s essential functionality.

ASU 2009-13 and ASU 2009-14 are effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, and must be adopted in the same period using the same transition method. If adoption is elected in a period other than the beginning of a fiscal year, the amendments in these standards must be applied retrospectively to the beginning of the fiscal year. Full retrospective application of these amendments to prior fiscal years is optional. Early adoption of these standards may be elected. We are currently evaluating the impact of these new accounting standards on our consolidated financial statements.

 

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Note 2. Per Share Amounts

Our Convertible Senior Notes as defined in Note 5 are participating securities whereby the holder would participate equally in any future dividends and in undistributed earnings with common stockholders; therefore, we calculated basic and diluted net income per share using the two-class method. Our unvested restricted stock awards and the Warrants as defined in Note 5 are also considered participating securities; however, the number of unvested restricted stock awards and Warrants outstanding is immaterial and therefore not included in our calculation under the two-class method. See Note 5 for further information regarding the Convertible Senior Notes and Warrants.

Under the two-class method, basic net income per share is computed by dividing the net income available to common stockholders by the weighted-average number of common shares outstanding for the period. Net income available to common stockholders is determined after allocating undistributed earnings to Convertible Senior Note holders. Diluted net income per share is computed using the weighted-average number of shares of common stock outstanding, including dilutive common shares subject to repurchase and potential shares assuming the (i) dilutive effect of outstanding stock awards, warrants and shares issuable under our employee stock purchase plan using the treasury stock method, and (ii) conversion of Convertible Senior Notes. For periods for which there is a net loss, the numbers of shares used in the computation of diluted net loss per share are the same as those used for the computation of basic net loss per share as the inclusion of dilutive securities would be anti-dilutive. No portion of the loss for the three and six months ended October 31, 2008 was allocated to the participating securities under the two-class method since there is no contractual obligation for the Convertible Senior Notes to share in our losses.

 

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The following table presents the calculation of weighted average common shares used in the computations of basic and diluted per share amounts presented in the accompanying condensed consolidated statements of operations reconciled to basic and diluted per share amounts available to common stockholders:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2009     2008     2009     2008  
     (in thousands, except per share amounts)  

Basic net income (loss) per share

        

Numerator:

        

Net income (loss)

   $ 8,367      $ (251   $ 12,363      $ (6,086

Less: undistributed earnings allocated to Convertible Senior Notes holders

     (737     —          (1,096     —     
                                

Net income (loss) available to common stockholders

   $ 7,630      $ (251   $ 11,267      $ (6,086

Denominator:

        

Basic weighted average common shares used in computing basic net income (loss) per share

     43,777        38,432        43,485        38,224   

Effect of participating Convertible Senior Notes

     (3,854     —          (3,854     —     
                                

Weighted average common shares outstanding using the two-class method

     39,923        38,432        39,631        38,224   
                                

Basic income (loss) available to common stockholders per share

   $ 0.19      $ (0.01   $ 0.28      $ (0.16
                                

Diluted net income (loss) per share

        

Numerator:

        

Net income (loss)

   $ 8,367      $ (251   $ 12,363      $ (6,086

Less: undistributed earnings allocated to Convertible Senior Notes holders

     (713     —          (1,064     —     
                                

Net income (loss) available to common stockholders

   $ 7,654      $ (251   $ 11,299      $ (6,086

Denominator:

        

Basic weighted average common shares used in computing basic net income (loss) per share

     43,777        38,432        43,485        38,224   

Add: Weighted average employee stock options

     1,155        —          1,006        —     

Add: Other weighted average dilutive potential common stock

     270        —          286        —     
                                

Weighted average common shares used in computing diluted net income (loss) per share

     45,202        38,432        44,777        38,224   

Effect of participating Convertible Senior Notes

     (3,854     —          (3,854     —     
                                

Weighted average common share outstanding using the two-class method

     41,348        38,432        40,923        38,224   
                                

Diluted income (loss) available to common stockholders per share

   $ 0.19      $ (0.01   $ 0.28      $ (0.16
                                

For the three and six months ended October 31, 2009, outstanding stock options and restricted stock awards covering 4.5 million and 5.0 million shares, respectively, were excluded from the calculation of diluted net income per share as their inclusion would have been anti-dilutive because their exercise prices were greater than or equal to the average market price of the common shares during the period.

For the three and six months ended October 31, 2008, outstanding stock options, employee stock purchase plan shares and restricted stock awards covering 6.5 million and 6.0 million shares, respectively, were excluded from the calculation of diluted net income per share because their inclusion would have been anti-dilutive due to our net loss for the period.

 

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Warrants to purchase 385,356 shares of our common stock were outstanding at October 31, 2009 and 2008. The warrants were included in the computation of the diluted net income per share for the three months ended October 31, 2009 because the exercise price of the warrants was less than the average market price of our common stock during the period.

The warrants were not included in the computation of diluted net income per share for six months ended October 31, 2009 and for the three and six months ended October 31, 2008 because the exercise price of the warrants was greater than the average market price of our common stock during those periods; therefore, their inclusion would have been anti-dilutive.

Shares of our common stock issuable upon the assumed conversion of the Convertible Senior Notes in the amount of 3,853,564 were not included in the computation of diluted net income per share for the three and six months ended October 31, 2008, due to our net loss for the period.

Note 3. Acquisitions

Fiscal 2009 Acquisition

Packeteer

We acquired Packeteer, a provider of sophisticated Wide Area Network (“WAN”) traffic prioritization technologies, on June 6, 2008, by means of a merger of our wholly owned subsidiary with and into Packeteer, such that Packeteer became our wholly-owned subsidiary. We acquired Packeteer, among other things, to add to our product portfolio products that identify and classify the applications on the network and monitor application response times and utilization. We have included the operating results of Packeteer in our consolidated financial results since the June 6, 2008 acquisition date.

The total purchase price was $278.6 million, which consisted of $264.0 million in cash paid to acquire the outstanding common stock of Packeteer, $4.6 million for the fair value of vested Packeteer equity awards assumed and $10.0 million in cash for direct transaction costs. In allocating the purchase price based on estimated fair values, we recorded approximately $145.8 million of goodwill, $55.4 million of identifiable intangible assets, $77.5 million of cash and short-term investments, $25.7 million of inventory, $16.0 million of deferred revenues and $9.8 million of other net tangible liabilities. Our acquisition of Packeteer did not result in the creation of a new business segment.

In connection with our acquisition of Packeteer, we formulated a plan to exit certain Packeteer facilities, discontinue certain Packeteer products, and involuntarily terminate the employment of certain Packeteer employees. In connection with this plan, on the acquisition date of June 6, 2008, we accrued $11.6 million related to employee severance costs and $1.9 million related to lease termination costs. From the acquisition date of June 6, 2008 through October 31, 2009, we paid $11.3 million related to employee severance costs and $3.5 million related to lease termination costs, and we decreased the employee severance accrual by $0.3 million and increased the lease termination accrual by $1.6 million. The increase to the lease termination accrual includes a $1.6 million real estate commission paid in fiscal 2009 in connection with the termination of an assumed lease. As of October 31, 2009, we had $53,000 in unpaid lease termination costs, the balance of which is included in other accrued liabilities in our condensed consolidated balance sheet as of October 31, 2009. We anticipate the unpaid balances for lease termination costs will be paid by the end of the third quarter of fiscal 2012.

 

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The following table summarizes the activity related to the acquisition restructuring accrual for the six months ended October 31, 2009:

 

     Severance     Facilities  
     (in thousands)  

Balance at April 30, 2009

   $ 79      $     893   

Cash payment

     (79     (416

Adjustment to accrual

     —          (384
                

Balance at July 31, 2009

     —          93   

Cash payment

     —          (40
                

Balance at October 31, 2009

   $     —        $ 53   
                

Pro Forma Financial Information

The unaudited financial information in the table below summarizes the combined results of operations of Blue Coat and Packeteer on a pro forma basis, after giving effect to the acquisition of Packeteer on June 6, 2008, and the issuance of convertible senior notes and associated warrants, the proceeds of which were used to finance a portion of the Packeteer acquisition. The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisition and convertible notes financing had taken place at the beginning of each of the periods presented.

The unaudited pro forma financial information for the six months ended October 31, 2008 combines the historical results of Blue Coat for the six months ended October 31, 2008 and, due to differences in our reporting periods, the historical results of Packeteer for one month ended May 31, 2008, due to the acquisition of Packeteer on June 6, 2008. We consider the Packeteer results for the period June 1 through June 6, 2008 to be immaterial and have, therefore, not accounted for that period in our pro forma financial information.

The following pro forma financial information for the period presented includes purchase accounting adjustments for amortization charges from acquired identifiable intangible assets, depreciation on acquired property and equipment, adjustments to interest expense and issuance costs associated with convertible notes, stock-based compensation expense and related tax effects:

 

     Six Months Ended
October 31, 2008
 
     (in thousands)  

Net revenue

   $     232,213   

Net loss

   $ (12,055

Net loss per share—basic

   $ (0.32

Net loss per share—diluted

   $ (0.32

Note 4. Goodwill and Intangible Assets

Goodwill

The changes in the carrying amount of goodwill generally are not deductible for tax purposes. Current activity recorded to goodwill was as follows (in thousands):

 

Balance at April 30, 2009

   $      238,466   

Goodwill adjustments

     (384
        

Balance at July 31, 2009

     238,082   

Goodwill adjustments

     —     
        

Balance at October 31, 2009

   $ 238,082   
        

 

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Intangible Assets

Our acquired intangible assets are as follows (in thousands):

 

October 31, 2009

   Amortization
period
   Gross
Amount
   Accumulated
Amortization
    Net Carrying
Value

Developed technology and patents

   3-7 years    $ 26,031    $ (9,394   $ 16,637

Core technology

   5 years      2,929      (2,908     21

Customer relationships

   5-7 years      37,023      (11,365     25,658

Trade name

   2 years      400      (280     120
                        

Total

      $ 66,383    $ (23,947   $ 42,436
                        

 

April 30, 2009

   Amortization
period
   Gross
Amount
   Accumulated
Amortization
    Net Carrying
Value

Developed technology and patents

   3-7 years    $ 26,031    $ (7,058   $ 18,973

Core technology

   5 years      2,929      (2,649     280

Customer relationships

   5-7 years      37,023      (7,722     29,301

Trade name

   2 years      400      (180     220
                        

Total

      $ 66,383    $ (17,609   $ 48,774
                        

Amortization expense for our intangibles assets for the three and six months ended October 31, 2009 and 2008 were allocated as follows:

 

     Three Months Ended
October 31,
   Six Months Ended
October 31,
     2009    2008    2009    2008
     (in thousands)

Included in cost of net revenue

   $ 1,347    $ 1,347    $ 2,695    $ 2,275

Included in operating expenses

     1,822      1,863      3,643      3,025
                           

Total

   $ 3,169    $ 3,210    $ 6,338    $ 5,300
                           

As of October 31, 2009, we had no identifiable intangible assets with indefinite lives. The weighted average remaining life of identifiable intangible assets was 3.6 years and 4.0 years as of October 31, 2009 and April 30, 2009, respectively.

Estimated amortization expense related to intangible assets in future periods is as follows:

 

Year Ended April 30,

   Amortization
     (in thousands)

2010 (remaining six months)

   $ 6,059

2011

     11,889

2012

     11,781

2013

     11,607

2014

     1,100

Thereafter

     —  
      
   $ 42,436
      

Note 5. Convertible Senior Notes

On June 2, 2008, we issued $80.0 million aggregate principal amount of Zero Coupon Convertible Senior Notes due June 2, 2013 (the “Convertible Senior Notes”) and warrants (the “Warrants”) to purchase an aggregate of 385,356 shares of our common stock at an exercise price of $20.76 to Manchester Securities Corp., an affiliate

 

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of Elliott Associates, L.P. (“Manchester”) and Francisco Partners II, L.P. and Francisco Partners Parallel Fund II, L.P. (together, the “FP Entities”) in a private placement. The Convertible Senior Notes are reported on the condensed consolidated balance sheets at $76.8 million as of October 31, 2009, net of discounts of $3.2 million primarily related to the value assigned to the Warrants, which is amortized to interest expense over the life of the Convertible Senior Notes.

The Convertible Senior Notes rank equal in right of payment to any of our other existing and future senior unsecured indebtedness. The Convertible Senior Notes are initially convertible into 3,853,564 shares of our common stock at the holders’ option at any time prior to maturity at the initial conversion price of $20.76. The Convertible Senior Notes do not bear interest. The conversion price of the Convertible Senior Notes and the exercise price of the Warrants are subject to adjustment, if we:

 

   

issue shares of our common stock as a dividend or distribution on our shares of common stock;

 

   

effect a stock split or stock combination;

 

   

issue shares of capital stock in the event of a reclassification; or

 

   

purchase shares of our common stock pursuant to a tender offer or exchange offer at a premium to market.

If we issue rights, options, warrants or pay a cash dividend or otherwise make a distribution of cash or other assets to all holders of our common stock, such right, option, warrant, dividend or distribution shall also be issued to the holders of the Convertible Senior Notes and the Warrants on an as-converted or as-exercised basis.

Subject to certain exceptions, the holders of the Convertible Senior Notes, at their option, may require us to repurchase for cash all or a portion of the Convertible Senior Notes at a purchase price equal to 100% of the outstanding principal amount of the Convertible Senior Notes, if our common stock is suspended from trading or ceases to be listed on an eligible market for a period of 5 consecutive trading days or for more than 15 trading days in any 365-day period.

On June 2, 2008, we and the FP Entities entered into a Registration Rights Agreement, (the “Registration Rights Agreement”) containing customary terms and conditions providing for the registration of our common stock underlying the Convertible Senior Notes and the Warrants issued to the FP Entities. Pursuant to the Registration Rights Agreement, we filed an automatically effective resale shelf registration statement on August 4, 2008. We filed an amendment to that registration statement on June 23, 2009.

Keith Geeslin, a partner of Francisco Partners II, L.P., has served as a member of our Board of Directors since June 2006.

Note 6. Consolidated Balance Sheet Data

Restructuring

In connection with our acquisition of Packeteer, we committed to a plan that resulted in the termination of the employment of 33 employees of Blue Coat. Restructuring charges consist primarily of personnel-related severance costs and stock-based compensation expenses. Stock-based compensation included in restructuring resulted primarily from the additional vesting of unvested option shares and restricted shares upon termination of the employment of those employees pursuant to the terms of their separation agreements. The termination of employment of all 33 employees occurred during the first quarter of fiscal 2009, and we recorded a restructuring charge of $1.5 million in our consolidated statements of operations, including $0.1 million of stock-based compensation related to the acceleration of certain equity awards during that quarter. Since inception of the plan through the first quarter of fiscal 2010, we paid severance in the amount of $1.5 million related to this accrual. We did not incur restructuring charges related to this plan in the second quarter of fiscal 2010 and do not anticipate incurring future restructuring charges related to this plan. See Note 13 for information regarding the restructuring plan that initiated in November 2009.

 

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Other Accrued Liabilities

Other accrued liabilities consisted of the following:

 

     As of
     October 31, 2009    April 30, 2009
     (in thousands)

Professional and consulting fees

   $ 1,583    $     2,450

Accrued facility related costs

     1,035      —  

Accrued royalty

     786      2,300

Warranty obligations

     688      876

Sales and marketing costs

     404      883

Lease termination costs

     53      893

Other

     4,307      4,897
             

Total other accrued liabilities

   $     8,856    $ 12,299
             

Deferred Revenue

Deferred revenue consisted of the following:

 

     As of
     October 31, 2009    April 30, 2009
     (in thousands)

Deferred product revenue, current

   $ 1,878    $ 5,263

Deferred service revenue, current

     88,832      91,393
             

Total deferred revenue, current

     90,710      96,656

Deferred service revenue, long-term

     41,877      33,923
             

Total deferred revenue

   $ 132,587    $ 130,579
             

Note 7. Fair Value of Assets and Liabilities

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Cash equivalents and Restricted Cash

The carrying amount of cash and cash equivalents and restricted cash reported on the balance sheet approximates its fair value. The fair values of cash equivalents are based upon quoted market prices.

Convertible Senior Notes

The carrying amount of the Convertible Senior Notes is net of discounts, primarily related to the associated Warrants. The fair value of the Convertible Senior Notes as of October 31, 2009 was determined based on an internal valuation model, which utilized quoted market prices and interest rates for similar instruments, and is approximately $91.5 million. See Note 5 for further information regarding the Convertible Senior Notes and Warrants.

 

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The estimated fair values of our financial instruments are as follows:

 

     As of
     October 31, 2009    April 30, 2009
     Amortized
Cost
   Estimated
Fair Value
   Amortized
Cost
   Estimated
Fair Value

Assets:

           

Cash

   $ 20,975    $ 20,975    $ 15,833    $ 15,833

Money market funds

     121,508      121,508      99,180      99,180
                           
   $ 142,483    $ 142,483    $ 115,013    $ 115,013
                           

Reported as:

           

Assets:

           

Cash and cash equivalents

      $ 141,521       $ 114,163

Long-term restricted cash

        962         850
                   
      $ 142,483       $ 115,013
                   

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy is based on three levels of inputs that may be used to measure fair value, of which the first two are considered observable and the last is considered unobservable. These levels of inputs are the following:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Fair Value Measurements on a Recurring Basis

Our financial instruments are valued using quoted prices in active markets. The following table sets forth the fair value of our financial assets and liabilities that were measured on a recurring basis as of October 31, 2009 and April 30, 2009 (in thousands):

 

     Level 1    Level 2    Level 3    Total

October 31, 2009:

           

Money market funds (1)

   $ 121,508    $     —      $     —      $ 121,508

April 30, 2009:

           

Money market funds (1)

   $ 99,180    $ —      $ —      $ 99,180

 

(1) Included in cash and cash equivalents on our condensed consolidated balance sheets as of October 31, 2009 and April 30, 2009.

Our investments in money market funds are measured at fair value on a recurring basis. Our money market funds comply with Rule 2a-7 of the Investment Company Act of 1940 and are targeted to be priced and have a value of $1 net asset value per share. These money market funds are actively traded and reported daily through a variety of sources. Due to the structure and valuation required by the Investment Company Act of 1940 regarding Rule 2a-7 funds, the fair value of the money market fund investments are classified as Level 1.

 

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Fair Value Measurements on a Nonrecurring Basis

During the quarter ended October 31, 2009, we did not remeasure any nonfinancial assets and liabilities measured at fair value on a nonrecurring basis (e.g., goodwill, intangible assets, property and equipment and nonfinancial assets and liabilities initially measured at fair value in a business combination).

Note 8. Stock-based Compensation

The following table summarizes the stock-based compensation expense for stock options, our Employee Stock Purchase Plan (“ESPP”), restricted stock awards and restricted stock unit awards that we recorded in our condensed consolidated statements of operations for the three and six months ended October 31, 2009 and 2008:

 

     Three Months Ended
October 31,
   Six Months Ended
October 31,
         2009            2008            2009            2008    
     (in thousands)

Stock-based compensation expense:

           

Cost of product

   $ 248    $ 165    $ 463    $ 324

Cost of service

     567      326      942      576

Sales and marketing

     2,070      1,730      3,757      3,251

Research and development

     1,457      1,384      2,989      2,501

General and administrative

     1,185      1,489      2,187      2,691
                           

Subtotal

     5,527      5,094      10,338      9,343

Restructuring

     —        —        —        88
                           

Total

   $ 5,527    $ 5,094    $ 10,338    $ 9,431
                           

We use the Black-Scholes option pricing model to calculate compensation expense. The expected life computation is based on historical exercise patterns and post-vesting termination behavior. We considered our historical volatility and implied volatility in developing our estimate of expected volatility.

For the three and six months ended October 31, 2009 and 2008, we used the following weighted average assumptions to estimate the fair value of stock options granted:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
         2009             2008             2009             2008      

Risk-free rate

   2.40   2.43   2.60   3.14

Expected dividend yield

   —        —        —        —     

Expected life (in years)

   4.80      4.00      4.80      4.00   

Expected volatility

   0.65      0.83      0.66      0.72   

Expected forfeitures

   14.0   14.0   14.0   14.0

For the three and six months ended October 31, 2009 and 2008, we used the following weighted average assumptions to estimate the fair value of shares purchased under our ESPP:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
         2009             2008             2009             2008      

Risk-free rate

   0.23   1.97   0.36   1.90

Expected dividend yield

   —        —        —        —     

Expected life (in years)

   0.50      0.50      0.50      0.50   

Expected volatility

   0.59      0.79      0.72      0.76   

 

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During the three and six months ended October 31, 2009, options to purchase 225,800 shares and 466,460 shares, respectively, were exercised. As of October 31, 2009, there was approximately $25.9 million and $1.0 million of unrecognized stock-based compensation expense related to stock option grants and ESPP awards, respectively, which will be recognized over the remaining weighted average vesting period of approximately 2.8 years and 0.1 years.

The cost of awards of restricted stock and restricted stock units is determined using the fair value of our common stock on the date of the grant, and compensation expense is recognized over the vesting period, which generally is four years. During the second quarter of fiscal 2010, we awarded 10,166 restricted stock units and canceled 27,111 shares of restricted stock awards and 4,576 restricted stock units. As of October 31, 2009, we had approximately $4.0 million and $3.6 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to awards of restricted stock and restricted stock units, respectively, which we will recognize over the remaining weighted average vesting period of approximately 2.5 years and 3.1 years.

Note 9. Income Taxes

The provision for income taxes for the three and six months ended October 31, 2009 was $1.7 million and $2.1 million, respectively, compared with $0.6 million and $1.5 million for the three and six months ended October 31, 2008, respectively. The provision primarily reflects current U.S. federal and state taxes and foreign income taxes in taxable foreign jurisdictions. The primary difference between the effective tax rate and the federal statutory tax rate relates to taxes in foreign jurisdictions with a tax rate different than the U.S. federal statutory rate, non-deductible stock-based compensation expense and the utilization of tax attributes, a temporary suspension of net operating losses under California Assembly Bill 1452 and retroactive renewal and extension of the federal research and development credit under the Emergency Economic Stabilization Act of 2008.

Our total gross unrecognized tax benefits as of October 31, 2009 and April 30, 2009 were $22.4 million and $18.8 million, respectively. The increase was primarily related to uncertainties with respect to the taxation of cross-border arrangements within the group that were recorded in the period. Included in our gross unrecognized tax benefits as of October 31, 2009 are approximately $20.9 million of tax benefits that, if recognized, would result in a reduction to our effective tax rate.

We have elected to classify interest and penalties related to uncertain tax positions as a component of our provision for income taxes. Accrued interest and penalties relating to our unrecognized tax benefits was approximately $1.2 million as of October 31, 2009, including approximately $0.1 million and $0.2 million charged to provision for income taxes for the three and six months ended October 31, 2009, respectively.

Due to our taxable loss position from inception through fiscal year 2007, all tax years are subject to examination in U.S. federal and state jurisdictions. We are also subject to examination in various foreign jurisdictions for tax years 2003 forward, none of which are individually material. We are unable to anticipate the change in the balance of the unrecognized tax benefits in the next twelve months due to the possibility of tax examinations and our continued assessment of potential contingencies.

Note 10. Commitments

Leases

We lease certain office equipment and office facilities under non-cancelable operating leases that expire at various dates through fiscal 2016. The facility leases generally require us to pay operating costs, including property taxes, insurance and maintenance, and may contain scheduled rent increases and certain other rent escalation clauses. Rent expense is recognized in our consolidated financial statements on a straight-line basis over the terms of the respective leases after consideration of rent holidays and improvement allowances, if applicable, with any assets purchased using a lessee improvement allowance capitalized as fixed assets and depreciated over the shorter of their useful lives or the lease term.

 

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Rent expense was $2.5 million and $5.0 million for the three and six months ended October 31, 2009, respectively, and $2.7 million and $4.7 million for the three and six months ended October 31, 2008, respectively.

As of October 31, 2009, future minimum lease payments under non-cancelable operating leases with initial or remaining terms in excess of one year are as follows:

 

Year ending April 30,

   Total
     (in thousands)

2010 (remaining six months)

   $ 4,882

2011

     8,948

2012

     8,598

2013

     8,530

2014

     7,901

Thereafter

     11,794
      

Total future minimum lease payments

   $ 50,653
      

Other

We have firm purchase and other commitments with various suppliers and contract manufacturers to purchase component inventory, manufacturing materials and equipment. These agreements are enforceable and legally binding against us in the short term and all amounts under these arrangements are due to be paid by the end of fiscal 2010. Our minimum obligation under these arrangements at October 31, 2009 was $4.6 million.

Note 11. Litigation

Although we cannot predict the outcome of the IPO allocation cases, the derivative litigations or the patent litigation discussed below, the costs of defending these matters (including, as applicable, our obligations to indemnify current or former officers, directors, employees or customers) could have a material adverse effect on our results of operations and financial condition.

From time to time and in the ordinary course of business, we may be subject to various other claims and litigation. Such claims could result in the expenditure of significant financial and other resources.

IPO Allocation Litigation

Beginning on May 16, 2001, a series of putative securities class actions were filed in the United States District Court for the Southern District of New York against the firms that underwrote our initial public offering, us, and some of our officers and directors. These cases have been consolidated under the case captioned In re CacheFlow, Inc. Initial Public Offering Securities Litigation, Civil Action No. 1-01-CV-5143. In November 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against the firms that underwrote Packeteer’s initial public offering, Packeteer, and some of its officers and directors. An amended complaint, captioned In re Packeteer, Inc. Initial Public Offering Securities Litigation, Civil Action No. 01-CV-10185, was filed on April 20, 2002.

These are two of a number of actions coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, 21 MC 92, with the first action filed on January 12, 2001. Plaintiffs in the coordinated proceeding are bringing claims under the federal securities laws against numerous underwriters, companies, and individuals, alleging generally that defendant underwriters engaged in improper and undisclosed activities concerning the allocation of shares in the IPOs of more than 300 companies during late 1998 through 2000. Among other things, the plaintiffs allege that the underwriters’ customers had to pay excessive brokerage commissions and purchase additional shares of stock in the aftermarket in order to receive favorable allocations of shares in an IPO.

 

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The consolidated amended complaint in our case seeks unspecified damages on behalf of a purported class of purchasers of our common stock between December 9, 1999 and December 6, 2000. Pursuant to a tolling agreement, the individual defendants were dismissed without prejudice. On February 19, 2003, the court denied our motion to dismiss the claims against us.

The amended complaint in the Packeteer case seeks unspecified damages on behalf of a purported class of purchaser’s of Packeteer’s common stock between July 27, 1999 and December 6, 2000.

In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us and Packeteer, was submitted to the Court for approval. On August 31, 2005, the Court preliminarily approved the settlement. In December 2006, the appellate court overturned the certification of classes in the six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceedings. Because class certification was a condition of the settlement, it was deemed unlikely that the settlement would receive final Court approval. On June 25, 2007, the Court entered an order terminating the proposed settlement based upon a stipulation among the parties to the settlement. Plaintiffs have filed amended master allegations and amended complaints in the six focus cases. On March 26, 2008, the Court denied the defendants’ motion to dismiss the amended complaints.

The parties have reached a global settlement of the litigation. Plaintiffs filed a motion for preliminary settlement approval with the Court on April 2, 2009. Under the settlement, the insurers will pay the full amount of settlement share allocated to the Company and Packeteer, and the Company and Packeteer would not bear any financial liability. On October 5, 2009, the Court entered an order granting final approval of the settlement. Certain objectors are seeking to appeal.

Derivative Litigations

Actions Pending Against Us

On May 18, 2005, a purported shareholder derivative action was filed in the Superior Court of California, Santa Clara County, alleging that certain of our officers and directors violated their fiduciary duties to the Company by making false or misleading statements about our prospects between February 20, 2004 and May 27, 2004. On July 17, 2006, plaintiffs filed a consolidated amended complaint, adding allegations that certain current and former officers and directors violated their fiduciary duties to us since our initial public offering by granting and failing to account correctly for stock options. That amended complaint sought various types of relief on our behalf from the individual defendants. On September 8, 2006, another and substantively identical purported shareholder derivative action was filed against certain of our current and former officers and directors. Both of these state derivative cases have been consolidated.

On August 8 and September 5, 2006, two purported shareholder derivative actions were filed in the United States District Court for the Northern District of California against certain of our current and former officers and directors. Like the state derivative actions, the federal derivative actions allege that certain of our current and former officers and directors violated their fiduciary duties since our initial public offering by granting and failing to account correctly for stock options and seek various relief on our behalf from the individual defendants. Both of these federal cases have been consolidated.

On November 30, 2007, the federal and state plaintiffs each filed consolidated amended complaints in their respective actions, which focus on our historical stock option granting practices and assert claims for breach of fiduciary duty and other state and federal law claims against certain of our current and former officers and directors.

The plaintiffs in the federal action, by letter dated June 20, 2008, demanded our Board of Directors take action to remedy the conduct complained of. The demand followed our filing of a motion to dismiss on the grounds that plaintiffs had failed to make a pre-suit demand. The demand letter largely repeats the allegations and requested relief in the federal and state derivative actions. The federal court stayed the action until December 18, 2009 to permit our Board of Directors to consider the demand. In response to the demand letter,

 

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our Board of Directors formed a special committee, composed of directors James R. Tolonen and Keith Geeslin, on June 25, 2008. The special committee was granted plenary authority to decide whether it is in the best interests of the Company and its shareholders to pursue or otherwise resolve the claims raised in the demand letter and in the federal and state derivative actions and any other claims of the Company that the special committee deems necessary or appropriate to consider concerning our historical stock option practices.

The court in the state action has stayed that action pending a case management conference presently scheduled for January 8, 2010.

Action Pending Against Packeteer

On or about October 10, 2007, Vanessa Simmonds, a purported shareholder of Packeteer, filed a complaint in the United States District Court, Western District of Washington, against the underwriters of Packeteer’s 1999 initial public offering of its common stock, seeking recovery in the name of Packeteer for alleged violation by those underwriters of Section 16(b) of the Securities Exchange Act of 1934, as amended. The complaint seeks to recover from the underwriters any “short-swing profits” obtained by them in violation of Section 16(b). Packeteer is named as a nominal defendant. On February 28, 2008, the plaintiff filed an amended complaint asserting substantially similar claims as those set forth in the initial complaint and naming three additional underwriters as defendants.

This is one of 54 actions that were coordinated for pretrial purposes as In re Section 16(b) Litigation, Master Case No. 07-1549 JLR, with the first action filed on October 2, 2007. In July 2008, Packeteer and 29 other nominal defendants moved to dismiss the amended complaint. Packeteer also separately moved to dismiss the action brought against it on the ground that the plaintiff lacks standing to pursue the action because her interest was extinguished when Packeteer merged into our wholly-owned subsidiary on June 6, 2008. The Court heard the motions to dismiss in January 2009. On March 12, 2009, as a consequence of those motions, the Court issued an Order Dismissing Cases and entered judgment dismissing the actions, including the action brought against Packeteer. The Court denied as moot, Packeteer’s separate motion to dismiss.

On March 31, 2009, Simmonds appealed the judgment to the Court of Appeals for the Ninth Circuit, and thereafter filed an amended notice of appeal on April 10, 2009 at the court’s request. The underwriter defendants filed a cross-appeal in each of the cases wherein the issuers moved for dismissal (including the appeal relating to Packeteer’s IPO). The parties have been engaged in briefing the matters to be heard on appeal.

Patent Litigation

On April 18, 2008, Realtime Data, LLC d/b/a IXO (“Realtime”) filed a patent infringement lawsuit in the United States District Court, Eastern District of Texas against Packeteer and eleven other companies, including five customers of Packeteer (Realtime Data, LLC d/b/a IXO v. Packeteer, Inc. et al., Civil Action No. 6:08-cv-144). The complaint asserted infringement of seven patents. Packeteer is alleged to have infringed five of those patents. On June 20, 2008, Realtime filed a First Amended Complaint which asserts infringement of two additional patents. Packeteer is alleged to have infringed one of those patents. The First Amended Complaint also names us as a defendant and asserts that we infringe the same six patents that allegedly are infringed by Packeteer. The plaintiff seeks damages for past infringement, enhanced damages for alleged willful infringement, and injunctive relief. We and Packeteer have denied infringement of the patents, and have counterclaimed against the plaintiff, asserting that all of the patent claims asserted against us are invalid or unenforceable. The Court issued a Memorandum and Order on Claim Construction on June 22, 2009. On July 22, 2009 the Court ruled that Realtime must elect a single patent to assert at Trial against each defendant with all other patent claims held in abeyance. Realtime has elected to assert against Blue Coat a patent that is allegedly infringed by our ProxySG product. The Court denied Realtime’s motion seeking leave to amend its infringement contentions to add additional claims of infringement against our ProxySG product on August 18, 2009. Blue Coat has filed a motion for summary judgment of non-infringement relating to the ProxySG product. This summary judgment motion is currently pending. Trial is set for January 4, 2010.

 

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Note 12. Geographic and Product Category Information Reporting

We conduct business in one operating segment that designs, develops and sells products and services that optimize and secure the delivery of business applications and other information to distributed users over a WAN. Our chief operating decision maker, our chief executive officer, allocates resources and makes operating decisions based on financial data consistent with the presentation in the accompanying condensed consolidated financial statements. Our revenue consists of two product categories: product and service.

Net revenue is attributed to geographic areas based on the location of the customers. The following is a summary of net revenue by geographic area:

 

     Three months ended October 31,  
     2009     2008  
     $    %     $    %  
     (dollars in thousands)  

Americas (1)

   $ 55,255    45.9   $ 61,295    51.5

EMEA (2)

     44,952    37.3        37,586    31.6   

APAC (3)

     20,229    16.8        20,143    16.9   
                          

Total net revenue

   $ 120,436    100.0   $ 119,024    100.0
                          
     Six months ended October 31,  
     2009     2008  
     $    %     $    %  
     (dollars in thousands)  

Americas (1)

   $ 108,560    45.9   $ 103,126    46.5

EMEA (2)

     86,705    36.7        78,857    35.6   

APAC (3)

     41,160    17.4        39,544    17.9   
                          

Total net revenue

   $ 236,425    100.0   $ 221,527    100.0
                          

 

(1) North America, Central America and Latin America (“Americas”)
(2) Europe, Middle East, and Africa (“EMEA”)
(3) Asia and Pacific regions (“APAC”)

The following is a summary of net revenue by product category:

 

     Three months ended October 31,  
     2009     2008  
     $    %     $    %  
     (dollars in thousands)  

Product

   $ 76,502    63.5   $ 84,797    71.2

Service

     43,934    36.5        34,227    28.8   
                          

Total net revenue

   $ 120,436    100.0   $ 119,024    100.0
                          
     Six months ended October 31,  
     2009     2008  
     $    %     $    %  
     (dollars in thousands)  

Product

   $ 150,194    63.5   $ 158,726    71.7

Service

     86,231    36.5        62,801    28.3   
                          

Total net revenue

   $ 236,425    100.0   $ 221,527    100.0
                          

At October 31, 2009, substantially all of our long-lived assets were located in the United States.

 

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Note 13. Subsequent Events

On November 3, 2009, we committed to a restructuring plan, which includes a planned net reduction of approximately 10% of our current headcount over the next two quarters and the closure of three facilities, including two research and development facilities located in Riga, Latvia, and South Plainfield, New Jersey. We plan to consolidate our research and development work at three existing locations—Sunnyvale, California, Draper, Utah and Waterloo, Ontario, Canada—and to open a new location in Bangalore, India. The restructuring commenced on November 4, 2009, and is expected to be completed by the end of the first quarter of fiscal 2011.

These actions were approved as part of our continuing effort to improve our profitability, to realign our research and development activity and resources, and to drive greater productivity throughout our organization.

We expect to incur restructuring charges of $12 to $16 million, including cash outlays of $11 to $14 million. Of the total restructuring charges, we expect to incur $10 to $13 million in charges related to severance and related benefits and $2 to $3 million in charges related to facility closures and consolidations. We expect to incur a majority of these charges in the third quarter of fiscal 2010, and to incur the remainder of the charges by the end of the first quarter of fiscal 2011.

On November 5, 2009, through certain wholly-owned subsidiaries, we entered into a Stock Purchase Agreement with S7 Software Solutions Pvt. Ltd. (“S7”) and its shareholders to acquire all of the shares of S7 for $5.25 million. The transaction is currently expected to be completed in the third fiscal quarter of 2010. The transaction is subject to approval by the Reserve Bank of India.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements that relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements include, but are not limited to, statements concerning the following: expectations with respect to future market growth opportunities; changes in and expectations with respect to revenues and gross margins; future operating expense levels and operating margins; the impact of quarterly fluctuations of revenue and operating results; our ability to achieve expected levels of revenues and profit contributions from acquired businesses; the impact of macroeconomic conditions on our business; the adequacy of our capital resources to fund operations and growth; investments or potential investments in acquired businesses and technologies (including our planned acquisition of S7 Software Solutions Pvt. Ltd.), as well as internally developed technologies; the effectiveness of our direct sales force, distribution channel, and marketing activities, including the realignment of our sales force and changes in our global fulfillment model; the impact of recent changes in accounting standards and assumptions underlying any of the foregoing. In some cases, forward-looking statements are identified by the use of terminology such as “anticipate,” “expect,” “intend,” “plan,” “predict,” “believe,” “estimate,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” or negatives or derivatives of the foregoing, or other comparable terminology.

The forward-looking statements in this Quarterly Report on Form 10-Q involve known and unknown risks, uncertainties and other factors that may cause industry and market trends, or our actual results, level of activity, performance or achievements, to be materially different from any future trends, results, level of activity, performance or achievements expressed or implied by these statements. For a detailed discussion of these risks, uncertainties and other factors, see the “Risk Factors” section under Part II, Item 1A of this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update forward-looking statements to reflect new information or events or circumstances occurring after the date of this Quarterly Report on Form 10-Q.

Overview

We sell a family of proxy appliances and related software and services. Proxy appliances are computer hardware devices that, together with internal software, optimize and secure the delivery of business applications and other information over a Wide Area Network (“WAN”) or across an enterprise’s Internet gateway, where its local computer network links to the public Internet.

In fiscal 2009, we commenced implementation of our business strategy to be the leader in the market for products and services that comprise an Application Delivery Network (“ADN”) infrastructure. We look at an ADN infrastructure as a set of products and services that provides visibility into the business applications operating on a network, as well as optimizing and securing the delivery of those applications. While much of our focus during the past two fiscal years has been in the area of WAN optimization, we believe that our ability to differentiate WAN optimization with our traditional secure web gateway products and technologies and with the application performance monitoring products and technologies we acquired from our acquisition of Packeteer, Inc., in June 2008, is fundamental to our current and continued success.

During the first half of fiscal 2010, we expanded our view of the ADN infrastructure, and refined our business strategy, to include the delivery of ADN functionality through the “cloud,” or as a service that is accessed by end users remotely through the Internet. We also have explored delivery of ADN functionality through software that can serve as a “virtual appliance” on third party hardware products. Additionally, we identified market opportunities in the telecommunications carrier business arising from the need of such carriers either to substantially increase their bandwidth consumption or to adopt other solutions, such as caching technology, where we have substantial expertise. As a consequence, during our second quarter of fiscal 2010 we took steps to reorganize our development and other product-oriented resources into groups focusing on three separate product and market opportunities: ADN appliances and software; cloud-based ADN services: and carrier infrastructure products. We will be implementing this reorganization during the remainder of fiscal 2010.

 

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In addition to reorganizing our product resources, we also recently took steps to re-align our corporate-wide resources in a manner designed both to effectively execute our business strategy and to increase our operating profitability. As a consequence of our present strategy, together with current business exigencies and revenue levels, we committed to a plan of restructuring on November 3, 2009. This plan was formally announced on November 5, 2009, and included a net reduction of approximately 10% of our then current headcount and the closure of three of our smaller remote facilities. We expect to incur restructuring charges of $12 to $16 million over the next several quarters as further disclosed below under “Restructuring Charges.”

We plan to consolidate our research and development activities at three existing facilities and a new facility to be opened in India. We announced that, through certain of our wholly-owned subsidiaries, we had entered into an agreement to acquire all of the shares of S7 Software Solutions (Pvt.) Ltd., a software services company located in Bangalore, India (“S7”), and our intent that S7 serve as our Indian development facility and constitute a platform upon which we would expand our development activities in this lower cost region.

Also in connection with our restructuring activities, we reorganized our services and support to more closely track our new tiered sales model (that assigns sales representatives based on the customer size and opportunity) and to more quickly bring skilled resources to address our customers’ complex problems.

We continue to monitor current global macroeconomic conditions and their actual and anticipated impact on IT spending, generally, and our business, specifically. While we believe that our ADN products offer an attractive return on investment to current and potential customers, the current economy may continue to affect our ability to close sales transactions.

Our sales mix during recent quarters has included an increasing portion of revenue from services, which we believe results in part from customers continuing to use existing IT products and systems rather than purchasing new products, as well as our increased focus on sales of multi-year service contracts, service renewal rates and customer budgets that favor spending on service.

We track many financial metrics as key measures of our business performance, including net revenue, operating margin, deferred revenue, cash flow from operations, and cash position.

Net Revenue

Net revenue, which includes product and service revenue, increased to $120.4 million in the second quarter of fiscal 2010 from $119.0 million in the second quarter of fiscal 2009. Net product revenue in the second quarter of fiscal 2010 was $76.5 million, an $8.3 million decrease compared with the same quarter in fiscal 2009, which we believe was primarily due to the current economy, which has affected our ability to close sales transactions as some customers are postponing or reducing their purchase size as they more carefully scrutinize their IT spending. Net product revenue primarily includes sales of our Proxy and PacketShaper appliances and licenses to our WebFilter product. We recognized $43.9 million in service revenue in the second quarter of fiscal 2010, a $9.7 million increase compared with the same quarter in fiscal 2009. The increase in service revenue was driven primarily by continued growth in our installed base, resulting in an increase in revenue from renewal service contracts.

Operating Margin

Our operating income increased $8.4 million to $10.1 million in the second quarter of fiscal 2010 compared with the second quarter of fiscal 2009. This increase was attributable to the increase in net revenue discussed above, as well as an increase in our gross profit margin from 68.8% in the second quarter of fiscal 2009 to 73.3% in the second quarter of fiscal 2010 and a decrease in operating expenses of $2.1 million in the second quarter of fiscal 2010 compared with that in fiscal 2009. The year-over-year gross margin increase primarily resulted from the application of fair value purchase accounting on Packeteer inventory and deferred revenue, which negatively

 

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impacted the cost of net revenue and service revenue by $11.3 million in total for the second quarter of fiscal 2009 compared with a negative impact of $1.6 million in total for the same period in fiscal 2010. At October 31, 2009, $0.5 million of the fair value write-up on the acquired Packeteer inventory and $1.7 million of the fair value write-down on Packeteer’s deferred service revenue remained to be recognized. Excluding the fair value purchase accounting impact on gross profit in these two periods, gross profit margin in the second quarter of fiscal 2010 would have been approximately 150 basis points lower than that of the same period in fiscal 2009 primarily as a result of changes in product and revenue mix and product pricing.

Operating expenses primarily consist of sales and marketing, research and development, general and administrative expenses, and amortization of intangible assets. Personnel-related costs, including stock-based compensation, are the primary driver of the expenses in each functional area. As of October 31, 2009 we had 1,481 full-time equivalent employees, an increase of 16% from the 1,279 full-time equivalent employees at October 31, 2008. The majority of those headcount increases related to additional personnel in sales and marketing and research and development.

Deferred Revenue

Net deferred revenue was $132.6 million at October 31, 2009 compared with $130.6 million at April 30, 2009. The increase was primarily due to a $6.3 million increase in the sales of new and renewal service contracts to our customers, including an increase in long-term service contracts sold with our appliances, partially offset by a $4.3 million decrease in deferred revenue related to our channel inventory as a result of the change to our direct fulfillment model.

Cash Flow from Operations and Cash Position

For the first six months of fiscal 2010, we generated cash flow from operations of $28.7 million, compared with $28.9 million generated for the same period in fiscal 2009. The decrease in operating cash flow was primarily driven by higher working capital requirements in the current period, offset by higher net income in fiscal 2010 of $12.4 million. Our cash and cash equivalents and restricted cash were $142.5 million at October 31, 2009, compared with $115.0 million at April 30, 2009. The overall increase in our cash and cash equivalents balance was primarily due to the cash generated by operations and net proceeds from issuance of common stock, partially offset by capital purchases during the period.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, net revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to Revenue Recognition, Allowance for Doubtful Accounts, Stock-Based Compensation, Supply Chain Liabilities and Valuation of Inventory, Acquisitions, Goodwill and Identifiable Intangible Assets, Income Taxes, and Legal and Other Contingencies. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and such differences could be material.

We have discussed the development and selection of critical accounting policies and estimates with the audit committee of our board of directors. We believe the accounting policies described below are those that most frequently require us to make estimates and judgments that materially affect our financial statements and that are critical to the understanding of our financial condition and results of operations:

 

   

Revenue Recognition

 

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Allowance for Doubtful Accounts

 

   

Stock-Based Compensation

 

   

Supply Chain Liabilities and Valuation of Inventory

 

   

Acquisitions, Goodwill and Identifiable Intangible Assets

 

   

Income Taxes

 

   

Legal and Other Contingencies

Revenue Recognition

Our products include stand-alone software and software that is essential to the functionality of our appliances. Additionally, we provide unspecified software upgrades, on a when-and-if available basis, through maintenance contracts for most of our products. We recognize revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery or performance has occurred; the sales price is fixed or determinable; and collection is probable.

We define each of the four criteria above as follows:

Persuasive evidence of an arrangement exists. Evidence of an arrangement generally consists of customer purchase orders and, in certain instances, sales contracts or agreements.

Delivery or performance has occurred. We use shipping and related documents, or written evidence of customer acceptance, when applicable, to verify delivery or performance.

For direct sales to end-users, value-added resellers and distributors that do not have stock rotation rights, we recognize product revenue upon transfer of title and risk of loss, which generally is upon shipment. We do not accept orders from value-added resellers when we are aware that the value-added reseller does not have an order from an end user customer. We generally do not have significant obligations for future performance, such as rights of return or pricing credits, associated with sales to end users and value-added resellers.

The sales price is fixed or determinable. We assess whether the sales price is fixed or determinable based on payment terms and whether the sales price is subject to refund or adjustment.

Collection is probable. We assess probability of collection on a customer-by-customer basis. We subject our customers to a credit review process that evaluates their financial condition and ability to pay for our products and services. If we conclude that collection is not probable based upon our initial review, we do not recognize revenue until cash is received.

For arrangements that include multiple elements, such as appliances, maintenance or software, we use the residual method to recognize revenue for the delivered elements. Under the residual method, the amount of revenue allocated to delivered elements equals the total arrangement consideration less the aggregate fair value of any undelivered elements, provided that vendor specific objective evidence (“VSOE”) of fair value exists for all undelivered elements. VSOE of fair value is based on the price charged when the element is sold separately. We analyze our stand alone maintenance renewals by stratification of sales channel and service offering. We determine the VSOE of fair value for maintenance by analyzing our stand alone maintenance renewals and noting that a substantial majority of transactions fall within a narrow range for each stratum. In limited cases, VSOE of fair value has been based on management determined prices. If evidence of the fair value of one or more undelivered elements does not exist, all revenue is generally deferred and recognized at the earlier of delivery of those elements or establishment of fair value for the remaining undelivered elements. When VSOE of fair value cannot be determined for any undelivered maintenance, subscription or service element, revenue for the entire arrangement is recognized ratably over the maintenance, subscription or service period.

 

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Maintenance and subscription revenue is initially deferred and recognized ratably over the life of the contract, with the related expenses recognized as incurred. Maintenance and subscription contracts usually have a term of one to three years. Unearned maintenance and subscription revenue is included in deferred revenue.

Allowance for Doubtful Accounts

We perform ongoing credit evaluations of our customers’ financial condition and maintain an allowance for doubtful accounts. We analyze accounts receivable and historical bad debts, customer geographic concentrations, customer solvency, current economic and geographic trends, and changes in customer payment terms and practices when evaluating the adequacy of such allowance, and record any required changes in the allowance account to general and administrative expense. We write off accounts receivable when they are deemed to be uncollectible.

Stock-Based Compensation

Effective May 1, 2006, we adopted the fair value recognition provisions of Accounting Standards Codification (“ASC”) No. 718, Compensation—Stock Compensation, (“ASC 718”, formerly FASB Statement No. 123(R)) using the modified prospective transition method. Under that transition method, compensation expenses recognized beginning on that date include: (a) compensation expense for all unvested share-based payments granted prior to May 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123; and (b) compensation expense for all share-based payments granted on or after May 1, 2006, based on the grant date fair value estimated in accordance with the provisions of ASC 718. We use the Black-Scholes option valuation model to calculate compensation expense.

The Black-Scholes option valuation model requires the input of highly subjective assumptions, including the expected term of options, the expected price volatility of the stock underlying such options, the risk-free interest rate, and the expected forfeiture rate.

Supply Chain Liabilities and Valuation of Inventory

We outsource our manufacturing, product fulfillment and repair operations to contract manufacturers, and a significant portion of our cost of net revenue is a result of this activity. Our contract manufacturers procure components and manufacture our products based on demand forecasts that we prepare. These forecasts are based on estimates of future product demand and are adjusted for overall market conditions. If the actual product demand is significantly lower than forecasted, we may be required to write down our inventory or accrue for excess supply chain liability, which could have an adverse impact on our gross margins and profitability.

Inventory consists of raw materials and finished goods. Inventory is recorded at the lower of cost (using the first-in, first-out method) or market, after we give appropriate consideration to obsolescence and inventory in excess of anticipated future demand. In assessing the ultimate recoverability of inventory, we are required to make estimates regarding future customer demand, last time buy decisions, the timing of new product introductions, economic trends and market conditions.

Acquisitions, Goodwill and Identifiable Intangible Assets

We account for acquired businesses using the purchase method of accounting, which requires that the assets acquired, liabilities assumed, contractual contingencies and contingent consideration be recorded at the date of acquisition at their respective fair values. Any excess of the purchase price over the estimated fair values of net assets acquired is recorded as goodwill. It further requires acquisition-related costs to be recognized separately from the acquisition and expensed as incurred, restructuring costs to be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period to impact the provision for income taxes. In addition, acquired in-process research and development is capitalized as an intangible asset and amortized over its estimated useful life.

 

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The fair value of identifiable intangible assets is based on significant judgments made by management. We typically engage third party valuation appraisal firms to assist us in determining the fair values and useful lives of the assets acquired. Such valuations and useful life determinations require us to make significant estimates and assumptions. These estimates and assumptions are based on historical experience and information obtained from the management of the acquired companies, and also include, but are not limited to, future expected cash flows earned from the product related technology and discount rates applied in determining the present value of those cash flows. Unanticipated events and circumstances may occur that could affect the accuracy or validity of such assumptions, estimates or actual results. Acquisition-related identifiable intangible assets are amortized on a straight-line basis over their estimated economic lives, which are three to seven years for developed technology and patents, five years for core technology, five to seven years for customer relationships and two years for trade name.

We perform goodwill impairment tests annually during our fourth fiscal quarter, and whenever events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. The first step of the test identifies whether potential impairment may have occurred, and the second step of the test measures the amount of the impairment, if any. An impairment of goodwill is recognized when the carrying amount of the assets exceeds their fair value. The process of evaluating the potential impairment of goodwill is highly subjective and requires the application of significant judgment. For purposes of the annual impairment test, we consider our market capitalization compared with the carrying amount of our assets on the date of the test, since we have only one reporting unit. We performed our annual review of goodwill in the fourth quarter of fiscal 2009 and concluded that no impairment existed at April 30, 2009. During the first six months of fiscal 2010, there were no significant events or changes of circumstances that affect our valuation of goodwill.

We periodically evaluate potential impairments of our long-lived assets, including identifiable intangible assets. We evaluate long-lived assets, including identifiable intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events or changes in circumstances that could result in an impairment review include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for our overall business, and significant negative industry or economic trends. Impairment is recognized when the carrying amount of an asset exceeds its fair value as calculated on a discounted cash flow basis.

Income Taxes

We use the liability method to account for income taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. This process involves determining our income tax expense and calculating the deferred income tax expense related to temporary difference resulting from the differing treatment of items for tax and accounting purposes, such as deferred revenue or deductibility of the amortization of certain intangible assets. These temporary differences result in deferred tax assets or liabilities, which are included within the consolidated balance sheets.

We record a valuation allowance to reduce certain deferred tax assets to an amount that we estimate is more likely than not to be realized. We consider estimated future taxable income and prudent tax planning strategies in determining the need for a valuation allowance. When we determine that it is more likely than not that some or all of our deferred tax assets will be realizable by either refundable income taxes or future taxable income, the valuation allowance will be reduced and the related tax impact will be recorded as a reduction to the tax provision in that quarter. Likewise, should we determine that we are not likely to realize all or part of our deferred tax assets in the future, an increase to the valuation allowance would be recorded as an increase to the tax provision in the period such determination was made.

As a multinational corporation, we conduct our business in many countries and are subject to taxation in many jurisdictions. The taxation of our business is subject to the application of multiple and conflicting tax laws

 

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and regulations as well as multinational tax conventions. Our effective tax rate is highly dependent upon the geographic distribution of our worldwide earnings or losses, the tax regulations and tax holidays in each geographic region, the availability of tax credits and carryforwards, and the effectiveness of our tax planning strategies. The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws themselves are subject to change as a result of changes in fiscal policy, changes in legislation, and the evolution of regulations and court rulings. Consequently, taxing authorities may impose tax assessments or judgments against us that could materially impact our tax liability and/or our effective income tax rate.

We use a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more likely than not to be realized upon settlement. We review our uncertain tax benefits quarterly, and we may adjust such uncertain tax benefits because of proposed assessments by tax authorities, changes in facts and circumstances, issuance of new regulations or new case law, previously unavailable information obtained during the course of an examination, negotiations with tax authorities of different countries concerning our transfer pricing, resolution with respect to individual audit issues/audit years, or expiration of statutes of limitations. In addition, our tax contingency reserve includes certain amounts for potential tax assessments for pre-acquisition tax years of acquired companies, which, if recognized, will be recorded to our provision for income taxes.

Legal and Other Contingencies

We are currently involved in various claims and legal proceedings. We review the status of each significant matter and assess our potential financial exposure on a quarterly basis. We record a charge equal to at least the minimum estimated liability for damages arising from litigation or other loss contingencies only when both of the following conditions are met: (i) information available prior to issuance of our consolidated financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements and (ii) the range of loss can be reasonably estimated. As additional information becomes available, we reassess the potential liability related to pending loss contingencies and may revise our estimates. Such revisions in the estimates of the potential liabilities could have a material impact on our results of operations and financial position.

 

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Results of Operations

The following table sets forth, as a percentage of net revenue, condensed consolidated statements of operations data for the periods indicated:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
         2009             2008             2009             2008      

Net revenue:

        

Product

   63.5   71.2   63.5   71.7

Service

   36.5   28.8   36.5   28.3
                        

Total net revenue

   100.0   100.0   100.0   100.0

Cost of net revenue:

        

Product

   16.0   21.1   16.4   21.3

Service

   10.7   10.1   10.6   9.9
                        

Total cost of net revenue

   26.7   31.2   27.0   31.2

Gross profit

   73.3   68.8   73.0   68.8

Operating expenses:

        

Sales and marketing

   37.9   37.8   38.6   40.0

Research and development

   16.2   17.0   16.7   17.3

General and administrative

   9.3   11.2   10.1   11.0

Amortization of intangible assets

   1.5   1.5   1.5   1.4

Restructuring

   —        —        —        0.7
                        

Total operating expenses

   64.9   67.5   66.9   70.4
                        

Operating income (loss)

   8.4   1.3   6.1   (1.6 )% 

Interest income

   0.1   0.1   0.1   0.2

Interest expense

   (0.2 )%    (0.0 )%    (0.2 )%    (0.0 )% 

Other income (expense), net

   0.1   (1.1 )%    0.1   (0.7 )% 
                        

Income (loss) before income taxes

   8.4   0.3   6.1   (2.1 )% 

Provision for income taxes

   1.4   0.5   0.9   0.7
                        

Net income (loss)

   7.0   (0.2 )%    5.2   (2.8 )% 
                        

Net Revenue

Net revenue includes product and service revenue. Net product revenue primarily includes sales of our Proxy and PacketShaper appliances and licenses to our WebFilter product. Net service revenue primarily includes sales of new and renewal service contracts and sales of third party software. Although it is generally our practice to promptly ship products upon receipt of properly finalized purchase orders based on our published shipping lead times, we occasionally have orders that have not shipped or have otherwise not met all the required criteria for revenue recognition at the end of the quarter. In some of these cases, we may exercise discretion over the timing of shipments, which affects the timing of revenue recognition for those orders. In such cases, we consider a number of factors, including: our operational capacity to fulfill orders at the end of the quarter; our published shipment lead times; the delivery dates requested by customers and resellers; the effect of the related revenue on our business plan; the amount of orders shipped and received in the quarter; and the concentration orders received at the end of the quarter.

 

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The following is a summary of net revenue and the changes in net revenue:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2009     2008     2009     2008  
     (dollars in thousands)  

Total net revenue

   $ 120,436      $ 119,024      $ 236,425      $ 221,527   

Change from same period prior year ($)

   $ 1,412      $ 45,599      $ 14,898      $ 85,699   

Change from same period prior year (%)

     1.2     62.1     6.7     63.1

Quarter Ended October 31, 2009 compared with Quarter Ended October 31, 2008: Net revenue, which includes product and service revenue, increased $1.4 million, or 1.2%, in the second quarter of fiscal 2010 compared with the same period in fiscal 2009. Net product revenue in the second quarter of fiscal 2010 was $76.5 million, an $8.3 million decrease compared with the same quarter in fiscal 2009, which we believe was primarily due to the current economy, which has affected our ability to close sales transactions as some customers are postponing or reducing their purchase size as they more carefully scrutinize their IT spending. In addition, we experienced a lower average transaction size in the largest transactions compared with the comparable prior year in the Americas. Net service revenue in the second quarter of fiscal 2010 was $43.9 million, a $9.7 million increase compared with the same period in fiscal 2009. The increase in service revenue was the result of continued growth in our installed base and a resulting increase in revenue from renewal service contracts. As our installed base continues to grow, we expect the proportion of revenue generated from services to increase.

Six Months Ended October 31, 2009 compared with Six Months Ended October 31, 2008: Net revenue, which includes product and service revenue, increased $14.9 million, or 6.7%, in the first six months of fiscal 2010 compared with the same period in fiscal 2009. Net product revenue in the first six months of fiscal 2010 was $150.2 million, an $8.5 million decrease compared with the same period in fiscal 2009, which we believe was primarily due to the current economy, which has affected our ability to close sales transactions as some customers are postponing or reducing their purchase size as they more carefully scrutinize their IT spending. Net service revenue in the first six months of fiscal 2010 was $86.2 million, a $23.4 million increase compared with the same period in fiscal 2009. The increase in service revenue was the result of continued growth in our installed base and the resulting increase in revenue from renewal service contracts.

The following is a summary of net revenue by geographic area:

 

     Three months ended October 31,  
     2009     2008  
     $    %     $    %  
     (dollars in thousands)  

Americas (1)

   $ 55,255    45.9   $ 61,295    51.5

EMEA (2)

     44,952    37.3        37,586    31.6   

APAC (3)

     20,229    16.8        20,143    16.9   
                          

Total net revenue

   $ 120,436    100.0   $ 119,024    100.0
                          
     Six months ended October 31,  
     2009     2008  
     $    %     $    %  
     (dollars in thousands)  

Americas (1)

   $ 108,560    45.9   $ 103,126    46.5

EMEA (2)

     86,705    36.7        78,857    35.6   

APAC (3)

     41,160    17.4        39,544    17.9   
                          

Total net revenue

   $ 236,425    100.0   $ 221,527    100.0
                          

 

(1) North America, Central America and Latin America (“Americas”)
(2) Europe, Middle East, and Africa (“EMEA”)
(3) Asia and Pacific regions (“APAC”)

 

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Revenues from customers outside of the Americas continued to be a significant part of our revenue mix. For the three and six months ended October 31, 2009, approximately 54.1% of our total net revenue was derived from customers outside of the Americas compared with 48.5% and 53.5% for the three and six months ended October 31, 2008.

Net revenue in the Americas decreased $6.0 million in the second quarter of fiscal 2010, down 9.9% compared with the same period in fiscal 2009. This decrease was driven by a $9.8 million decrease in product revenue primarily because of a lower average transaction size in the largest transactions compared with the comparable prior year period. This decline was offset by a $3.8 million increase in service revenue driven by continued growth in our installed base, resulting in an increase in revenue from renewal service contracts. Net revenue in the Americas for the six months ended October 31, 2009 increased $5.4 million, up 5.3% compared with the same period in fiscal 2009, driven by an increase in product revenue in the first quarter of fiscal 2010 primarily from sales of our Proxy appliances and an increase in service revenue driven by continued growth in our installed base, resulting in an increase in sales of renewal service contracts.

Net revenue in EMEA increased $7.4 million in the second quarter of fiscal 2010, up 19.6% from the same period in fiscal 2009. This increase was driven by a $3.4 million increase in product revenue primarily from sales our Proxy appliances in addition to a $4.0 million increase in service revenue driven by continued growth in our installed base, resulting in an increase in revenue from renewal service contracts. Net revenue in EMEA for the six months ended October 31, 2009 increased $7.8 million, up 10.0% compared with the same period in fiscal 2009 for similar reasons as previously noted.

Net revenue in APAC increased $0.1 million in the second quarter of fiscal 2010, up 0.4% from the same period in fiscal 2009. We believe that the rate of revenue growth in APAC from the second quarter of fiscal 2009 to the same period in fiscal 2010 was static because of unfavorable economic conditions in APAC. The $1.8 million decline in product revenue was offset by a $1.9 million increase in service revenue driven by continued growth in our installed base, resulting in an increase in revenue from renewal service contracts. Net revenue in APAC for the six months ended October 31, 2009 increased $1.6 million, up 4.1% compared with the same period in fiscal 2009 for similar reasons as previously noted.

Gross Profit

The following is a summary of gross profit:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2009     2008     2009     2008  
     (dollars in thousands)  

Gross profit

   $ 88,228      $ 81,887      $ 172,697      $ 152,323   

Gross profit margin

     73.3     68.8     73.0     68.8

Quarter Ended October 31, 2009 compared with Quarter Ended October 31, 2008: Gross profit increased $6.3 million, or 7.7%, in the second quarter of fiscal 2010 compared with the same period of fiscal 2009, as a result of an increase in net revenue and related gross profit margin. Gross profit margin in the second quarter of fiscal 2010 increased to 73.3% from 68.8% in the second quarter of fiscal 2009, primarily as a result of the application of fair value purchase accounting on Packeteer inventory and deferred revenue, which negatively impacted the cost of net revenue and service revenue by $11.3 million in total for the second quarter of fiscal 2009 compared with a negative impact of $1.6 million in total for the same period in fiscal 2010. Excluding the fair value purchase accounting impact on gross profit in these two periods, gross profit margin in the second quarter of fiscal 2010 would have been approximately 150 basis points lower than that of the same period in fiscal 2009 primarily as a result of changes in product and revenue mix and product pricing. Included in the current quarter is an inventory write-down related to excess quantity of a component part of the PacketShaper appliance, which negatively impacted gross profit margin by 0.5%.

 

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Six Months Ended October 31, 2009 compared with Six Months Ended October 31, 2008: Gross profit increased $20.4 million, or 13.4%, in the first six months of fiscal 2010 compared with the same period of fiscal 2009, as a result of an increase in net revenue and related gross profit margin. Gross profit margin in the first six months of fiscal 2010 increased to 73.0% from 68.8% in the first six months of fiscal 2009, primarily as a result of the application of fair value purchase accounting on Packeteer inventory and deferred revenue, which negatively impacted the cost of net revenue and service revenue by $20.8 million in total for the first six months of fiscal 2009 compared with a negative impact of $3.9 million in total for the same period in fiscal 2010.

We currently expect gross margins to improve in fiscal 2010 compared with fiscal 2009 due to a continued lower impact on cost of net revenue and service revenue from the remaining Packeteer fair value purchase accounting adjustments, which materially impacted gross margins in fiscal 2009.

Sales and Marketing

Sales and marketing expense consists primarily of salaries and benefits, commissions, travel, advertising and promotional expenses. The following is a summary of sales and marketing expense:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2009     2008     2009     2008  
     (dollars in thousands)  

Sales and marketing

   $ 45,608      $ 44,952      $ 91,184      $ 88,600   

Sales and marketing as a percentage of net revenue

     37.9     37.8     38.6     40.0

Quarter Ended October 31, 2009 compared with Quarter Ended October 31, 2008: Sales and marketing expense increased $0.7 million, or 1.5%, in the second quarter of fiscal 2010 compared with the second quarter of fiscal 2009. The increase in sales and marketing expense was primarily attributable to a $2.1 million increase in salaries and benefits as a result of higher headcount and related expenses, including increased commission payments offset by lower travel expenses. The second quarter of fiscal 2009 included $1.6 million of Packeteer integration and transition related costs. Sales and marketing headcount was 546 at October 31, 2009 and 489 at October 31, 2008.

Six Months Ended October 31, 2009 compared with Six Months Ended October 31, 2008: Sales and marketing expense increased $2.6 million, or 2.9%, in the first six months of fiscal 2010 compared with the first six months of fiscal 2009. The increase in sales and marketing expense was primarily attributable to a $5.7 million increase in salaries and benefits as a result of higher headcount and related expenses, including commission payments as well as an increase in various other sales and marketing expenses to promote our Application Delivery Network strategy and market position. The first six months of fiscal 2009 included $3.6 million of Packeteer integration and transition related costs.

For the remainder of fiscal 2010, we currently expect sales and marketing expense to decline in absolute dollars and as a percentage of net revenue compared to the first half of fiscal 2010 as a result of our recently announced global restructuring plan and as we continue to manage our discretionary spending.

Research and Development

Research and development expense consists primarily of salaries and benefits, prototype costs, and testing equipment costs. The following is a summary of research and development expense:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2009     2008     2009     2008  
     (dollars in thousands)  

Research and development

   $ 19,568      $ 20,171      $ 39,404      $ 38,358   

Research and development as a percentage of net revenue

     16.2     17.0     16.7     17.3

 

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Quarter Ended October 31, 2009 compared with Quarter Ended October 31, 2008: Research and development expense decreased $0.6 million, or 3.0%, in the second quarter of fiscal 2010 compared with the same period in fiscal 2009. The decrease in research and development expense from the second quarter of fiscal 2009 was largely attributable to the second quarter of fiscal 2009 including $1.6 million of Packeteer integration and transition related costs with no comparable costs in the current period. This decrease was offset by a $1.1 million increase in salaries and benefits as a result of higher headcount in the second quarter of fiscal 2010 compared with the same period in fiscal 2009. The research and development headcount was 425 at October 31, 2009 compared with 335 at October 31, 2008.

Six Months Ended October 31, 2009 compared with Six Months Ended October 31, 2008: Research and development expense increased $1.0 million, or 2.7%, in the first six months of fiscal 2010 compared with the same period in fiscal 2009. The increase in research and development expense from the first six months of fiscal 2009 was largely attributable to a $3.5 million increase in salaries and benefits as a result of higher headcount. The first six months of fiscal 2009 included $3.0 million of Packeteer integration and transition related costs.

We believe that continued investment in product enhancements and new product development is critical to achieving our strategic objectives in fiscal 2010. We currently expect research and development expense to be approximately flat in absolute dollars and to decline slightly as a percentage of net revenue compared to the first half of fiscal 2010. Although we recently announced a global restructuring plan and acquisition of S7, we do not expect to see a decline in research and development expenses for the remainder of fiscal 2010 as a majority of the headcount impacted by the restructuring plan is on transition through the end of the fiscal year.

General and Administrative

General and administrative expense consists primarily of salaries and benefits, legal services, accounting and audit services, and other general corporate expenses. The following is a summary of general and administrative expense:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2009     2008     2009     2008  
     (dollars in thousands)  

General and administrative

   $ 11,176      $ 13,281      $ 23,892      $ 24,314   

General and administrative as a percentage of net revenue

     9.3     11.2     10.1     11.0

Quarter Ended October 31, 2009 compared with Quarter Ended October 31, 2008: General and administrative expense decreased $2.1 million, or 15.8%, in the second quarter of fiscal 2010 compared with the second quarter of fiscal 2009. The decrease was primarily due to the second quarter of fiscal 2009 including a $1.2 million charge for bad debt expense with no comparable charge in the current period as well as $0.8 million of Packeteer integration and transition related costs.

Six Months Ended October 31, 2009 compared with Six Months Ended October 31, 2008: General and administrative expense decreased $0.4 million, or 1.7%, in the first six months of fiscal 2010 compared with the first six months of fiscal 2009. The decrease was primarily due to the second quarter of fiscal 2009 including a $1.2 million charge for bad debt expense with no comparable charge in the current period as well as $1.7 million of Packeteer integration and transition related costs, offset by a $3.0 million increase in salaries, benefits and occupancy related charges as a result of higher headcount.

For the remainder of fiscal 2010, we currently expect general and administrative expenses to be approximately flat in absolute dollars and to decline slightly as a percentage of net revenue compared to the first half of fiscal 2010 due to lower headcount as a result of our recently announced global restructuring plan.

 

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Amortization of Intangible Assets

We completed the acquisition of Packeteer on June 6, 2008. The acquired intangible assets associated with the Packeteer acquisition consist of developed technology and patents, customer relationships and trade name. Developed technology is comprised of products that have reached technological feasibility and are a part of Packeteer’s product lines, and patents related to the design and development of Packeteer’s products. Customer relationships represent Packeteer’s underlying relationships with its customers. Trade name represents the fair value of brand and name recognition associated with the marketing of Packeteer’s products and services. The amounts assigned to customer relationships, developed technology and patents, and trade name were $35.0 million, $20.0 million, and $0.4 million, respectively. We amortize customer relationships, developed technology and patents, and trade name on a straight-line basis over their weighted average expected useful lives of 5, 5, and 2 years, respectively.

For the three and six months ended October 31, 2009 and 2008, the amortization of intangible assets was related to our acquisitions of Packeteer, certain assets of the NetCache business from Network Appliance, Permeo, Inc., Cerberian, Inc. and Ositis Software, Inc. The amortization of developed technology, core technology, patents and trade name is charged to cost of net revenue, while the amortization of customer relationships is charged to operating expense. Total amortization expense for our identifiable intangible assets for the three and six months ended October 31, 2009 was $3.2 million and $6.3 million, respectively, and $3.2 million and $5.3 million for the three and six months ended October 31, 2008, respectively. Amortization expense related to intangible assets in the remaining six months of fiscal 2010 is expected to be $6.1 million.

Restructuring Charges

In connection with our acquisition of Packeteer, we committed to a plan that resulted in the termination of the employment of 33 employees of Blue Coat. Restructuring charges consist primarily of personnel-related severance costs and stock-based compensation expenses. Stock-based compensation included in restructuring resulted primarily from the additional vesting of unvested option shares and restricted shares upon termination of the employment of those employees pursuant to the terms of their separation agreements. The termination of employment of all 33 employees occurred during the first quarter of fiscal 2009, and we recorded a restructuring accrual of $1.5 million in our consolidated statements of operations, including $0.1 million of stock-based compensation related to the modification of certain equity awards during that quarter. Since inception of the plan through the first quarter of fiscal 2010, we have paid severance in the amount of $1.5 million related to this accrual. We did not incur restructuring charges related to this plan in the second quarter of fiscal 2010 and do not anticipate incurring future restructuring charges related to this plan.

On November 3, 2009, we committed to a restructuring plan, which includes a planned net reduction of approximately 10% of our current headcount over the next two quarters and the closure of three facilities, including two research and development facilities located in Riga, Latvia, and South Plainfield, New Jersey. We plan to consolidate our research and development work at three existing locations—Sunnyvale, California, Draper, Utah and Waterloo, Ontario, Canada—and to open a new location in Bangalore, India. The restructuring plan was initiated on November 4, 2009, and is expected to be completed by the first quarter of fiscal 2011. We expect to incur restructuring charges of $12 to $16 million, including cash outlays of $11 to $14 million. Of the total restructuring charges, we expect to incur $10 to $13 million in charges related to severance and related benefits and $2 to $3 million in charges related to facility closures and consolidations. We expect to incur a majority of these charges in the third quarter of fiscal 2010, and to incur the remainder of the charges by the end of the first quarter of fiscal 2011.

Interest Income, Interest Expense and Other Income (Expense), Net

Interest income consists of interest income earned on our cash and marketable securities. Cash has historically been invested in highly liquid investments such as time deposits held at major banks, commercial paper, U.S. government agency discount notes, money market mutual funds and other money market securities

 

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with maturities at the date of purchase of 90 days or less. At October 31, 2009, our cash was invested in money market mutual funds. Interest expense relates to amortization of the fair value of warrants and a beneficial conversion feature associated with our Convertible Senior Notes. Other income (expense), net consists primarily of foreign currency exchange gains or losses, banking fees, and non-recurring gains or losses realized outside our normal course of business. The following is a summary of interest income, interest expense and other income (expense), net:

 

     Three Months Ended
October 31,
    Six Months Ended
October 31,
 
     2009     2008     2009     2008  
     (dollars in thousands)  

Interest income

   $ 72      $ 349      $ 173      $ 851   

Interest expense

   $ (227   $ (232   $ (455   $ (389

Other income (expense), net

   $ 155      $ (1,353   $ 139      $ (1,540

Quarter Ended October 31, 2009 compared with Quarter Ended October 31, 2008: Interest income decreased for the second quarter of fiscal 2010 compared with the same period of fiscal 2009 as a result of a significant decrease in our average investment yield due to lower interest rates as our cash and cash equivalents are invested in money market funds. Interest expense was essentially flat in the second quarter of fiscal 2010 compared with the second quarter of fiscal 2009. Other income (expense), net increased during the second quarter of fiscal 2010 compared with the same period in fiscal 2009, because of a reduction in foreign exchange losses as fluctuations between the U.S. dollar and certain foreign currencies were less significant in the second quarter of fiscal 2010 as compared with the same period of fiscal 2009.

Six Months Ended October 31, 2009 compared with Six Months Ended October 31, 2008: Interest income decreased for the first six months of fiscal 2010 compared with the same period of fiscal 2009 for similar reasons as discussed above. Interest expense increased in the first six months of fiscal 2010 due to the recognition of a full six months of amortization of the fair value of warrants and the beneficial conversion feature associated with the Convertible Senior Notes compared with five months of amortization in the first six months of fiscal 2009. Other income (expense), net increased during the first six months of fiscal 2010 compared with the same period in fiscal 2009 for similar reasons as discussed above.

Provision for Income Taxes

The provision for income taxes for the three and six months ended October 31, 2009 was $1.7 million and $2.1 million, respectively, compared with $0.6 million and $1.5 million for the three and six months ended October 31, 2008, respectively. The provision primarily reflects current U.S. federal and state taxes and foreign income taxes in taxable foreign jurisdictions. The primary difference between the effective tax rate and the federal statutory tax rate relates to taxes in foreign jurisdictions with a tax rate different than the U.S. federal statutory rate, non-deductible stock-based compensation expense and the utilization of tax attributes, a temporary suspension of net operating losses under California Assembly Bill 1452 and retroactive renewal and extension of the federal research and development credit under the Emergency Economic Stabilization Act of 2008.

Our total gross unrecognized tax benefits as of October 31, 2009 and April 30, 2009 were $22.4 million and $18.8 million, respectively. The increase is primarily related to uncertainties with respect to the taxation of cross-border arrangements within the group that were recorded in the period. Included in our gross unrecognized tax benefits as of October 31, 2009 are approximately $20.9 million of tax benefits that, if recognized, would result in a reduction to our effective tax rate.

We have elected to classify interest and penalties related to uncertain tax positions as a component of our provision for income taxes. Accrued interest and penalties relating to our unrecognized tax benefits was approximately $1.2 million as of October 31, 2009, including approximately $0.1 million and $0.2 million charged to provision for income taxes for the three and six months ended October 31, 2009, respectively.

 

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Due to our taxable loss position from inception through fiscal year 2007, all tax years are subject to examination in U.S. federal and state jurisdictions. We are also subject to examination in various foreign jurisdictions for tax years 2003 forward, none of which are individually material. We are unable to anticipate the change in the balance of the unrecognized tax benefits in the next twelve months due to the possibility of tax examinations and our continued assessment of potential contingencies.

Liquidity and Capital Resources

Since our inception, we have financed our operations and capital expenditures through cash provided by operating activities, private sales of preferred and common stock, bank loans, equipment leases, private sales of convertible notes and warrants and an initial public offering of our common stock.

Cash Equivalents and Restricted Cash

We consider all highly liquid investments with insignificant interest rate risk and original maturities of three months or less to be cash equivalents. We determine the appropriate classification of our investments at the time of purchase and evaluate such designation as of each balance sheet date based on our intent and whether it is more likely than not that we will be required to sell the instrument before recovery of its amortized cost basis. To date, all of our investments have been classified as available-for-sale and are carried at fair value, with unrealized gains and losses, excluding the portion relating to credit loss, if any, included in accumulated other comprehensive income (loss) in stockholders’ equity. The fair value of these securities is determined based on quoted market prices in active markets.

As of October 31, 2009, we had cash and cash equivalents of $141.5 million and restricted cash of $1.0 million. We believe our existing cash and cash equivalents and anticipated cash from operations will be sufficient to meet our operating requirements for at least the next twelve months, including working capital requirements and capital expenditures. We may seek to raise additional capital to strengthen our financial condition, facilitate expansion and pursue strategic acquisitions or investments, or to take advantage of other business opportunities as they arise.

The following summarizes cash and cash equivalents and restricted cash:

 

     As of
October 31, 2009
    As of
April 30, 2009
 
     (dollars in thousands)  

Cash and cash equivalents

   $ 141,521      $ 114,163   

Restricted cash

     962        850   
                

Total cash and cash equivalents and restricted cash

   $ 142,483      $ 115,013   
                

Percentage of total assets

     24.2     20.5
                

Should prevailing economic conditions or financial, business and other factors beyond our control adversely affect our future cash requirements, or if cash is used for unanticipated purposes, we may need additional capital sooner than expected. Although we believe that we can achieve our planned cash flow for fiscal 2010, we cannot guarantee such achievement. As well, given the current uncertainty in debt and equity capital markets, we cannot guarantee that, should it be required, sufficient debt or equity capital will be available to us under acceptable terms, if at all. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our existing stockholders will be reduced.

 

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Cash Flow:

 

     Six Months Ended
October 31,
 
     2009     2008  
     (in thousands)  

Cash provided by operating activities

   $ 28,743      $ 28,864   

Cash used in investing activities

     (10,854     (179,423

Cash provided by financing activities

     9,469        86,529   
                

Net increase (decrease) in cash and cash equivalents

   $ 27,358      $ (64,030
                

Cash Flows from Operating Activities: Our largest source of operating cash flows is cash collected from our customers who purchase our products and services. Our primary uses of cash from operating activities are for personnel related costs, product costs, and facilities costs.

Net cash provided by operating activities was $28.7 million for the first six months of fiscal 2010, compared with $28.9 million in the same period of fiscal 2009. Although the net cash provided by operating activities was relatively flat for the first six months of fiscal 2010 compared with the prior year same period, there were significant differences in the operating activities in the two comparable periods. The first six months of fiscal 2010 had significantly higher net income offset by working capital uses of cash including a decrease in accounts payable due to timing of payments to our vendors, a decrease in other accrued liabilities due to payments made in connection with our Packeteer acquisition, and the buy-out of an existing license agreement. The first six months of fiscal 2009 included a net loss and net sources of cash from working capital including an increase in accounts receivable primarily attributable to higher revenues associated with the Packeteer acquisition and a decrease in other accrued liabilities primarily due to the unpaid balance of transaction costs associated with the Packeteer acquisition, offset by an increase in deferred revenue primarily attributable to additional deferred revenue recorded in connection with the Packeteer acquisition and an increase in inventory primarily attributable to higher finished goods inventory held as a result of the Packeteer acquisition.

Cash Flows from Investing Activities: The changes in cash flows from investing activities primarily relate to acquisitions and purchases of property and equipment.

Net cash used by investing activities was $10.9 million for the first six months of fiscal 2010, compared with $179.4 million in the same period last year. The higher use of cash for investing activities in the first six months of fiscal 2009 was primarily due to cash used to purchase Packeteer of $169.3 million, net of cash acquired. The net cash used by our investing activities for the first six months of fiscal 2010 primarily consisted of purchases of property and equipment, primarily leasehold improvements and computer and office equipment.

Cash Flows from Financing Activities: The changes in cash flows from financing activities primarily relate to proceeds from issuance of debt obligations as well as proceeds from issuances of common stock.

Net cash provided by financing activities was $9.5 million for the first six months of fiscal 2010, compared with $86.5 million provided in the same period last year. The increase in cash provided by financing activities in the first six months of fiscal 2009 was primarily due to the net proceeds of $79.7 million from our issuance of convertible notes. The net cash provided by our financing activities for the first six months of fiscal 2010 primarily consisted of the proceeds from the exercise of employee stock options and purchases of our stock under our employee stock purchase plan.

We continue to maintain a minimum amount of cash and cash equivalents for operational purposes and to invest the remaining amount of our cash in interest bearing and highly liquid cash equivalents and short-term investments.

 

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Convertible Senior Notes

On June 2, 2008, we issued $80.0 million aggregate principal amount of Zero Coupon Convertible Senior Notes due June 2, 2013 (the “Convertible Senior Notes”) and warrants (the “Warrants”) to purchase an aggregate of 385,356 shares of our common stock at an exercise price of $20.76 to Manchester Securities Corp., an affiliate of Elliott Associates, L.P. (“Manchester”) and Francisco Partners II, L.P. and Francisco Partners Parallel Fund II, L.P. (together, the “FP Entities”) in a private placement. The Convertible Senior Notes are reported on the condensed consolidated balance sheets at $76.8 million as of October 31, 2009, net of discounts of $3.2 million primarily related to the Warrants. The value assigned to the Warrants is amortized to interest expense over the life of the Convertible Senior Notes.

Contractual Obligations

Leases

We lease certain office equipment and office facilities under non-cancelable operating leases that expire at various dates through 2016. The facility leases generally require us to pay operating costs, including property taxes, insurance and maintenance, and contain scheduled rent increases and certain other rent escalation clauses. Rent expense is recognized in our consolidated financial statements on a straight-line basis over the terms of the respective leases after consideration of rent holidays and improvement allowances, if applicable. Any assets purchased using a lessee improvement allowance are capitalized as fixed assets and depreciated over the shorter of their useful lives or the lease term.

As of October 31, 2009, future minimum lease payments under non-cancelable operating leases with initial or remaining terms in excess of one year are as follows:

 

Year ending April 30,

   Total
     (in thousands)

2010 (remaining six months)

   $ 4,882

2011

     8,948

2012

     8,598

2013

     8,530

2014

     7,901

Thereafter

     11,794
      

Total future minimum lease payments

   $ 50,653
      

Other

We have firm purchase and other commitments with various suppliers and contract manufacturers to purchase component inventory, manufacturing materials and equipment. These agreements are enforceable and legally binding against us in the short term and all amounts under these arrangements are due to be paid by the end of fiscal 2010. Our minimum obligation under these arrangements at October 31, 2009 was $4.6 million.

Off-Balance Sheet Arrangements

As of October 31, 2009, we did not have any material off-balance sheet arrangements.

Recent Accounting Pronouncements

For information with respect to recent accounting pronouncements and the impact of these pronouncements on our consolidated financial statements, see Note 1 of Notes to Condensed Consolidated Financial Statements.

 

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are subject to certain market risks, including changes in exchange rates and interest rates. We do not undertake any specific actions to cover our exposures to exchange and interest rate risks, and we are not a party to any risk management transactions. We also do not purchase or hold any derivative financial instruments for hedging, speculative or trading purposes.

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. As of October 31, 2009, we had cash and cash equivalents of $141.5 million and restricted cash of $1.0 million. These amounts are primarily held in money market funds. We maintain a strict investment policy, which is intended to enhance the safety and preservation of our invested funds by limiting default risk, market risk and reinvestment risk. The fair value of our investment portfolio would not be significantly impacted by either a 100 basis point increase or decrease in market interest rates, given the short-term nature of the majority of our investment portfolio.

Foreign Currency Exchange Rate Risk

We primarily develop products in the United States and sell them throughout the world. As a result, our financial results are affected by factors such as changes in foreign currency exchange rates and economic conditions in foreign markets. Because all of our sales are currently billed and collected in U.S. dollars, a strengthening of the dollar could potentially make our products less price-competitive in foreign markets. Since a significant portion of our net revenue and earnings are derived from international operations, this could adversely affect our net revenue and earnings. For the three and six months ended October 31, 2009, approximately 54.1% of our total net revenue was derived from customers outside of the Americas. In contrast, substantially all of the expenses of operating our foreign subsidiaries are incurred in foreign currencies, which we consider to be an insignificant portion of our total operating expenses. As a result, our U.S. dollar earnings and net cash flows from international operations may be affected by changes in foreign currency exchange rates. The currency exchange risks associated with our international operations have been material in the past and could be material in the future.

Item 4. Controls and Procedures

Under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial and Accounting Officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this report (the “Evaluation Date”). Based on this evaluation, our Principal Executive Officer and Principal Financial and Accounting Officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to Blue Coat, including our consolidated subsidiaries, required to be disclosed in our SEC reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to Blue Coat’s management, including our Principal Executive Officer and Principal Financial and Accounting Officer, as appropriate to allow timely decisions regarding required disclosure.

Under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial and Accounting Officer, we conducted an evaluation of any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during our most recently completed fiscal quarter. Based on that evaluation, our Principal Executive Officer and Principal Financial and Accounting Officer concluded that there has not been any change in our internal control over financial reporting during that quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The information set forth above under Note 11 contained in the “Notes to Condensed Consolidated Financial Statements” is incorporated herein by reference.

Item 1A. Risk Factors

In addition to the other information contained in this Quarterly Report on Form 10-Q, the following risk factors should be carefully considered by investors before making an investment decision. Our business, financial condition and results of operations could be seriously harmed as a consequence of any of the following risks and uncertainties. The trading price of our common stock could decline due to any of these risks, and investors may lose all or part of their investment. These risks and uncertainties are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem less significant also may impair our business, financial condition and results of operations, or result in a decline in the trading price of our common stock.

We have updated certain risk factors affecting our business since those presented in our Annual Report on Form 10-K, Part I, Item 1A, for the fiscal year ended April 30, 2009, to reflect our current business operations. We also have added two risk factors to those presented in our Annual Report on Form 10-K, Part I, Item 1A, for the fiscal year ended April 30, 2009. These risk factors are set forth at the end of this section and reflect the implementation of our recently announced plan of global restructuring and our planned acquisition of S7.

Our quarterly operating results fluctuate significantly, are difficult to predict and may not meet our guidance or third party expectations.

Our net revenue and operating results have in the past, and may in the future, vary significantly from quarter to quarter due to a number of factors, many of which are outside of our control, including the current economic environment and market uncertainty. These factors limit our ability to accurately predict our operating results on a quarterly basis and include factors discussed throughout this “Risk Factors” section, including the following:

 

   

Macroeconomic conditions in our market, either domestic or international, as well as the level of discretionary IT spending;

 

   

The timing, size and mix of orders from customers, including the timing of large orders;

 

   

Fluctuations in demand for our products and services;

 

   

The markets in which we compete are evolving;

 

   

Variability and unpredictability in the rate of growth in the markets in which we compete;

 

   

Our ability to continue to increase our market share consistent with past rates of increase;

 

   

Our variable sales cycles, which may lengthen as the complexity of products and competition in our market increases and as a consequence of the current economic environment;

 

   

The level of competition in our markets, including the consequences of new entrants, consolidation, technological innovation or substantial price discounting;

 

   

Market acceptance of our new products and product enhancements and our services;

 

   

Product announcements, introductions, transitions and enhancements by us or our competitors, and resulting in deferrals of customer orders;

 

   

Technological changes in our markets;

 

   

The quality and level of our execution of our business strategy and operating plan;

 

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The level of industry consolidation among our competitors and customers;

 

   

The impact of future acquisitions or divestitures;

 

   

Changes in accounting rules and policies; and

 

   

The need to recognize certain revenue ratably over a defined period or to defer revenue recognition to a later period.

A high percentage of our expenses, including those related to manufacturing overhead, service and support, research and development, sales and marketing, and general and administrative functions are generally fixed in nature in the short term. As a result, if our net revenue is less than forecasted, such expenses cannot effectively be reduced to compensate for the revenue shortfall and our quarterly operating results will be adversely affected.

We believe that quarter-to-quarter comparisons of our operating results should not necessarily be relied upon as indicators of our future performance. In the past our quarterly results have on occasion failed to meet our quarterly guidance and the expectations of public market analysts or investors, and it is likely that this will occur in the future. If this occurs our stock price likely will decline, and may decline significantly. Such a decline may also occur even when we meet our published guidance, but our results or future guidance fail to meet third party expectations.

Economic uncertainty and adverse macroeconomic conditions may harm our business.

Our revenues and margins are dependent on various economic factors, including rates of inflation, currency fluctuations, energy costs, levels of consumer sentiment and other macroeconomic factors, which may impact levels of business spending. These conditions, including the current uncertainties in the global credit markets, may adversely affect corporate spending for IT products and services in specific geographies or more broadly, and could result in:

 

   

a significant reduction in our net revenue, gross margin and operating margin;

 

   

increased price competition for our products and services;

 

   

risk of excess and obsolete inventory;

 

   

higher overhead costs as a percentage of net revenue;

 

   

difficulty in accurately forecasting demand for our products and services;

 

   

insolvency or credit difficulties confronting our customers and channel partners, affecting their ability to purchase or pay for our products and services; and

 

   

insolvency or credit difficulties confronting our key suppliers, which could disrupt our supply chain.

In addition, a significant percentage of our operating expenses are generally fixed in nature, particularly in the short term, which could limit our ability to mitigate any negative impact on our profit margins.

Recent adverse economic and market conditions in the United States and globally have resulted in delays in closing customer orders and such delays may continue in the future. Continued uncertainty or deterioration in these macroeconomic conditions could materially impact our business, financial condition and results of operations.

The market for Application Delivery Network infrastructure products and services is intensely competitive and certain of our competitors have greater resources.

Our products and services focus on the emerging market for Application Delivery Network infrastructure products and services. This market is intensely competitive, and the intensity of this competition is expected to increase, particularly given current economic pressures and industry consolidation. Such increased competition

 

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may result in price reductions, reduced margins and loss of market share, any one of which could seriously impact our business, financial condition and results of operations. We may not be able to compete successfully against current or future competitors, including those resulting from consolidation, and we cannot be certain that the competitive pressures we face will not seriously impact our business. In addition, we expect that there will be competition from other established and emerging companies as the market for Application Delivery Network infrastructure products and services continues to develop and expand.

Some of our current and potential competitors have longer operating histories; significantly greater financial, technical, sales and marketing resources; significantly greater name recognition; and a larger installed base of customers than we do. Such competitors also may have well-established relationships with our current and potential customers and extensive knowledge of our industry. As a result, those competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, marketing, promotion and sale of their products than we can. They also may make strategic acquisitions or establish cooperative relationships among themselves or with other providers, thereby increasing their ability to provide a broader suite of products, and potentially causing customers to defer purchasing decisions. Also, larger competitors may be able to integrate some of the functionality of our products into existing infrastructure products or to bundle Application Delivery Network infrastructure products and services with other product offerings. Finally, they may engage in aggressive pricing strategies or discounting. Any of the foregoing may limit our ability to compete effectively in the market and adversely affect our business, financial condition and results of operations.

We rely significantly on third party sales channel partners to sell our products.

Substantially all of our revenue is generated through sales by our channel partners, which include distributors and value-added resellers. During fiscal 2009 and the first six months of fiscal 2010, approximately 98% of our revenue was generated through our channel partners. We depend upon these partners to generate sales opportunities and to independently manage the sales process for opportunities with which they are involved. In order to increase our net revenue, we will need to maintain our existing sales channel partners and to add new sales channel partners and effectively train and integrate them with our sales process. If we are unsuccessful in those efforts, this will limit our ability to grow our business and our business, financial condition and results of operations will be adversely affected.

Our products are complex, and there can be no assurance that the sales training programs that are offered to our sales channel partners will always be effective. In addition, our sales channel partners may be unsuccessful in marketing, selling and supporting our products and services for reasons unrelated to training. Most of our sales channel partners do not have minimum purchase or resale requirements, and may cease selling our products at any time. They may also market, sell and support products and services that are competitive with ours, and may devote more resources to the marketing, sales and support of products competitive to ours. There is no assurance that we will retain these sales channel partners or that we will be able to secure additional or replacement sales channel partners in the future. The loss of one or more of our key sales channel partners in a given geographic area could harm our operating results within that area, as new sales channel partners typically require extensive training and take several months to achieve acceptable productivity.

We also depend on some of our sales channel partners to deliver first line service and support for our products. Any significant failure on their part to provide such service and support could impact customer satisfaction and future sales of our products. We historically have recognized a portion of our revenue based on a sell-through model using information provided by our distributors that stock our products. If we are provided with inaccurate or untimely information, the amount, timing or accuracy of our reported net revenue could be affected.

While we require that our third party sales channel partners comply with applicable regulatory requirements, they could engage in behavior or practices that expose us to legal or reputational risk.

 

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We depend on single and, in some cases, limited source suppliers for several key products and components of products.

We have limited sources of supply for certain key components of our products, which exposes us to the risk of component shortages or unavailability. In addition, we are unable to rapidly change quantities and delivery schedules because the procurement of certain components is subject to lengthy lead times and the qualification of additional or alternate sources is time consuming, costly and difficult. In the event our business growth exceeds our projections, or required components are otherwise in scarce supply, we may be subject to shortages, delays or unavailability of such components, or potential price increases, which may be substantial. If we are unable to secure sufficient components at reasonable prices in order to timely build our products, customer shipments may be delayed. This would adversely affect both our relationships with those customers and our net revenue. Alternatively, we may pay increased prices, which would impact our gross margin. Any of the foregoing could adversely affect our business, financial condition and results of operations.

We are dependent on original design manufacturers, contract manufacturers and third party logistics providers to design and manufacture our products and to fulfill orders for our products.

We depend primarily on original design manufacturers (each of which is a third party original design manufacturer for numerous companies) to co-design and co-develop the hardware platform for our products. We also depend on independent contract manufacturers (each of which is a third party manufacturer for numerous companies) to manufacture and fulfill our products. These supply chain partners are not committed to design or manufacture our products, or to fulfill orders for our products, on a long-term basis in any specific quantity or at any specific price. Also, from time to time, we may be required to add new supply chain partner relationships or new manufacturing or fulfillment sites to accommodate growth in orders or the addition of new products. It is time consuming and costly to qualify and implement new supply chain partner relationships and new manufacturing or fulfillment sites, and such additions increase the complexity of our supply chain management. Our ability to ship products to our customers could be delayed if we fail to effectively manage our supply chain partner relationships; if one or more of our design manufacturers does not meet our development schedules; if one or more of our contract manufacturers experiences delays, disruptions or quality control problems in manufacturing our products; or if one or more of our third party logistics providers experiences delays or disruptions or otherwise fails to meet our fulfillment schedules; or if we are required to add or replace design manufacturers, contract manufacturers, third party logistics providers or fulfillment sites. In addition, these supply chain partners have access to certain of our critical confidential information and could wrongly disclose such information. Moreover, an increasing portion of our manufacturing is performed outside the United States and is, therefore, subject to risks associated with doing business in foreign countries. Each of these factors could adversely affect our business, financial condition and results of operations.

If we fail to accurately predict our manufacturing requirements and manage our supply chain we could incur additional costs or experience manufacturing delays that could harm our business.

We provide forecasts of our requirements to our supply chain partners on a rolling 12-month basis. If our forecast exceeds our actual requirements, a supply chain partner may assess additional charges or we may have liability for excess inventory, each of which could negatively affect our gross margin. If our forecast is less than our actual requirements, the applicable supply chain partner may have insufficient time or components to produce or fulfill our product requirements, which could delay or interrupt manufacturing of our products or fulfillment of orders for our products, and result in delays in shipments, customer dissatisfaction, and deferral or loss of revenue. As well, we may be required to purchase sufficient inventory to satisfy our future needs in situations where a component or product is being discontinued. If we fail to accurately predict our requirements, we may be required to record charges for excess inventory that we and our supply chain partners cannot use or we may be unable to fulfill customer orders. Any of the foregoing could adversely affect our business, financial condition and results of operations.

 

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We may not be able to successfully manage the growth of our business and may suffer other losses if we are unable to improve our systems and processes.

Our growth, including growth through the acquisition of Packeteer, together with evolving regulatory requirements and changes in financial standards, has placed increased demands on our management and our business infrastructure. We need to continue to improve our systems and processes to effectively manage our operations and growth, including our growth into new geographies. We may not be able to successfully implement improvements to these systems and processes in a timely or efficient manner. As well, our systems and processes may not prevent or detect all errors, omissions or fraud. Our failure to improve our systems and processes, or their failure to operate in the intended manner, may result in our inability to manage the growth of our business and to accurately forecast our revenue, expenses and earnings, or to prevent certain losses. This could adversely affect our business, financial condition and results of operations.

Third parties may bring legal actions against us.

As described in Note 11 of Notes to Condensed Consolidated Financial Statements, we presently are a party to various litigation, including stockholder derivative actions arising out of allegedly misleading statements about our prospects made between February 20, 2004 and May 27, 2004, which actions were subsequently amended to seek relief on our behalf from certain defendants with respect to our historical stock option practices. As well, on or about April 18, 2008, Realtime Data, LLC d/b/a IXO filed a patent infringement lawsuit against Packeteer, Inc., a company we acquired on June 6, 2008, and subsequently amended the complaint and named us as a defendant on June 20, 2008. We have incurred substantial costs to defend these lawsuits, or to engage in related proceedings, on our behalf and on behalf of parties to whom we may have indemnification obligations.

It is likely that in the future other parties may bring legal actions against us. Such actions, even if without merit, could harm our business. Any material litigation or arbitration inevitably results in the diversion of the attention of our management and other relevant personnel. To the extent uninsured, such claims further require the expenditure of our resources for defense costs for us and for parties to whom we may have indemnification obligations. We also may be required to pay material amounts in settlement costs or damages. As well, if the matter relates to intellectual property infringement, we may be required to enter into royalty or licensing agreements or to develop non-infringing technology, and injunctive relief could be entered against us. Customer concerns with respect to material litigation can result in delayed or lost sales. Any of the foregoing could seriously harm our business and have a material adverse effect on our business, financial condition and results of operations.

Our gross margin is affected by a number of factors, and we may not be able to sustain it at present levels.

Our gross margin percentage has been and will continue to be affected by a variety of factors, including:

 

   

market acceptance of our products and fluctuations in demand;

 

   

the timing, size and mix of customer orders and product implementations;

 

   

increased service revenue due to a growing installed base which is historically at lower margins than our product margins;

 

   

increased price competition and changes in product pricing;

 

   

actions taken by our competitors;

 

   

new product introductions and enhancements;

 

   

manufacturing and component costs;

 

   

availability of sufficient inventory to meet demand;

 

   

purchase of inventory in excess of demand;

 

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our execution of our strategy and operating plans;

 

   

changes in our sales model;

 

   

geographies in which sales are made; and

 

   

revenue recognition rules.

For example, we have in the past entered into large revenue transactions with certain customers that, because of the product mix and volume discount, have decreased our gross margin percentage. We may, in the future, enter into similar transactions. As well, our lower end appliances typically have lower margins than our higher end appliances, and therefore large orders for our lower end appliances could negatively impact our overall gross margin percentage. Macroeconomic and competitive developments could put further pressure on our gross margin.

Even if we achieve our net revenue and operating expense objectives, our net income and operating results may be below our expectations and the expectations of investors and analysts if our gross margins are below expectations.

Our products or services may be found to infringe third party intellectual property rights.

Third parties have in the past and may in the future claim that our current or future products or services infringe their intellectual property rights, and these claims, even if without merit, could harm our business by increasing our costs, reducing our net revenue or by creating customer concerns that result in delayed or reduced sales. This is particularly true in the patent area, as an increasing number of U.S. patents covering computer networking and Internet technology have been issued in recent years. Patent owners, including those that do not commercially manufacture or sell products, may claim that one or more of our products infringes a patent they own. For example, on or about April 18, 2008, Realtime Data, LLC d/b/a IXO filed a patent infringement lawsuit against Packeteer, Inc., a company we acquired on June 6, 2008, and certain of its customers, and subsequently amended the complaint and named us as a defendant on June 20, 2008 (see Note 11 in the Condensed Consolidated Financial Statements).

We expect that companies in the Internet and networking industries will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims could be time-consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements, or to develop non-infringing technology. As well, injunctive relief could be entered against us or trade restrictions could be imposed. Any of the foregoing could seriously harm our business, financial condition and results of operations.

We must anticipate market needs, and develop and introduce new products and enhancements to rapidly meet those needs.

To maintain our competitive position in a market characterized by rapid rates of technological advancement, we must correctly anticipate market requirements and invest our research and development resources to meet those requirements. The introduction of new products by others, market acceptance of products based on new or alternative technologies, or the emergence of new industry standards, could render our existing products obsolete or make it easier for other products to compete with our products. Our future success will depend in part upon our ability to:

 

   

develop and maintain competitive products;

 

   

enhance our products by adding innovative features that differentiate our products from those of our competitors;

 

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bring products to market on a timely basis at competitive prices;

 

   

identify and respond to emerging technological trends in the market; and

 

   

respond effectively to new technological changes or new product announcements by others.

There is no guarantee that we will accurately predict the direction in which the market for Application Delivery Network infrastructure products and services will evolve. Failure on our part to anticipate the direction of this market and to develop products, enhancements and service offerings that meet the needs of this market will significantly impair our business, financial condition and results of operations.

Our internal investments in research and development may not yield the benefits we anticipate.

The success of our business is predicated on our ability to create new products and technologies and to anticipate future market requirements and applicable industry standards. The process of developing new technologies is time consuming, complex and uncertain, and requires commitment of significant resources well in advance of being able to fully determine market requirements and industry standards. Furthermore, we may not be able to timely execute new product or technical initiatives because of errors in product planning or timing, technical difficulties that we cannot timely resolve, or a lack of appropriate resources. This could result in competitors bringing products to market before we do and a consequent decrease in our market share and net revenue. Our inability to timely and cost-effectively introduce new products and product enhancements, or the failure of these new products or enhancements to achieve market acceptance and comply with industry standards, could seriously harm our business, financial condition and results of operations. Additionally, our introduction of new products and product enhancements could result in the obsolescence of previously purchased or committed inventory, which would reduce our net income.

We must continue to develop market awareness of our market, our company and our products and services.

We have focused our business strategy and investments on the market for Application Delivery Network infrastructure products and services. Our marketing efforts are directed at creating awareness of this new and evolving market, how it addresses specific customer requirements, and our participation in the market and the value and capabilities of our products and services.

Market awareness is essential to our continued growth and our success. If our advertising and marketing programs are not successful in creating market awareness of the need for Application Delivery Network infrastructure products and services—and the value and capabilities of our specific products and services—we may not be able to achieve sustained growth. Moreover, if the market for Application Delivery Network infrastructure products and services fails to grow as we anticipate, we may not be able to sell as many of our products and services as we currently project, which would result reduce our anticipated net revenue and could result in a decline in our stock price.

Product quality problems may result in delayed market acceptance, additional costs, reduced sales or litigation.

Our products are highly complex and may contain undetected operating errors or quality problems when first introduced or as new versions or upgrades are released. Despite testing by us and by current and potential customers, errors or quality problems may not be found in new products or new versions until after commencement of commercial shipments, resulting in customer dissatisfaction and loss of or delay in market acceptance and sales opportunities. This could materially adversely affect our operating results. These errors and quality problems could also cause us to incur significant warranty costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems. In addition, all of our products operate on our internally developed operating system. As a result, any error in the operating system may affect all of our products. We have experienced errors or quality problems in the past in connection

 

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with new products and enhancements to existing products. We expect that errors or quality problems will be found from time to time in new or enhanced products after commencement of commercial shipments, which could seriously harm our business.

Since our end user customers install our appliances directly into their network infrastructures, any errors, defects or other problems with our products could negatively impact their networks or other Internet users, resulting in financial or other losses. While we typically seek by contract to limit our exposure to damages, it is possible that such limitations might not exist or might not be enforced in the event of a product liability claim. Moreover, a product liability claim brought against us, even if not successful, would likely be time-consuming and costly and could seriously harm the reputation of our business and products.

Our ability to sell our products depends on the quality of our support and services offerings.

Our products are provided as part of an Application Delivery Network infrastructure, which is important to the ability of our end user customers to effectively use their networks. Our end user customers look to us and, as applicable, to our channel partners to ensure that our products are properly configured and installed, and efficiently and effectively operate within their networks. To the extent we or our channel partners fail to effectively assist our end user customers in their efforts to deploy and operate our products, or fail to timely and adequately address product problems, it may adversely affect our ability to sell our products to those customers in the future and could harm our business and product reputation and impact other sales. Failure to maintain high quality support and services may harm our business, financial condition and results of operations.

Our acquisitions may not provide the benefits we anticipate and may disrupt our existing business.

In the past, we have acquired other businesses, including our acquisition of Packeteer, Permeo Technologies, Inc. and our acquisition of certain assets of the NetCache business from Network Appliance, Inc. We have recently announced that we plan to acquire S7, a research and development outsourcing firm located in Bangalore, India, and it is likely we will acquire additional businesses or assets in the future. There is no guaranty that such acquisitions will yield the benefits we anticipate. The success of any acquisition is impacted by a number of factors, and may be subject to the following risks:

 

   

inability to successfully integrate the operations, technologies, products and personnel of the acquired companies;

 

   

diversion of management’s attention from normal daily operations of the business;

 

   

loss of key employees; and

 

   

substantial transaction costs.

Acquisitions may also result in risks to our existing business, including:

 

   

dilution of our current stockholders’ percentage ownership to the extent we issue new equity;

 

   

assumption of additional liabilities;

 

   

incurrence of additional debt or a decline in available cash;

 

   

adverse effects to our financial statements, such as the need to make large and immediate write-offs or the incurrence of restructuring and other related expenses;

 

   

liability for intellectual property infringement and other litigation claims, which we may or may not be aware of at the time of acquisition; and

 

   

creation of goodwill or other intangible assets that could result in significant amortization expense or impairment charges.

The occurrence of any of the above risks could seriously impact our business, financial condition and results of operations.

 

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We must attract, assimilate and retain key personnel on a cost-effective basis.

We depend on our ability to attract and retain highly qualified and skilled personnel on an ongoing basis. Our success will depend in part on our ability to recruit and retain key personnel.

The majority of our employees, including our senior management personnel, are employed on an “at-will” basis, which may make it easier for key employees to move to new employment. Our inability to timely hire replacement or additional employees may impact our operations, since new hires, particularly sales personnel, frequently require extensive training before they achieve desired levels of productivity. This may affect our ability to grow our net revenue.

Our international operations expose us to risks.

We currently have operations in a number of foreign countries. In fiscal 2009, 55.0% of our total net revenue was derived from customers outside of the Americas and during the first six months of fiscal 2010 54.1% of our total net revenue was derived from customers outside of the Americas; thus, our business is substantially dependent on economic conditions and IT spending in markets outside the Americas. The expansion of our international operations and entry into additional international markets requires significant management attention and financial resources, and subjects us to certain inherent risks including:

 

   

technical difficulties and costs associated with product localization;

 

   

challenges associated with coordinating product development efforts among geographically dispersed areas;

 

   

potential loss of proprietary information due to piracy, misappropriation or laws that may be less protective of our intellectual property rights;

 

   

our limited experience in establishing a sales and marketing presence, together with the appropriate internal systems, processes and controls, in certain geographic markets;

 

   

longer payment cycles for sales in certain foreign countries;

 

   

seasonal reductions in business activity in the summer months in Europe and at other times in various countries;

 

   

the significant presence of some of our competitors in some international markets;

 

   

potentially adverse tax consequences or changes in applicable tax laws;

 

   

import and export restrictions and tariffs and other trade protection initiatives;

 

   

potential failures of our foreign employees to comply with both U.S. and foreign laws, including antitrust laws, trade regulations and the Foreign Corrupt Practices Act;

 

   

compliance with foreign laws and other government controls, such as those affecting trade, privacy, the environment and employment;

 

   

management, staffing, legal and other costs of operating an enterprise spread over various countries;

 

   

fluctuations in foreign exchange rates;

 

   

political or economic instability, war or terrorism in the countries where we are doing business; and

 

   

fears concerning travel or health risks that may adversely affect our ability to sell our products and services in any country in which the business sales culture encourages face-to-face interactions.

To the extent we are unable to effectively manage our international operations and these risks, our international sales may be adversely affected, we may incur additional and unanticipated costs, and we may be subject to litigation or regulatory action. As a consequence, our business, financial condition and results of operations could be seriously harmed.

 

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Forecasting our estimated annual effective tax rate is complex and subject to uncertainty, and there may be material differences between our forecasted and actual tax rates.

Forecasts of our income tax position and effective tax rate are complex and subject to uncertainty because our income tax position for each year combines the effects of a mix of profits and losses earned by us and our subsidiaries in various tax jurisdictions with a broad range of income tax rates, as well as changes in the valuation of deferred tax assets and liabilities, the impact of various accounting rules and changes to these rules and tax laws, the results of examinations by various tax authorities, and the impact of any acquisition, business combination or other reorganization or financing transaction. To forecast our global tax rate, we estimate our pre-tax profits and losses by jurisdiction and forecast our tax expense by jurisdiction. If the mix of profits and losses, our ability to use tax credits, or effective tax rates by jurisdiction is different than those estimated, our actual tax rate could be materially different than forecasted, which could have a material impact on our results of business, financial condition and results of operations.

As a multinational corporation, we conduct our business in many countries and are subject to taxation in many jurisdictions. The taxation of our business is subject to the application of multiple and conflicting tax laws and regulations as well as multinational tax conventions. Our effective tax rate is highly dependent upon the geographic distribution of our worldwide earnings or losses, the tax regulations and tax holidays in each geographic region, the availability of tax credits and carryforwards, and the effectiveness of our tax planning strategies. The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws themselves are subject to change as a result of changes in fiscal policy, changes in legislation, and the evolution of regulations and court rulings. Consequently, taxing authorities may impose tax assessments or judgments against us that could materially impact our tax liability and/or our effective income tax rate.

In addition, we may be subject to examination of our income tax returns by the Internal Revenue Service and other tax authorities. If tax authorities challenge the relative mix of U.S. and international income, our future effective income tax rates could be adversely affected. While we regularly assess the likelihood of adverse outcomes from such examinations and the adequacy of our provision for income taxes, there can be no assurance that such provision is sufficient and that a determination by a tax authority will not have an adverse effect on our business, financial condition and results of operations.

Our internal investments in our sales organization may not yield the benefits we anticipate.

We have continued to increase the size of our sales force in order to invest for future growth even during the current economic downturn, and have recently tiered the structure of our sales force. We will not immediately realize the benefits of investments in new sales personnel, as it typically takes a number of quarters before a sales person becomes fully productive. In addition, the realignment of our sales force may not yield the intended sales coverage and efficiencies. Should the market for Application Delivery Network infrastructure products and services not grow as anticipated, including as a result of further deterioration in the U.S. and global economies, the return on these investments may be lower than we have projected, which would adversely affect our business, financial condition and results of operations.

We rely on technology that we license from third parties, including software that is integrated with internally developed software and used with our products.

We rely on technology that we license from third parties, including third party commercial software and open source software that is used with certain of our products. If we are unable to continue to license any of this software on commercially reasonable terms, we will face delays in releases of our software or we will be required to delete this functionality from our software until equivalent technology can be licensed or developed and integrated into our current product. In addition, the inability to obtain certain licenses or other rights might require us to engage in litigation regarding these matters, which could have a material adverse effect on our business, financial condition and results of operations.

 

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We issued convertible notes to fund our acquisition of Packeteer, which could impact our liquidity.

We issued zero coupon convertible senior notes in an aggregate principal amount of $80 million that mature in 2013, in order to acquire Packeteer. If these notes are not converted prior to maturity we will be required to repay the principal amount, and may not have funds available to do so. As well, the notes contain certain conditions of default and, should a default occur, the holders of the notes may be able to require early payment of the notes.

We may be unable to raise additional capital.

We believe that our available cash, cash equivalents and short term investments will enable us to meet our capital requirements for at least the next 12 months. However, if cash is required for unanticipated needs, including payment of our zero coupon convertible senior notes in the event of default, we may need additional capital during that period. The development and marketing of new products and our investment in sales and marketing efforts requires a significant commitment of resources. If the market for our products develops at a slower pace than anticipated, we could be required to raise substantial additional capital. Given the current dislocation in debt and equity capital markets, we cannot guarantee that, should it be required, sufficient debt or equity capital will be available to us under acceptable terms, if at all. If we were unable to raise additional capital when required, our business, financial condition and results of operations could be seriously harmed.

If the protection of our proprietary technology is inadequate, our competitors may gain access to our technology.

Our success is heavily dependent on our ability to create proprietary technology and to protect and enforce our intellectual property rights in that technology, as well as our ability to defend against adverse claims of third parties with respect to our technology and intellectual property. To protect our proprietary technology, we rely primarily on a combination of contractual provisions, confidentiality procedures, trade secrets, copyright and trademark laws, and patents. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Our means of protecting our proprietary rights may not be adequate and unauthorized third parties, including our competitors, may independently develop similar or superior technology, duplicate or reverse engineer aspects of our products, or design around our patented technology or other intellectual property.

As of October 31, 2009, we had 95 issued U.S. patents, 86 pending U.S. patent applications (provisional and non-provisional), 2 foreign issued patents and 4 pending foreign patent applications. There can be no assurance that any of our pending patent applications will issue or that the patent examination process will not result in our narrowing the claims applied for. Furthermore, there can be no assurance that we will be able to detect any infringement of our existing or future patents (if any) or, if infringement is detected, that our patents will be enforceable or that any damages awarded to us will be sufficient to adequately compensate us.

There can be no assurance or guarantee that any products, services or technologies that we are presently developing, or will develop in the future, will result in intellectual property that is subject to legal protection under the laws of the United States or a foreign jurisdiction and that produces a competitive advantage for us.

We are subject to various governmental regulations that could subject us to liability or impair our ability to compete in international markets.

Our products are subject to various governmental regulations, including U.S. and foreign import and export control laws and various environmental regulations, including the Waste Electrical and Electronic Equipment (WEEE) and Restriction of the Use of Certain Hazardous Substances in Electrical and Electric Equipment

 

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(RoHS) regulations adopted by the European Union. In addition, our products contain encryption technology and various countries regulate the import of certain encryption technology and have enacted laws that could limit our ability to distribute our products or could limit our customers’ ability to implement our products in those countries. Changes in our products or changes in applicable regulations or enforcement may create delays in the introduction of our products in international markets, prevent our customers with international operations from deploying our products globally or, in some cases, prevent the export or import of our products to certain countries altogether. Any decreased use of our products or limitation on our ability to export or sell our products would likely adversely affect our business, financial condition and results of operations.

Changes in our global fulfillment model may harm our business.

In fiscal 2009, we devised a plan to revise our global fulfillment model to ship directly to our end user customers and value-added resellers worldwide. We implemented these revised practices in the first quarter of fiscal 2010. This did not materially impact our distribution practices in North America, Latin America and Asia Pacific, where most of our distributors did not stock inventory. However, it constituted a significant change in our Europe, Middle East and Africa region, where the stocking of our products had been common. The success of this change will depend on our ability to forecast our requirements for inventory. If we fail to effectively forecast our requirements, we may be unable to fulfill customer orders or we may hold excess inventory, each of which could adversely affect our business, financial condition and results of operations.

Our operations could be significantly hindered by the occurrence of a natural disaster, terrorist attack or other catastrophic event.

Our business operations are susceptible to outages due to fire, floods, power loss, telecommunications failures, terrorist attacks and other events beyond our control. In addition, a substantial portion of our facilities, including our headquarters, are located in Northern California, an area susceptible to earthquakes. We do not carry earthquake insurance for earthquake-related losses. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any of these events. To the extent that such events disrupt our business or adversely impact our reputation, such events could adversely affect our business, financial condition and results of operations.

Third party product developments may impact the value of our products to users.

Our appliances are purchased to optimize and secure the delivery of third party software applications and content. It is possible that the providers of software applications and operating systems which operate with the software applications and content optimized by our appliances may enhance the performance of their software, such that further optimization of affected applications and content is not necessary. This could make our products less valuable to users of that software. In addition, manufacturers of hardware or software may incorporate functionality similar to that offered by our products directly into their products, which would make our products less valuable to users of those products. Any of the foregoing may limit our ability to sell our products and adversely affect our business, financial condition and results of operations.

The market price of our stock is volatile, and is likely to be volatile in the future.

Since our initial public offering, the market price of our common stock has experienced significant fluctuations and may continue to fluctuate significantly. Such volatility in the trading price of our stock can occur in response to general market conditions, changes in the IT or technology market generally or changes in the specific markets in which we operate, and cause an increase or decline in our stock price without regard to our operating performance. The market price of our common stock could decline quickly and significantly if we fail to achieve our guidance or if our performance fails to meet the expectation of public market analysts or investors.

 

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The market price of our common stock may fluctuate significantly in response to the following factors, among others:

 

   

variations in our quarterly operating results;

 

   

changes in financial estimates or investment recommendations by securities analysts;

 

   

changes in macroeconomic conditions;

 

   

the introduction of new products by our competitors;

 

   

our ability to keep pace with changing technological requirements;

 

   

changes in market valuations of Internet-related and networking companies;

 

   

announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments;

 

   

loss of customers who represent a significant portion of the company’s revenues;

 

   

additions or departures of key personnel;

 

   

fluctuations in stock market volumes;

 

   

investor confidence in our stock, technology stocks and the stock market in general;

 

   

speculation in the press or investment communication about our strategic position, financial condition, results of operations or business;

 

   

significant transactions; and

 

   

regulatory or litigation matters.

It is not uncommon for securities class actions or other litigation to be brought against a company after periods of volatility in the market price of a company’s stock, and we have been subject to such litigation in the past. Such actions could result in management distraction and expense and could result in a decline in our stock price.

We have a history of losses and profitability could be difficult to sustain.

While we have been profitable in certain quarters, we have not been able to maintain consistent profitability on a quarterly basis. Although we were profitable in all four quarters of fiscal 2008 and in the first and second quarters of fiscal 2010, we were only profitable in the third quarter of fiscal 2009, and may not be profitable on a quarterly or annual basis in the future. Our ability to achieve, sustain or increase profitability on a quarterly or annual basis will be affected by changes in our business and the demand for our products and services. We expect our operating expenses to increase as we endeavor to grow revenue, and we anticipate that we will make investments in our business. Our results of operations will be harmed if our revenue does not increase at a rate commensurate with the rate of increase in our expenses. If our revenue is less than anticipated or if our operating expenses exceed our expectations or cannot be adjusted quickly and efficiently, we may continue to experience quarterly or annual losses.

The legal environment in which we operate is uncertain and claims against us could cause our business to suffer.

Our products operate in part by storing material available on the Internet and making this material available to end users from our appliance. As well, our appliance may be used to block content from being accessed. This creates the potential for claims to be made against us, either directly or through contractual indemnification provisions with our customers, for defamation, negligence, intellectual property infringement, personal injury, censorship, invasion of privacy or other legal theories based on the nature, content, copying or modification of

 

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this content. As of October 31, 2009, we have not accrued any liabilities relating to indemnification provisions with our customers. It is also possible that if any information provided through any of our products contains errors, third parties could make claims against us for losses incurred in reliance on this information. Our insurance may not cover potential claims of this type or be adequate to protect us from all liability that may be imposed. Any of the foregoing actions could adversely affect our business, financial condition and results of operations.

If we are unable to manage the transition of significant research and development operations from existing locations to India, our business could be adversely affected.

On November 5, 2009, as part of a global restructuring of our business operations, we entered into an agreement to purchase all of the shares of S7, a research and development outsourcing firm located in Bangalore, India. We currently expect the transaction to close in the third fiscal quarter of fiscal 2010, after which S7 will wind down its outsourcing work and become our dedicated Indian development center. Following the closing, we intend to transition existing development work presently being handled at other sites to the new Indian development center, and also intend to assign various new development projects to those employed at that center. While we believe that our Indian development center will achieve significant efficiencies and will reduce our operational costs, the success of this transition and the Indian development center will be affected by our ability to integrate the operation into our existing global organization. The risks inherent in this transition and remote operation include:

 

   

the possibility that the transition of existing work will be more difficult and more expensive than anticipated;

 

   

the possibility that the business cultures will not be compatible;

 

   

unanticipated expenses related to integration activities;

 

   

the impairment of relationships with existing employees as a result of the integration of new personnel;

 

   

costs, difficulties and delays in implementing common systems and procedures, including information technology systems and human resources practices;

 

   

potential inability to retain, integrate and motivate personnel; and

 

   

risks related to remote development operations, including management risks and risks related to intellectual property protection.

Establishing a remote development center in India will be complex and time-consuming, and may result in operational difficulties and project delays if not completed in a timely and efficient matter. We may be required to spend additional time or money on integration activities that would otherwise be spent on developing our business or on other matters. There can be no assurance that we will succeed in addressing these risks or any other problems encountered in connection with the acquisition and integration.

We recently commenced a restructuring program, which could have a material negative impact on our business.

On November 3, 2009, we committed to a restructuring plan, which includes a planned net reduction of approximately 10% of our headcount as of such date over the next two quarters and the closure of three facilities, including two research and development facilities located in Riga, Latvia, and South Plainfield, New Jersey. These actions were approved as part of our continuing effort to improve our profitability, and as a consequence of our re-alignment of our research and development activity and resources, and our efforts to drive greater productivity throughout our organization.

There can be no assurance that the expected benefits of the restructuring, included the anticipated cost reductions and productivity improvements, will be achieved. Significant risks associated with the restructuring that may impair our ability to achieve the anticipated benefits or that may otherwise harm our business include:

 

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delays in implementation of workforce reductions in highly regulated locations outside of the United States, particularly in Europe and Asia; decreased employee morale and unanticipated turnover; increased legal expenses; and the failure to meet operational targets due to the loss of employees or the disruption of ongoing projects.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

On October 30, 2009, we held our Annual Meeting of Stockholders for fiscal year 2009 at our headquarters in Sunnyvale, California.

On the record date of September 1, 2009, we had 39,963,436 shares of common stock outstanding and entitled to vote. At the meeting, all of the stockholders were asked to vote with respect to: (i) the election of seven (7) directors to hold office until the fiscal year 2010 Annual Meeting of Stockholders or until such time as their respective successors are elected and qualified; (ii) the ratification of the selection of Ernst & Young LLP as our independent registered public accounting firm for fiscal year 2010; (iii) the proposal to amend the share reserve under the Company’s 2007 Stock Incentive Plan; and (iv) the proposal to amend the Company’s Employee Stock Purchase Plan.

The following nominees were elected as directors, each to hold office until the fiscal year 2010 Annual Meeting of Stockholders or until such time as their respective successors are elected and qualified, by the vote set forth below:

 

Nominee

   Votes For    Withheld

Brian M. NeSmith

   37,255,993    148,823

David W. Hanna

   36,274,870    1,129,946

James A. Barth

   36,901,156    503,660

Keith Geeslin

   36,973,644    431,172

Timothy A. Howes

   37,104,540    300,276

James R. Tolonen

   37,217,117    187,699

Carol G. Mills

   37,141,717    263,099

The selection of Ernst & Young LLP as our independent registered public accounting firm for Fiscal Year 2010 was ratified by the vote set forth below:

 

Votes For

   36,459,021

Votes Against

   911,720

Abstentions

   34,075

The proposal to amend the share reserve under the Company’s 2007 Stock Incentive Plan was withdrawn by the Company.

The proposal to amend the Company’s Employee Stock Purchase Plan was approved by the vote set forth below:

 

Votes For

   28,574,975

Votes Against

   2,364,379

Abstentions

   189,874

 

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Item 5. Other Information

None

Item 6. Exhibits

 

Number

  

Description

10.64    Amended and restated form of CEO Change in Control Severance Agreement, between the Company and its Chief Executive Officer, effective August 20, 2009 (corrected).
10.65    Amended and Restated 2007 Stock Incentive Plan, effective August 20, 2009.
10.66    Amended and Restated Employee Stock Purchase Plan, effective October 30, 2009.
10.67    Stock Option Agreement with Gordon C. Brooks.
31.1      Principal Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2      Principal Financial and Accounting Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1      Principal Executive Officer and Principal Financial and Accounting Officer Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

BLUE COAT SYSTEMS, INC.

/s/ Gordon C. Brooks

Gordon C. Brooks

Senior Vice President and Chief Financial Officer

(Principal Financial and Accounting Officer)

Dated: November 30, 2009

 

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