News Column

BROCADE COMMUNICATIONS SYSTEMS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

June 6, 2014

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



Overview

We are a leading supplier of networking equipment and software for businesses and organizations of many types and sizes. Our end customers include global enterprises that use our products and services as part of their communications infrastructure, and service providers such as telecommunication firms, cable operators and mobile carriers who use our products and services as part of their production operations. Our products and services are marketed, sold and supported worldwide to end-user customers through distribution partners, including original equipment manufacturer ("OEM") partners, distributors, systems integrators, and value-added resellers, as well as directly to end users by our sales force. Our business model is focused on two key markets: our Storage Area Networking ("SAN") business, where we offer Fibre Channel ("FC") SAN backbones, directors, fixed form factor switches and embedded switches, and our Internet Protocol ("IP") Networking business, where we offer IP routers, Ethernet switches, network security and monitoring, as well as products used to manage application delivery. Our IP products are available in modular, fixed, and virtualized or software form factors and can be deployed in both traditional network designs and full-featured Ethernet fabrics. We also provide product-related customer support and services in both our SAN business and our IP Networking business. We expect growth opportunities in the SAN market over time to be driven by key customer Information Technology ("IT") initiatives such as server virtualization, enterprise mobility, data center consolidation, and migration to higher performance technologies, such as solid state storage and cloud computing initiatives. Our IP Networking business strategies are intended to increase new customer accounts and expand our market share through product innovation, such as our Ethernet fabric and virtualized software networking products (also known as software-defined networking, or "SDN," and Network Functions Virtualization, or "NFV"), and the development and expansion of our routes to market. The success of Ethernet fabrics, in particular, will depend on customers recognizing the benefits of upgrading their data center networks to fabric-based networking architectures and our future success in this area would be negatively impacted if this technological transition does not occur at the anticipated rate or at all. While our NFV revenues have not been material to date, customer interest in NFV is very high and we believe that customers prefer to buy networking products from suppliers that offer a portfolio of solutions that address their current and future needs. We plan to continue to support our SAN and IP Networking growth plans by continuous innovation, leveraging the strategic investments we have made in our core businesses, developing emerging technologies (such as SDN and NFV), new product introductions, and enhancing our existing partnerships and forming new ones through our various distribution channels. In the second quarter of fiscal year 2013, we announced that we were making certain changes in our strategic direction by focusing on key technology segments, such as our SAN fabrics, Ethernet fabrics and software networking products, for the data center. As part of this change in focus, we reduced our cost of revenues and other operating expenses by $100 million on an annualized basis when comparing the first quarter of fiscal year 2014 to the first quarter of fiscal year 2013. We achieved our targeted cost reduction opportunities ahead of our previously announced schedule by focusing on the optimization of discretionary spending and rebalancing personnel resources. We previously disclosed that this change in focus will also result in a rebalancing of resources away from certain non-key areas of our business, which has impacted our ability to generate revenue from certain products, markets, geographies and customers. In the second quarter of fiscal year 2014, we made a strategic decision to reduce our investment in the hardware-based ADX products and to increase investment in the software-based ADX products for the Layer 4-7 market. As a result of this change in strategy, we expect hardware-based ADX and related support revenue to be negatively impacted by $20 million to $40 million on an annualized basis. Based on the decrease in the hardware-based ADX revenue forecast, we recognized an $83 million non-cash goodwill impairment charge during the second quarter of fiscal year 2014. Combined with the other rebalancing actions taken through the first quarter of fiscal year 2014, which, among other actions, included divestiture of our network adapter business and a change in our wireless business strategy, we believe our changes in strategic direction will cause our annualized revenues in fiscal year 2014 to be lower by approximately $80 million to $100 million compared with fiscal year 2013. 34



--------------------------------------------------------------------------------

Table of Contents

We continue to face multiple challenges, including aggressive price discounting from competitors, new product introductions from competitors, rapid adoption of new technologies by customers, an uneven recovery in the worldwide macroeconomic climate and its impact on IT spending patterns globally, as well as uncertain federal government spending in the United States. We are also cautious about the stability and health of certain international markets, including China, and current global and country-specific dynamics, including inflationary risks in China. These factors may impact our business and that of our partners. While the diversified portfolio of products that we offer helps mitigate the effect of some of these challenges and we expect IT spending levels to generally rise in the long term, it is difficult for us to offset short-term reductions in IT spending, which may adversely affect our financial results and stock price. We expect the number of SAN and IP Networking products we ship to fluctuate depending on the demand for our existing and recently introduced products, and sales support for our products from our distribution and resale partners, as well as the timing of product transitions by our OEM partners. The average selling prices per port for our SAN and IP Networking products have typically declined over time, unless impacted favorably by a new product introduction or mix, and will likely decline in the future. Our plans for our operating cash flows are to provide liquidity for operations, to repurchase our stock to reduce the dilutive effects of our equity award programs and, from time to time, we may also opportunistically repurchase our stock under our previously announced stock repurchase programs. In addition, we may use our operating cash flows to strengthen our networking portfolios through acquisitions and strategic investments. In September 2013, we announced our intent to return at least 60% of our adjusted free cash flow, which we define as operating cash flow adjusted for the impact of the excess tax benefits from stock-based compensation, less capital expenditures, to investors in the form of share repurchases or dividends. In the third quarter of fiscal year 2014, our Board of Directors initiated a quarterly cash dividend of $0.035 per share of our common stock. The first dividend payment will be made on July 2, 2014, to stockholders of record as of the close of market on June 10, 2014. Future dividend payments are subject to review and approval by our Board of Directors. 35



--------------------------------------------------------------------------------

Table of Contents

Results of Operations Our results of operations for the three and six months ended May 3, 2014, and April 27, 2013, are reported in this discussion and analysis as a percentage of total net revenues, except for gross margin with respect to each segment, which is indicated as a percentage of the respective segment net revenues. Revenues. Our revenues are derived primarily from sales of our SAN and IP Networking products, and support and services related to these products, which we call Global Services. Our total net revenues are summarized as follows (in thousands, except percentages): Three Months Ended % of Net April 27, % of Net Increase/ % May 3, 2014 Revenues 2013

Revenues (Decrease) Change SAN Products $ 321,164 59.8 % $ 319,088 59.2 % $ 2,076 0.7 % IP Networking Products 121,116 22.6 % 132,658 24.6 % (11,542 ) (8.7 )% Global Services 94,630 17.6 % 87,038 16.2 % 7,592 8.7 % Total net revenues $ 536,910 100.0 % $ 538,784 100.0 % $ (1,874 ) (0.3 )% Six Months Ended % of Net % of Net Increase/ % May 3, 2014 Revenues April 27, 2013 Revenues (Decrease) Change SAN Products $ 676,620 61.4 % $ 680,822 60.4 % $ (4,202 ) (0.6 )% IP Networking Products 240,865 21.9 % 273,171 24.2 % (32,306 ) (11.8 )% Global Services 183,960 16.7 % 173,520 15.4 % 10,440 6.0 % Total net revenues $ 1,101,445 100.0 % $ 1,127,513



100.0 % $ (26,068 ) (2.3 )%

The decrease in total net revenues for the three months ended May 3, 2014, compared to the three months ended April 27, 2013, primarily reflects lower sales for our IP Networking products, partially offset by increase in sales for our Global Services and SAN products. The increase in SAN product revenues was caused by an increase in switch



and server product revenues, partially offset by a decrease in director

product revenue, due to demand changes from our OEM partners. We continue

to maintain a positive view of the long-term SAN market despite a soft storage market in the near term. Our average selling price per port decreased by 4.4% during the three months ended May 3, 2014, which was



offset by the 5.3% increase in the number of ports shipped during the same

period, resulting in higher SAN product revenues for the three months

ended May 3, 2014;

The decrease in IP Networking product revenues primarily reflects lower

revenues from our IP routing, adapter, and application delivery products

due to the divestiture of the network adapter business, our shift in strategy with respect to our ADX product line, our wireless business and certain other product lines. These decreases were partially offset by an increase in our Ethernet switch products for data center and campus customers. Based on our analysis of the information we collect in our



sales management system, we estimate that revenues from our U.S. federal

government and enterprise end customers, as well as network carrier

customers have decreased for the three months ended May 3, 2014, compared

with the three months ended April 27, 2013. The decrease in revenues from

our U.S. federal government, enterprise end customers, and network carrier

customers is due to the current challenging U.S. federal budget

environment and due to lower demand from our enterprise and network

carrier end customers. As the percentage of our IP Networking products

being sold through two-tier distribution has increased, it has become

increasingly difficult to quantify our revenues by end customer, and, therefore, these results are based solely on our estimates; and



The increase in Global Services revenues was primarily attributable to an

additional week of amortized support revenue from the 14-week quarter in

the second quarter of fiscal year 2014 and an increase in the revenue

recognized from sales of initial support contracts and renewal support

contracts for our SAN products, partially offset by a decrease in the sale

of professional services. 36



--------------------------------------------------------------------------------

Table of Contents

The decrease in total net revenues for the six months ended May 3, 2014, compared with the six months ended April 27, 2013, reflects lower sales of our IP Networking and SAN products, partially offset by higher sales of our Global Services offerings, as further described below. The decrease in SAN product revenues was caused by a decrease in director



product revenue, partially offset by an increase in switch and server

product revenues, due to demand changes from our OEM partners. We continue

to maintain a positive view of the long-term SAN market despite a soft

storage market in the near term. Our average selling price per port

decreased by 4.3% during the six months ended May 3, 2014, as compared

with the same period in the prior year, which was partially offset by the

3.8% increase in the number of ports shipped during the same period;

The decrease in IP Networking product revenues primarily reflects lower

revenues from our IP routing and application delivery products. Based on

our analysis of the information we collect in our sales management system,

we estimate that revenues from our U.S. federal government and enterprise

end customers, as well as network carrier customers, have decreased for

the six months ended May 3, 2014, compared with the six months ended April

27, 2013. The decrease in revenues from our U.S. federal government and

enterprise end customers is due to the current challenging federal budget

environment, and due to lower demand in the United States and Japan. As

the percentage of our IP Networking products being sold through two-tier

distribution has increased, it has become increasingly difficult to quantify our revenues by end customer, and, therefore, these results are based solely on our estimates; and



The increase in Global Services revenues was primarily attributable to an

additional week of amortized support revenue from the 14-week quarter in

the second quarter of fiscal year 2014 and an increase in the revenue

recognized from sales of initial support contracts and renewal support

contracts for both our SAN products and IP Networking products.

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

Three Months Ended % of Net April 27, % of



Net Increase/ %

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



(1) Includes net revenues of $89.9 million and $93.4 million for the three

months ended May 3, 2014, and the three months ended April 27, 2013,

respectively, relating to the Netherlands.

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



100.0 % $ (26,068 ) (2.3 )%

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



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

37



--------------------------------------------------------------------------------

Table of Contents

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



Net Increase/ % Points

May 3, 2014 Revenues 2013 Revenues (Decrease) Change SAN Products $ 236,650 73.7 % $ 231,191 72.5 % $ 5,459 1.2 % IP Networking Products 63,359 52.3 % 55,956 42.2 % 7,403 10.1 % Global Services 54,283 57.4 % 46,965 54.0 % 7,318 3.4 % Total gross margin $ 354,292 66.0 % $ 334,112 62.0 % $ 20,180 4.0 % Six Months Ended % of Net April 27, % of Net Increase/ % Points May 3, 2014 Revenues 2013 Revenues (Decrease) Change SAN Products $ 499,165 73.8 % $ 495,972 72.8 % $ 3,193 1.0 % IP Networking Products 122,422 50.8 % 119,047 43.6 % 3,375 7.2 % Global Services 105,375 57.3 % 93,018 53.6 % 12,357 3.7 % Total gross margin $ 726,962 66.0 % $ 708,037 62.8 % $ 18,925 3.2 % The gross margin percentage for each reportable segment increased for the three months ended May 3, 2014, compared with the three months ended April 27, 2013, primarily due to the following factors (the percentages below reflect the impact on gross margin): SAN gross margins relative to net revenues increased primarily due to a 1.2% decrease in manufacturing overhead costs primarily due to lower headcount, lower freight costs, and lower outside services spending,



partially offset by an increase in variable performance-based compensation

and an additional week of payroll expense from the 14-week quarter in the

second quarter of fiscal year 2014;

IP Networking gross margins relative to net revenues increased primarily

due to a 6.9% decrease in amortization of IP Networking-related intangible

assets, as most of these assets were acquired during the acquisition of Foundry Networks, LLC ("Foundry") and were fully amortized prior to the three months ended May 3, 2014. In addition, manufacturing overhead costs



decreased 2.3%, relative to net revenues, primarily due to lower overhead

labor cost, lower freight costs, and lower outside services spending,

partially offset by an increase in variable performance-based compensation

and an additional week of payroll expense from the 14-week quarter in the

second quarter of fiscal year 2014. Product costs also decreased 1.4%,

relative to net revenues, which is mainly attributable to a more favorable

mix of IP Networking products as well as product cost reductions resulting

from our ongoing efforts to reduce costs with our suppliers; and

Global Services gross margins relative to net revenues increased primarily

due to a 3.2% decrease in service and support costs relative to net revenues, due to a decrease in period costs resulting primarily from lower overhead labor cost, and lower rework expenses, partially offset by an increase in variable performance-based compensation for the 38



--------------------------------------------------------------------------------

Table of Contents

three months ended May 3, 2014. The decrease in service and support costs relative to net revenues was also due to lower legal, IT and facilities expenses allocated to Global Services. Gross margin percentage for each reportable segment increased for the six months ended May 3, 2014, compared with the six months ended April 27, 2013, primarily due to the following factors (the percentages below reflect the impact on gross margin): SAN gross margins relative to net revenues increased due to a 0.9%



decrease in manufacturing overhead costs primarily due to lower overhead

labor cost, lower freight costs and lower outside services spending,

partially offset by an increase in variable performance-based compensation

and an additional week of payroll expense from the 14-week quarter in the

second quarter of fiscal year 2014. In addition, SAN gross margins

relative to net revenues increased due to a 0.2% decrease in amortization

of SAN-related intangible assets, relative to net revenues. These decreases were partially offset by a 0.2% increase in product and other costs relative to net revenues;



IP Networking gross margins relative to net revenues increased primarily

due to a 4.2% decrease in amortization of IP Networking-related intangible

assets, as most of these assets were acquired during the acquisition of Foundry and were fully amortized prior to the three months ended May 3,



2014, and a 2.3% decrease in product costs, which is mainly attributable

to a more favorable mix of IP Networking products as well as product cost reductions resulting from our ongoing efforts to reduce costs with our suppliers, in each case, relative to net revenues; and



Global Services gross margins relative to net revenues increased primarily

due to a 3.3% decrease in service and support costs relative to net

revenues, due to a decrease in period costs, primarily resulting from

lower overhead labor cost, and lower rework expenses, partially offset by

an increase in variable performance-based compensation for the six months

ended May 3, 2014. The decrease in service and support costs relative to

net revenues was also due to lower legal, IT and facilities expenses

allocated to Global Services.

Research and development expenses. Research and development ("R&D") expenses consist primarily of compensation and related expenses for personnel engaged in engineering and R&D activities, fees paid to consultants and outside service providers, engineering expenses, which primarily consist of nonrecurring engineering charges and prototyping expenses related to the design, development, testing and enhancement of our products, depreciation related to engineering and test equipment, and allocated expenses related to legal, IT, facilities and other shared functions. R&D expenses are summarized as follows (in thousands, except percentages): May 3, 2014 April 27, 2013 Research and % of Net % of Net Increase/ % development expense: Expense Revenues Expense Revenues (Decrease) Change Three months ended $ 90,554 16.9 % $ 98,429 18.3 % $ (7,875 ) (8.0 )% Six months ended $ 177,710 16.1 % $ 196,119 17.4 % $ (18,409 ) (9.4 )%



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

Increase (Decrease) Engineering expense $ (2,959 ) Expenses related to legal, IT, facilities and other shared functions (2,450 ) Depreciation and amortization expense (1,121 ) Salaries and other compensation (882 ) Various individually insignificant items (463 ) Total change $ (7,875 ) Engineering expense decreased primarily due to lower nonrecurring engineering spending related to new product development and lower prototype costs for the three months ended May 3, 2014. Expenses related to legal, IT, facilities and other shared functions allocated to R&D activities decreased primarily due to overall decreased costs with respect to IT-related projects and IT personnel, due to lower facilities costs as part of our spending reduction plan, as well as due to lower overall legal expense resulting from the settlement of litigation matters during fiscal year 2013. Depreciation and amortization expense decreased primarily due to a decrease in engineering capital spending. In addition, salaries and other compensation decreased primarily due to decreased engineering headcount and a related decrease in payroll expense, partially offset by an increase in 39



--------------------------------------------------------------------------------

Table of Contents

variable performance-based compensation and an additional week of payroll expense from the 14-week quarter in the second quarter of fiscal year 2014. R&D expenses decreased for the six months ended May 3, 2014, compared with the six months ended April 27, 2013, due to the following (in thousands):

Increase (Decrease) Engineering expense $ (5,906 ) Expenses related to legal, IT, facilities and other shared functions (5,301 ) Outside services expense (3,026 ) Depreciation and amortization expense (1,675 ) Salaries and other compensation (909 ) Various individually insignificant items (1,592 ) Total change $ (18,409 ) Engineering expense decreased primarily due to lower nonrecurring engineering spending related to new product development and lower prototype costs for the six months ended May 3, 2014. Expenses related to legal, IT, facilities and other shared functions allocated to R&D activities decreased overall primarily due to decreased costs with respect to IT-related projects and IT personnel, due to lower facilities costs as part of our spending reduction plan, as well as due to lower overall legal expense resulting from the settlement of litigation matters during fiscal year 2013. Outside services expense decreased primarily due to a reduction in outside engineering services and decreased support expenses for our engineering laboratories. Depreciation and amortization expense decreased primarily due to a decrease in engineering capital spending. In addition, salaries and other compensation decreased primarily due to decreased engineering headcount and a related decrease in payroll expense, partially offset by an increase in variable performance-based compensation and an additional week of payroll expense from the 14-week quarter in the second quarter of fiscal year 2014. Sales and marketing expenses. Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in sales and marketing functions, costs associated with promotional and marketing programs, travel and entertainment expenses, and allocated expenses related to legal, IT, facilities and other shared functions. Sales and marketing expenses are summarized as follows (in thousands, except percentages): May 3, 2014 April 27, 2013 % of Net % of Net Increase/ % Sales and marketing expense: Expense Revenues Expense

Revenues (Decrease) Change Three months ended $ 139,597 26.0 % $ 145,316 27.0 % $ (5,719 ) (3.9 )% Six months ended $ 272,262 24.7 % $ 294,327 26.1 % $ (22,065 ) (7.5 )% Sales and marketing expenses decreased for the three months ended May 3, 2014, compared with the three months ended April 27, 2013, due to the following (in thousands): Increase (Decrease)



Expenses related to legal, IT, facilities and other shared functions $ (6,965 ) Various individually insignificant items

(399 ) The decrease in S&M expenses was partially offset by a increase in: Outside services and other marketing expense

1,195

Stock-based compensation expense 450 Total change $ (5,719 ) Expenses related to legal, IT, facilities and other shared functions allocated to sales and marketing activities decreased primarily due to decreased overall costs with respect to IT-related projects and IT personnel, due to lower facilities costs as part of our spending reduction plan, as well as due to lower overall legal expense resulting from the settlement of litigation matters during fiscal year 2013. Outside services and other marketing expense increased primarily due to increased costs related to our company-wide salesforce training delivered during the three months ended May 3, 2014, partially offset by lower spending on conferences and trade shows in the three months ended May 3, 2014. Stock-based compensation expense increased primarily 40



--------------------------------------------------------------------------------

Table of Contents

due to an increase in the grant date per-unit fair values of restricted stock units granted to employees in recent quarters, as well as due to an increase in stock option grants made in fiscal year 2013 (see Note 11, "Stock-Based Compensation," of the Notes to Condensed Consolidated Financial Statements). Sales and marketing expenses decreased for the six months ended May 3, 2014, compared with the six months ended April 27, 2013, due to the following (in thousands): Increase (Decrease)



Expenses related to legal, IT, facilities and other shared functions $ (11,415 ) Salaries and other compensation

(5,969 ) Outside services and other marketing expense (3,196 ) Stock-based compensation expense (930 ) Various individually insignificant items (555 ) Total change $ (22,065 ) Expenses related to legal, IT, facilities and other shared functions allocated to sales and marketing activities decreased primarily due to decreased overall costs with respect to IT-related projects and IT personnel, due to lower facilities costs as part of our spending reduction plan, as well as due to lower overall legal expense resulting from the settlement of litigation matters during fiscal year 2013. Salaries and other compensation decreased primarily due to decreased headcount, partially offset by an increase in variable performance-based compensation and an additional week of payroll expense from the 14-week quarter in the second quarter of fiscal year 2014. Outside services and other marketing expense decreased primarily due to less spending on advertising and other marketing, as well as on conferences and trade shows, in the six months ended May 3, 2014, partially offset by increased costs related to salesforce training delivered during the six months ended May 3, 2014. Stock-based compensation expense decreased primarily due to a decline in the Employee Stock Purchase Plan ("ESPP") expense as a result of certain offering periods being closer to the end of the offering period in the six months ended May 3, 2014. Our ESPP offering periods include four purchase periods, and expense related to each of these purchase periods is amortized over six, twelve, eighteen and twenty-four months starting from the beginning date of the offering period. This results in higher amortization expense at the beginning of the offering period compared with amortization expense closer to the end of the offering period (see Note 11, "Stock-Based Compensation," of the Notes to Condensed Consolidated Financial Statements). General and administrative expenses. General and administrative ("G&A") expenses consist primarily of compensation and related expenses for corporate management, finance and accounting, human resources, legal, IT, facilities and investor relations, as well as recruiting expenses, professional fees, and other corporate expenses, less certain expenses allocated to other functions as described above. G&A expenses are summarized as follows (in thousands, except percentages): May 3, 2014 April 27, 2013 % of Net % of Net Increase/ % G&A expense: Expense Revenues Expense Revenues (Decrease) Change Three months ended $ 21,112 3.9 % $ 20,037 3.7 % $ 1,075 5.4 % Six months ended $ 41,255 3.7 % $ 39,114 3.5 % $ 2,141 5.5 %



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

Increase (Decrease) Stock-based compensation expense $



1,575

The increase in G&A expenses was partially offset by a decrease in: Salaries, other compensation and other expenses

(500 ) Total change $ 1,075 Stock-based compensation expense increased primarily due to an increase in the grant date per-unit fair values of restricted stock units granted to employees in recent quarters, as well as due to an increase in stock option grants made in fiscal year 2013 (see Note 11, "Stock-Based Compensation," of the Notes to Condensed Consolidated Financial Statements). Salaries, other compensation and other expenses decreased primarily due to decreased headcount, partially offset by an increase in 41



--------------------------------------------------------------------------------

Table of Contents

variable performance based compensation and an additional week of payroll expense from the 14-week quarter in the second quarter of fiscal year 2014. G&A expenses increased for the six months ended May 3, 2014, compared with the six months ended April 27, 2013, due to the following (in thousands):

Increase (Decrease) Stock-based compensation expense $



3,546

The increase in G&A expenses was partially offset by a decrease in: Salaries, other compensation and other expenses

(1,405 ) Total change $ 2,141 Stock-based compensation expense increased primarily due to an increase in the grant date per-unit fair values of restricted stock units granted to employees in recent quarters, as well as due to an increase in stock option grants made in fiscal year 2013 (see Note 11, "Stock-Based Compensation," of the Notes to Condensed Consolidated Financial Statements). Salaries, other compensation and other expenses decreased primarily due to decreased headcount, partially offset by an increase in variable performance-based compensation and an additional week of payroll expense from the 14-week quarter in the second quarter of fiscal year 2014. Amortization of intangible assets. Amortization of intangible assets is summarized as follows (in thousands, except percentages): May 3, 2014 April 27, 2013 Amortization of % of Net % of Net Increase/ % intangible assets: Expense Revenues Expense Revenues (Decrease) Change Three months ended $ 131 - % $ 13,151 2.4 % $ (13,020 ) (99.0 )% Six months ended $ 10,014 0.9 % $ 28,007 2.5 % $ (17,993 ) (64.2 )% The decrease in amortization of intangible assets for the three and six months ended May 3, 2014, compared with the three and six months ended April 27, 2013, was primarily due to the completion of amortization of certain of our intangible assets (see Note 4, "Goodwill and Intangible Assets," of the Notes to Condensed Consolidated Financial Statements). Restructuring, goodwill impairment, and other related costs. Restructuring, goodwill impairment, and other related costs are summarized as follows (in thousands, except percentages): May 3, 2014 April 27,



2013

Restructuring, goodwill impairment, and other % of Net % of Net Increase/ % related costs: Expense Revenues Expense Revenues (Decrease) Change Three months ended $ 82,703 15.4 % $ - - % $ 82,703 * Six months ended $ 88,920 8.1 % $ - - % $ 88,920 * * Not meaningful In May 2013, we announced that we were making certain changes in our strategic direction by focusing on key technology segments, such as our SAN fabrics, Ethernet fabrics and software networking products, for the data center. As a result, during the fiscal year ended October 26, 2013, we reevaluated our business model to restructure certain business operations, reorganize certain business units, and reduce our operating expense structure. In connection with this restructuring plan, we incurred restructuring charges and other costs primarily related to severance and benefits charges and lease loss reserve and related costs. We substantially completed the restructuring plan by the end of the first quarter of fiscal year 2014. As we continue to balance our remaining resources related to the restructuring plan, we made the decision to reduce our investment in the hardware-based ADX products and to increase investment in the software-based ADX products for the Layer 4-7 market during the three months ended May 3, 2014. As a result of this decision, we expect hardware-based ADX and related support revenue to be negatively impacted by $20 million to $40 million on an annualized basis. Based on the decrease in the hardware-based ADX revenue forecast, we recognized an $83.4 million goodwill impairment charge during the second quarter of fiscal year 2014. 42



--------------------------------------------------------------------------------

Table of Contents

Restructuring, goodwill impairment, and other related costs for the three months ended May 3, 2014, were primarily due to the $83.4 million of goodwill impairment, slightly offset by changes in estimates for our previously established lease loss reserves. Restructuring, goodwill impairment, and other related costs for the six months ended May 3, 2014, were primarily due to the $83.4 million in goodwill impairment and $7.3 million in estimated lease loss reserve and related costs recorded during the six months ended May 3, 2014, partially offset by a $1.8 million reduction in expense for severance and benefits due to actual cash payments made during the six months ended May 3, 2014, being lower than originally estimated (see Note 7, "Restructuring and Other Costs," of the Notes to Condensed Consolidated Financial Statements). We did not incur any restructuring or other related costs during the six months ended April 27, 2013. As a result of the completion of our restructuring plan and other related spending changes, our cost of revenues and other operating expenses have been reduced by more than $100 million on an annualized basis relative to cost of revenues and other operating expenses incurred during the first quarter of fiscal year 2013. We anticipate that these savings will carry over into future periods; however, actual savings realized may differ if our assumptions are incorrect or if other unanticipated events occur. Savings may also be offset, or additional expenses incurred, if and when we make additional investments in new technologies or solutions related to our strategy in the future, or if we decide to strengthen our networking portfolios through acquisitions and strategic investments. Combining the change in strategy for our ADX products with the other rebalancing actions taken through the first quarter of fiscal year 2014, which, among other actions, included our divestiture of our network adapter business and the change in our wireless business strategy, we believe our changes in strategic direction will cause our annualized revenues to be lower by approximately $80 million to $100 million compared with fiscal year 2013. Gain on sale of network adapter business. During the six months ended May 3, 2014, a gain of $4.9 million was recorded in connection with the sale of our network adapter business to QLogic Corporation ("QLogic") (see Note 3, "Acquisitions and Divestitures," of the Notes to Condensed Consolidated Financial Statements). We had no similar divestitures during the six months ended April 27, 2013. Interest expense. Interest expense primarily represents the interest cost associated with our senior secured notes and senior unsecured notes (see Note 8, "Borrowings," of the Notes to Condensed Consolidated Financial Statements). Interest expense is summarized as follows (in thousands, except percentages): May 3, 2014 April 27, 2013 % of Net % of Net (Increase)/ % Interest expense: Expense Revenues Expense Revenues Decrease Change Three months ended $ (9,234 ) (1.7 )% $ (10,432 ) (1.9 )% $ 1,198 (11.5 )% Six months ended $ (18,430 ) (1.7 )% $ (36,800 ) (3.3 )% $



18,370 (49.9 )%

Interest expense decreased for the six months ended May 3, 2014, compared with the six months ended April 27, 2013, primarily due to the $15.3 million expense that we recorded in the first quarter of fiscal year 2013, for the call premium, debt issuance costs and original issue discount relating to the redemption of our 6.625% senior secured notes due (the "2018 Notes"), in accordance with the applicable accounting guidance for debt modification and extinguishment, and for interest cost accounting, (additionally, see Note 8, "Borrowings," of the Notes to Condensed Consolidated Financial Statements). The decrease in interest expense was also due to the refinancing of the 2018 Notes to a lower interest rate. In January 2013, we issued $300.0 million in aggregate principal amount of 4.625% Senior Notes due 2023 (the "2023 Notes") in a private placement (the "Offering"). The proceeds from the Offering, together with cash on hand, were used on February 21, 2013, to redeem all of the outstanding 2018 Notes, which had a higher interest rate. The transactions are described further below in "Liquidity and Capital Resources." 43



--------------------------------------------------------------------------------

Table of Contents

Interest and other income (loss), net. Interest and other income (loss), net, are summarized as follows (in thousands, except percentages):

May 3, 2014April 27,



2013

Interest and other % of Net % of Net Increase/ % income (loss), net: Loss Revenues Income Revenues (Decrease) Change Six months ended $ (1,356 ) (0.1 )% $ 97 - % $ (1,453 ) * * Not meaningful Interest and other income (loss), net, for the six months ended May 3, 2014, was primarily related to the loss on the sale of certain property and equipment during the period. Interest and other income (loss), net was not significant for the three months ended May 3, 2014, and the three and six months ended April 27, 2013. Income tax expense. Income tax expense (benefit) and the effective tax rates are summarized as follows (in thousands, except effective tax rates): Three Months Ended Six Months Ended May 3, April 27, May 3, April 27, 2014 2013 2014 2013



Income tax expense (benefit) $ 24,625$ (171 )$ 54,699$ 88,073 Effective tax rate

225.1 % (0.4 )% 44.9 % 77.4 % In general, our provision for income taxes differs from tax computed at the U.S. federal statutory tax rate of 35% due to state taxes, the effect of non-U.S. operations, nondeductible stock-based compensation expense and adjustments to unrecognized tax benefits. The effective tax rates for the three and six months ended May 3, 2014, were higher than the federal statutory rate of 35% primarily due to a goodwill impairment charge of $83.4 million, which is non-deductible for tax purposes, and an increase in certain unrecognized tax benefits, partially offset by effects of earnings in foreign jurisdictions taxed at rates lower than the U.S. federal statutory tax rate (additionally, see Note 13, "Income Taxes," of the Notes to Condensed Consolidated Financial Statements). The effective tax rate for the three months ended April 27, 2013, was lower than the federal statutory rate of 35% primarily due to a discrete benefit from reserve releases resulting from audit settlements. In addition, the effective tax rate for the six months ended April 27, 2013, was higher than the federal statutory tax rate of 35% primarily due to a charge of $78.2 million to reduce our previously recognized California deferred tax assets as a result of a change in California tax law. This charge was partially offset by an increase in foreign earnings, discrete benefits from reserve releases resulting from audit settlements, and an increase in the federal research and development tax credit that was reinstated on January 2, 2013, for calendar year 2013 and made retroactive to January 1, 2012. Based on our fiscal year 2014 financial forecast, we expect our effective tax rate in fiscal year 2014 to be lower than that of fiscal year 2013. Factors such as the mix of IP Networking versus SAN products, which have different gross margins, and domestic versus international profits affect our tax expense. As estimates and judgments are used to project such domestic and international earnings, the impact to our tax provision could vary if the current planning or assumptions change. Our income tax provision could change from either effects of changing tax laws and regulations or differences in international revenues and earnings from those historically achieved, a factor largely influenced by the buying behavior of our OEM and channel partners. In addition, we do not forecast discrete events, such as settlement of tax audits with governmental authorities, due to their inherent uncertainty. Such settlements have in the past and could in the future materially impact our tax expense. Given that the tax rate is affected by several different factors, it is not possible to estimate our future tax rate with a high degree of certainty. The Internal Revenue Service ("IRS") and other tax authorities regularly examine our income tax returns. The IRS is currently examining our federal tax returns for fiscal years 2009 and 2010. In addition, we are in negotiations with foreign tax authorities to obtain correlative relief on transfer pricing adjustments previously settled with the IRS. We believe that our reserves for unrecognized tax benefits are adequate for all open tax years. The timing of income tax examinations, as well as the amounts and timing of related settlements, if any, are highly uncertain. We believe that, before the end of fiscal year 2014, it is reasonably possible that either certain audits will conclude or the statutes of limitations relating to certain income tax examination periods will expire, or both. After we reach settlement with the tax authorities, we expect to record a corresponding adjustment to our unrecognized tax benefits. Taking into consideration the inherent uncertainty as to settlement terms, the timing of payments and the impact of such settlements on other uncertain tax positions, we estimate the range of potential 44



--------------------------------------------------------------------------------

Table of Contents

decreases in underlying uncertain tax positions is between $0 and $5.0 million in the next 12 months. For additional discussion, see Note 13, "Income Taxes," of the Notes to Condensed Consolidated Financial Statements. We believe that sufficient positive evidence exists from historical operations and projections of taxable income in future years to conclude that it is more likely than not that we will realize our deferred tax assets, except for certain California deferred tax assets and capital loss carryforwards. Accordingly, we apply a valuation allowance to the California deferred tax assets due to the 2012 change in California law and to capital loss carryforwards due to the limited carryforward periods of these tax assets.



Liquidity and Capital Resources

May 3, October 26, Increase/ 2014 2013 (Decrease) (In thousands)



Cash and cash equivalents $ 1,137,613$ 986,997$ 150,616 Percentage of total assets 32 %

27 % We use cash generated by operations as our primary source of liquidity. We expect that cash provided by operating activities will fluctuate in future periods as a result of a number of factors, including fluctuations in our revenues, the timing of product shipments during the quarter, accounts receivable collections, inventory and supply chain management, the timing and amount of tax, and other payments or receipts. For additional discussion, see "Part II-Other Information, Item 1A. Risk Factors." In January 2013, we issued $300.0 million of the 2023 Notes in the Offering. On January 22, 2013, we called the 2018 Notes for redemption. On February 21, 2013, we used the net proceeds from the Offering, together with cash on hand, to redeem all of our outstanding 2018 Notes, including the payment of the applicable premium and expenses associated with the redemption, and the interest on the 2018 Notes up to the date of redemption (see Note 8, "Borrowings," of the Notes to Condensed Consolidated Financial Statements). On November 9, 2012, we completed our acquisition of Vyatta, Inc. ("Vyatta"). The total purchase price was $44.8 million, consisting of a $43.6 million cash consideration, $7.0 million of which was held in escrow for a period of 18 months from the closing of the acquisition, and $1.2 million related to prepaid license fees paid to Vyatta that was effectively settled at the recorded amount as a result of the acquisition. In May 2014, the $7.0 million cash consideration was released from escrow upon resolution of certain contingencies (see Note 3, "Acquisitions and Divestitures," of the Notes to Condensed Consolidated Financial Statements). Based on past performance and current expectations, we believe that internally generated cash flows and cash on hand are generally sufficient to support business operations, capital expenditures, contractual obligations, and other liquidity requirements associated with our operations for at least the next 12 months, including our debt service requirements. Also, we have up to $125.0 million available under our revolving credit facility, and we can factor up to an aggregate amount of $50.0 million of our trade receivables under our factoring facility to provide additional liquidity. There are no other transactions, arrangements, or other relationships with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity of, availability of, or our requirements for capital resources. Financial Condition Cash and cash equivalents as of May 3, 2014, increased by $150.6 million over the balance as of October 26, 2013, primarily due to the cash generated from operations, proceeds from the issuance of our common stock in connection with employee participation in our equity compensation plans, and proceeds from the sale of our network adapter business, partially offset by the cash used for the purchases of property and equipment and the repurchase of outstanding shares of our common stock. In September 2013, we announced our intent to return at least 60% of our adjusted free cash flow to investors in the form of share repurchases or other alternatives such as dividends. In the third quarter of fiscal year 2014, our Board of Directors initiated a quarterly cash dividend of $0.035 per share of our common stock. The first dividend payment will be made on July 2, 2014, to stockholders of record as of the close of market on June 10, 2014. Future dividend payments are subject to review and approval by our Board of Directors. Net proceeds from the issuance of common stock in connection with employee participation in our equity compensation plans have historically been a significant component of our liquidity. The extent to which we receive proceeds from these plans can increase or decrease based upon changes in the market price of our common stock, and from the amount and type of awards 45



--------------------------------------------------------------------------------

Table of Contents

granted to employees. For example, a change in the mix of granted restricted stock unit and stock option awards towards granting fewer stock option awards reduces the net proceeds from the issuance of common stock in connection with employee participation in our equity compensation plans. As a result, our cash flow resulting from the issuance of common stock in connection with employee participation in equity compensation plans will vary. A majority of our accounts receivable balance is derived from sales to our OEM partners. As of May 3, 2014, three customers individually accounted for 15%, 11%, and 11% of total accounts receivable, for a combined total of 37% of total accounts receivable. As of October 26, 2013, four customers individually accounted for 18%, 12%, 11%, and 11% of total accounts receivable, for a combined total of 52% of total accounts receivable. We perform ongoing credit evaluations of our customers and generally do not require collateral or security interests on accounts receivable balances. We have established reserves for credit losses, sales allowances, and other allowances. While we have not experienced material credit losses in any of the periods presented, there can be no assurance that we will not experience material credit losses in the future. Six Months Ended May 3, 2014, Compared to Six Months Ended April 27, 2013 Operating Activities. Cash provided by operating activities is net income adjusted for certain non-cash items and changes in certain assets and liabilities. Net cash provided by operating activities increased by $98.6 million primarily due to increased accounts receivable collections and decreased payments with respect to accrued employee incentive compensation, partially offset by an increase in excess tax benefits from stock-based compensation. The six months ended May 3, 2014, only includes a semiannual payout of the employee incentive compensation for the second half of fiscal year 2013 due to a change in our employee incentive compensation plan structure. The first quarter of fiscal year 2013 includes an annual payout of the employee incentive compensation for fiscal year 2012 . Investing Activities. Net cash used in investing activities decreased by $58.8 million. The decrease was primarily due to the $44.6 million of cash used for the Vyatta acquisition during the first quarter of fiscal year 2013. The decrease was also due to cash received from QLogic for the purchase of our network adapter business during the first quarter of fiscal year 2014, as well as lower capital expenditures during the six months ended May 3, 2014. Financing Activities. Net cash used in financing activities increased by $60.1 million. The increase was primarily due to higher repurchases of our Company's stock, partially offset by higher proceeds from the issuance of common stock pursuant to our equity compensation plans during the six months ended May 3, 2014, as well as an increase in excess tax benefits from stock-based compensation.



Liquidity

Manufacturing and Purchase Commitments. We have manufacturing arrangements with contract manufacturers under which we provide 12 month product forecasts and place purchase orders in advance of the scheduled delivery of products to our customers. Our purchase commitments reserve reflects our estimate of purchase commitments we do not expect to consume in normal operations within the next 12 months, in accordance with our policy (see Note 9, "Commitments and Contingencies," of the Notes to Condensed Consolidated Financial Statements). Income Taxes. We accrue U.S. income taxes on the earnings of our foreign subsidiaries unless the earnings are considered to be indefinitely reinvested outside of the United States. We intend to indefinitely reinvest current and accumulated earnings of our foreign subsidiaries for expansion of our business operations outside the United States. Our existing cash and cash equivalents totaled $1,137.6 million as of May 3, 2014. Of this amount, approximately 61% was held by our foreign subsidiaries. We do not currently anticipate a need for these funds held by our foreign subsidiaries for our domestic operations and our intent is to permanently reinvest such funds outside of the United States. Under current tax laws and regulations, if these funds are distributed to any of our United States entities in the form of dividends or otherwise, we may be subject to additional United States income taxes and foreign withholding taxes. The IRS and other tax authorities regularly examine our income tax returns (see Note 13, "Income Taxes," of the Notes to Condensed Consolidated Financial Statements). We believe we have adequate reserves for all open tax years. Senior Secured Credit Facility. In October 2008, we entered into a credit agreement for (i) a five-year, $1,100.0 million term loan facility and (ii) a five-year, $125.0 million revolving credit facility, which includes a $25.0 million swing line loan sub-facility and a $25.0 million letter of credit sub-facility (the "Senior Secured Credit Facility"). The credit agreement was subsequently amended in January 2010, June 2011, October 2013 and April 2014 to, among other things, provide us with greater operating flexibility, reduce interest rates on the term loan facility, reduce interest rates and fees on the revolving credit 46



--------------------------------------------------------------------------------

Table of Contents

facility and extend the maturity date of the revolving credit facility to January 7, 2015 (see Note 8, "Borrowings," of the Notes to Condensed Consolidated Financial Statements). We prepaid the term loan in full in the fourth quarter of fiscal year 2012, and there were no principal amounts or commitments outstanding under the term loan facility as of either May 3, 2014, or October 26, 2013. We have the following amount available for borrowing under the Senior Secured Credit Facility for ongoing working capital and other general corporate purposes, if needed, as of May 3, 2014 (in thousands): Original Amount May 3, 2014 Available Used Available



Revolving credit facility $ 125,000 $ - $ 125,000

Senior Secured Notes. In January 2010, we issued $300.0 million in aggregate principal amount of senior secured notes due 2018 (the "2018 Notes") and $300.0 million in aggregate principal amount of senior secured notes due 2020 (the "2020 Notes" and together with the 2018 Notes, the "Senior Secured Notes") (see Note 8, "Borrowings," of the Notes to Condensed Consolidated Financial Statements). We used the proceeds to pay down a substantial portion of the outstanding term loan, and to retire the convertible subordinated debt due on February 15, 2010, which had been assumed in connection with our acquisition of McDATA Corporation. The 2018 Notes were redeemed in the second quarter of fiscal year 2013, as described further below. Senior Unsecured Notes. In January 2013, we issued $300.0 million in aggregate principal amount of the 2023 Notes. We used the proceeds and cash on hand to redeem all of the outstanding 2018 Notes in the second quarter of fiscal year 2013, as described in Note 8, "Borrowings," of the Notes to Condensed Consolidated Financial Statements. Trade Receivables Factoring Facility. We have an agreement with a financial institution to sell certain of our trade receivables from customers with limited, non-credit-related recourse provisions. The sale of receivables eliminates our credit exposure in relation to these receivables. No trade receivables were sold under our factoring facility during the six months ended May 3, 2014, and the six months ended April 27, 2013. Under the terms of the factoring agreement, the total and available amounts of the factoring facility as of May 3, 2014, were $50.0 million. Covenant Compliance. Senior Unsecured Notes Covenants. The 2023 Notes were issued pursuant to an indenture, dated as of January 22, 2013, among the Company, the subsidiary guarantors named therein and Wells Fargo Bank, National Association, as trustee (the "2023 Indenture"). The 2023 Indenture contains covenants that, among other things, restrict the ability of the Company and its subsidiaries to: Incur certain liens and enter into certain sale-leaseback transactions;



Create, assume, incur or guarantee additional indebtedness of the

Company's subsidiaries without such subsidiary guaranteeing the 2023 Notes

on a pari passu basis; and Consolidate or merge with, or convey, transfer or lease all or substantially all of the Company's or its subsidiaries' assets.



These covenants are subject to a number of other limitations and exceptions set forth in the indenture. The Company was in compliance with all applicable covenants of the 2023 Indenture as of May 3, 2014.

47



--------------------------------------------------------------------------------

Table of Contents

Senior Secured Notes Covenants. The 2020 Notes and the 2018 Notes were issued pursuant to two separate indentures (the "2020 Indenture" and the "2018 Indenture," respectively), each dated as of January 20, 2010, among the Company, the subsidiary guarantors named therein and Wells Fargo Bank, National Association, as trustee. The 2020 Indenture contains covenants that, among other things, restrict the ability of the Company and its restricted subsidiaries to: Pay dividends, make investments or make other restricted payments;



Incur additional indebtedness;

Sell assets;

Enter into transactions with affiliates;

Incur liens;

Permit consensual encumbrances or restrictions on the Company's restricted

subsidiaries' ability to pay dividends or make certain other payments to

the Company;

Consolidate, merge, sell or otherwise dispose of all or substantially all

of the Company's or its restricted subsidiaries' assets; and

Designate subsidiaries as unrestricted.

These covenants are subject to a number of limitations and exceptions set forth in the indenture. The Company was in compliance with all applicable covenants of the 2020 Indenture as of May 3, 2014. The 2018 Indenture was discharged as of January 22, 2013 (see Note 8, "Borrowings," of the Notes to Condensed Consolidated Financial Statements). Prior to discharge, the 2018 Indenture contained substantially similar covenants and events of default to those in the 2020 Indenture. The Company was in compliance with all applicable covenants of the 2018 Indenture as of the date of discharge. The 2020 Indenture provides for customary events of default, including, but not limited to, cross defaults to specified other debt of the Company and its subsidiaries. In the case of an event of default arising from specified events of bankruptcy or insolvency, all outstanding senior secured notes will become due and payable immediately without further action or notice. If any other event of default under the 2020 Indenture occurs or is continuing, the applicable trustee or holders of at least 25% in aggregate principal amount of the then outstanding 2020 Notes, as applicable, may declare all of the 2020 Notes to be due and payable immediately. Senior Secured Credit Facility Covenants. The credit agreement governing the Senior Secured Credit Facility contains customary representations and warranties and customary affirmative and negative covenants applicable to the Company and its subsidiaries, including, among other things, restrictions on liens, indebtedness, investments, fundamental changes, dispositions, capital expenditures, prepayment of other indebtedness, redemption or repurchase of subordinated indebtedness, share repurchases, dividends and other distributions. The credit agreement contains financial covenants that require the Company to maintain a minimum consolidated fixed charge coverage ratio and a maximum consolidated leverage ratio, each as defined in the credit agreement and described further below. The credit agreement also includes customary events of default, including cross-defaults on the Company's material indebtedness and change of control. The Company was in compliance with all applicable Senior Secured Credit Facility covenants as of May 3, 2014. Consolidated Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA"), as defined in the credit agreement, is used to determine the Company's compliance with certain covenants in the Senior Secured Credit Facility. Consolidated EBITDA is defined as: Consolidated net income;



Plus:

Consolidated interest charges;

Provision for federal, state, local and foreign income taxes;

Depreciation and amortization expense;

Fees, costs and expenses incurred on or prior to the closing date of the

acquisition of Foundry in connection with the acquisition and the

financing thereof;

Any cash restructuring charges and integration costs in connection with

the acquisition of Foundry, in an aggregate amount not to exceed $75.0

million;

Approved non-cash restructuring charges incurred in connection with the

acquisition of Foundry and the financing thereof;

Other nonrecurring expenses reducing consolidated net income that do not

represent a cash item in such period or future periods;

Any non-cash stock-based compensation expense; and

48



--------------------------------------------------------------------------------

Table of Contents

Legal fees associated with the indemnification obligations for the benefit

of former officers and directors in connection with Brocade's historical

stock option litigation;

Minus:

Federal, state, local and foreign income tax credits; and

All non-cash items increasing consolidated net income.

The financial covenants imposed under the Senior Secured Credit Facility are described below. Consolidated Fixed Charge Coverage Ratio. Consolidated fixed charge coverage ratio means, at any date of determination, the ratio of (a)(i) consolidated EBITDA (excluding interest expense, if any, attributable to a campus sale-leaseback), plus (ii) rentals payable under leases of real property, less (iii) the aggregate amount of all capital expenditures to (b) consolidated fixed charges; provided that, for purposes of calculating the consolidated fixed charge coverage ratio for any period ending prior to the first anniversary of the closing date, consolidated interest charges shall be an amount equal to actual consolidated interest charges from the closing date through the date of determination multiplied by a fraction, the numerator of which is 365 and the denominator of which is the number of days from the closing date through the date of determination. Under the terms of the credit agreement, the Company is required to maintain a minimum fixed charge coverage ratio of at least 1.75:1. Consolidated fixed charges, as defined in the credit agreement, are comprised of the following: Consolidated interest charges; Plus: Regularly scheduled principal payments or redemptions or similar acquisitions for value of outstanding debt for borrowed money, but excluding any such payments to the extent refinanced through the incurrence of additional indebtedness;



Rentals payable under leases of real property;

Restricted payments; and

Federal, state, local and foreign income taxes paid in cash.

Consolidated Leverage Ratio. Consolidated leverage ratio means, as of any date of determination, the ratio of (a) consolidated funded indebtedness as of such date to (b) consolidated EBITDA for the measurement period ending on such date. Under the terms of the credit agreement, the Company may not permit the consolidated leverage ratio at any time to exceed 3:1. 49



--------------------------------------------------------------------------------

Table of Contents

Contractual Obligations The following table summarizes our contractual obligations, including interest expense, and commitments as of May 3, 2014 (in thousands): Less Than More Than Total 1 Year 1-3 Years 3-5 Years 5 Years Contractual Obligations: Senior secured notes due $ 418,594$ 20,625$ 41,250$ 41,250$ 315,469 2020 (1) Senior unsecured notes due 417,518 13,875 27,750 27,750 348,143 2023 (1) Non-cancellable operating leases 61,585 10,658 32,343 11,771 6,813 (2) Non-cancellable capital leases 2,967 2,405 562 - -



(1)

Purchase commitments, gross (3) 158,688 158,688 - - - Total contractual obligations $ 1,059,352$ 206,251$ 101,905$ 80,771$ 670,425 Other Commitments: Standby letters of credit $ 156 n/a n/a n/a n/a Unrecognized tax benefits and related accrued interest (4) $ 124,643 n/a n/a n/a n/a (1) Amount reflects total anticipated cash payments, including anticipated interest payments.



(2) Amount excludes contractual sublease income of $19.6 million, which consists

of $3.6 million to be received in less than one year, $13.5 million to be

received in one to three years, and $2.5 million to be received in three to

five years.

(3) Amount reflects total gross purchase commitments under our manufacturing

arrangements with a third-party contract manufacturer. Of this amount, we

have accrued $3.3 million for estimated purchase commitments that we do not

expect to consume in normal operations within the next 12 months, in accordance with our policy.



(4) As of May 3, 2014, we had a gross liability for unrecognized tax benefits of

$122.0 million and a net accrual for the payment of related interest and penalties of $2.6 million. Share Repurchase Program. As of May 3, 2014, our Board of Directors had authorized a total of $2.0 billion for the repurchase of our common stock since the inception of the program in August 2004. The purchases may be made, from time to time, in the open market or by privately negotiated transactions, and are funded from available working capital. The number of shares to be purchased and the timing of purchases are based on the level of our cash balances, general business and market conditions, our debt covenants, the trading price of our common stock and other factors, including alternative investment opportunities. For the three months ended May 3, 2014, we repurchased 5.3 million shares for an aggregate purchase price of $50.1 million. Approximately $809.6 million remained authorized for future repurchases under this program as of May 3, 2014. Subsequently, between May 3, 2014, and the date of the filing of this Quarterly Report on Form 10-Q, we repurchased 8.3 million shares of our common stock for an aggregate purchase price of $70.1 million. We are subject to certain covenants relating to our borrowings that may potentially restrict the amount of our Company's shares that we can repurchase. As of May 3, 2014, we were in compliance with all covenants. Off-Balance Sheet Arrangements As part of our ongoing business, we do not participate in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as "structured finance" or "special purpose entities," which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As of May 3, 2014, we did not have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Securities and Exchange Commission ("SEC") Regulation S-K. Critical Accounting Estimates There have been no material changes in the matters for which we make critical accounting estimates in the preparation of our condensed consolidated financial statements during the six months ended May 3, 2014, as compared to those disclosed in our Annual Report on Form 10-K for the fiscal year ended October 26, 2013. Impairment of Goodwill and Other Indefinite-Lived Intangible Assets. Goodwill and other indefinite-lived intangible assets are generated as a result of business combinations. Our indefinite-lived assets are comprised of acquired in-process research and development ("IPRD") and goodwill. 50



--------------------------------------------------------------------------------

Table of Contents

IPRD Impairment Testing. IPRD is an intangible asset accounted as an indefinite-lived asset until the completion or abandonment of the associated research and development effort. During the development period, we conduct our IPRD impairment test annually, as of the first day of the second fiscal quarter, and whenever events or changes in facts and circumstances indicate that it is more likely than not that IPRD is impaired. Events that might indicate impairment include, but are not limited to, adverse cost factors, deteriorating financial performance, strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on us and our customer base, and/or other relevant events such as changes in management, key personnel, litigations, or customers. Our ongoing consideration of all of these factors could result in IPRD impairment charges in the future, which could adversely affect our net income. We performed our annual development period's IPRD impairment test using measurement data as of the first day of the second fiscal quarter of 2014. During the test, we first assessed qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of our IPRD asset is less than its carrying amount. After assessing the totality of events and circumstances, we determined that it was not more likely than not that the fair values of our IPRD assets were less than their carrying amounts and no further testing was required. Goodwill Impairment Testing. We conduct our goodwill impairment test annually, as of the first day of the second fiscal quarter, and whenever events occur or facts and circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Events that might indicate impairment include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on our customer base, material negative changes in relationships with significant customers, and/or a significant decline in our stock price for a sustained period. Our ongoing consideration of all of these factors could result in goodwill impairment charges in the future, which could adversely affect our net income. We perform the two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of a goodwill impairment loss to be recognized, if any. The first step tests for potential impairment by comparing the fair value of reporting units with reporting units' net asset values. The reporting units are determined by the components of our operating segments that constitute a business for which both (i) discrete financial information is available and (ii) segment management regularly reviews the operating results of that component. If the fair value of the reporting unit exceeds the carrying value of the reporting unit's net assets, then goodwill is not impaired and no further testing is required. If the fair value of the reporting unit is below the reporting unit's carrying value, then the second step is required to measure the amount of potential impairment. The second step requires an assignment of the reporting unit's fair value to the reporting unit's assets and liabilities, using the relevant acquisition accounting guidance, to determine the implied fair value of the reporting unit's goodwill. The implied fair value of the reporting unit's goodwill is then compared with the carrying amount of the reporting unit's goodwill to determine the goodwill impairment loss to be recognized, if any. If the carrying value of a reporting unit's goodwill exceeds its implied fair value, we record an impairment loss equal to the difference. To determine the reporting unit's fair values, we use the income approach, the market approach, or a combination thereof. The income approach provides an estimate of fair value based on discounted expected future cash flows. The market approach provides an estimate of the fair value of our four reporting units applying various observable market-based multiples to the reporting unit's operating results and then applying an appropriate control premium. Determining the fair value of a reporting unit or an intangible asset is judgmental in nature and involves the use of significant estimates and assumptions. We based our fair value estimates on assumptions we believe to be reasonable but inherently uncertain. Estimates and assumptions with respect to the determination of the fair value of our reporting units using the income approach include, among other inputs: The Company's operating forecasts;



Revenue growth rates; and

Risk-commensurate discount rates and costs of capital.

Our estimates of revenues and costs are based on historical data, various internal estimates and a variety of external sources, and are developed as part of our regular long-range planning process. The control premium used in market or combined approaches is determined by considering control premiums offered as part of acquisitions that have occurred in a reporting unit's comparable market segments. Consistent with prior years, we perform our annual goodwill impairment test using measurement data as of the first day of the second fiscal quarter of 2014. At the time of goodwill impairment testing, our reporting units were: SAN Products; Ethernet Switching & IP Routing, which includes Open Systems Interconnection Reference Model ("OSI") Layer 2-3 products; Application Delivery Products ("ADP"), which includes OSI Layer 4-7 products; and Global Services. As of the date of the fiscal year 2014 annual goodwill impairment testing, Ethernet Switching & IP Routing and ADP reporting units' goodwill carrying value was $1,102 million and $207 million, respectively. In the second quarter of fiscal year 2014, we changed our 51



--------------------------------------------------------------------------------

Table of Contents

internal financial reporting, realigning it with the changes in our strategic direction to focus on key technology segments. As a result of this change, Ethernet Switching & IP Routing and ADP business components were combined into the IP Networking Products operating segment, and separate discrete financial information is no longer available for either Ethernet Switching & IP Routing or ADP components. During our fiscal year 2014 annual goodwill impairment test, we used a combination of the income approach and the market approach. We believe that, at the time of impairment testing performed in the second fiscal quarter of 2014, the income approach and the market approach were equally representative of a reporting unit's fair value. During the first step of goodwill impairment testing, we determined that the fair value of the ADP reporting unit was below the reporting unit's carrying value. Accordingly, we performed the second step of goodwill impairment testing to measure the amount of the impairment. During the second step, we assigned the ADP reporting unit's fair value to the reporting unit's assets and liabilities, using the relevant acquisition accounting guidance, to determine the implied fair value of the reporting unit's goodwill. The implied fair value of the reporting unit's goodwill was then compared with the carrying value of the ADP reporting unit's goodwill to record an impairment loss equal to the difference in values. For additional information, see Note 4, "Goodwill and Intangible Assets," of the Notes to Condensed Consolidated Financial Statements. During the first step of goodwill impairment testing, we determined that no impairment needed to be recorded for the SAN Products, Ethernet Switching & IP Routing, and Global Services reporting units as these reporting units passed the first step of goodwill impairment testing. However, because some of the inherent assumptions and estimates used in determining the fair value of these reportable segments are outside the control of management, changes in these underlying assumptions can adversely impact fair value. The sensitivity analysis below quantifies the impact of key assumptions on certain reporting units' fair value estimates. The key assumptions impacting our estimates were (i) discount rates and (ii) discounted cash flow ("DCF") terminal value multipliers. As these assumptions ultimately reflect the risk of achieving reporting units' revenue and cash flow projections, we determined that a separate sensitivity analysis for changes in revenue and cash flow projections is not meaningful or useful. The estimated fair value of the Ethernet Switching & IP Routing reporting unit exceeded its net assets' carrying value by approximately $57 million. The respective fair values of the SAN and Global Services reporting units were substantially in excess of these reporting units' carrying values and were not subject to the sensitivity analysis presented below. The following table summarizes the approximate impact that a change in key assumptions would have on the estimated fair value of the Ethernet Switching & IP Routing reporting unit, leaving all other assumptions unchanged: Approximate Excess of Impact on Fair Fair Value over Value Carrying Value Change (In millions) (In millions) Discount rate 1% $(38) - 41 $19 - 98



DCF terminal value multiplier 0.5x $(33) - 33 $24 - 90

Recent Accounting Pronouncements For a description of recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on our condensed consolidated financial statements, see Note 2, "Summary of Significant Accounting Policies," of the Notes to Condensed Consolidated Financial Statements.


For more stories on investments and markets, please see HispanicBusiness' Finance Channel



Source: Edgar Glimpses


Story Tools






HispanicBusiness.com Facebook Linkedin Twitter RSS Feed Email Alerts & Newsletters