News Column

QUANTUM CORP /DE/ - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

June 6, 2014

OVERVIEW

Quantum Corporation ("Quantum", the "Company", "us" or "we"), founded in 1980, is a is a leading expert in scale-out storage, archive and data protection, providing solutions for capturing, sharing and preserving digital assets over the entire data lifecycle. Our customers, ranging from small businesses to major enterprises, have trusted us to address their most demanding data workflow challenges. We provide solutions for storing and protecting information in physical, virtual and cloud environments that are designed to help customers Be CertainTM they have an end-to-end storage foundation to maximize the value of their data by making it accessible whenever and wherever needed, retaining it indefinitely and reducing total cost and complexity. We work closely with a broad network of distributors, value-added resellers ("VARs"), direct marketing resellers ("DMRs"), original equipment manufacturers ("OEMs") and other suppliers to meet customers' evolving needs. Our stock is traded on the New York Stock Exchange under the symbol QTM.



Business

We believe our combination of expertise, innovation and platform independence enables us to solve data protection and scale-out storage challenges more easily, cost-effectively and securely. We earn our revenue from the sale of products, systems and services through an array of channel partners and our sales force. Our products are sold under both the Quantum brand name and the names of various OEM customers. Our scale-out storage and archive solutions, StorNext« file system and archive software, StorNext appliances and LattusTM Object Storage systems, are designed to help customers manage large unstructured data sets in an information workflow, encompassing high-performance ingest, real-time collaboration, scalable processing, intelligent protection and high-value monetization. Our data protection solutions include DXi« deduplication systems and Scalar« automated tape libraries that optimize backup and recovery, simplify management and lower cost. Our vmPROTM virtual server backup and disaster recovery offerings protect virtual environments while minimizing the impact on servers and storage. In addition, we also offer software for cloud backup and disaster recovery of physical and virtual servers. We have a full range of services and the global scale and scope to support our worldwide customer base. Our goals for fiscal 2014 were to continue to capitalize on market opportunities while balancing cash flow generation and operating profit against revenue growth associated with potential opportunities and go-to-market strategies, with an emphasis on delivering results that we expect to be more predictable going forward. In some cases, as was the case in the second through fourth quarters of fiscal 2014, this means we may generate lower overall revenue but more cash flow and profit in order to provide greater operating leverage for future revenue increases. Our revenue growth strategy in fiscal 2014 was focused on leveraging our StorNext and Lattus solutions to drive deeper into rich media and other vertical markets and extending the reach of these solutions into the data center and the cloud in addition to expanding relationships with our partners and gaining additional access to end users through existing and new channel partners. We continued our efforts to further leverage our tape automation and DXi expertise, our installed product base and our broad data protection product portfolio in order to gain market share in the data center. During fiscal 2014, we improved our operational efficiency and effectiveness in a number of areas. We initiated and completed a transition to outsource our manufacturing and repair operations, streamlined our service capabilities and refined our sales model. In addition, we realigned our engineering and product groups to leverage our product development strengths from our data center products to scale-out storage products in an effort to increase our overall product development capabilities, reduce our time-to-market, especially in launching new scale-out storage products, decrease our operational costs and increase our operational leverage across the company. Refinement of our operational model in fiscal 2014 included focusing our scale-out storage go-to-market and sales team on vertical markets where they are particularly strong, while enabling our larger data center sales team to focus on sales of tape automation and disk solutions in the data center and identifying StorNext and Lattus opportunities around specific data center use cases. We believe these operational improvements contributed to the record revenue from scale-out storage products in fiscal 2014, in part from key sales in the media and entertainment vertical market and specific use cases in the data center. We continued to improve our strategic positioning and visibility among end user customers and channel partners in our core markets of tape automation, purpose built deduplication appliances and scale-out storage in fiscal 2014. We focused on new product introductions, providing a broad range of products to solve customer problems and expanding our strategic and channel partners in an effort to gain greater end-user access and additional market share in fiscal 2014. We are a smaller market participant in some of the markets we participate in and compete against well known, larger companies in all the markets for our products. We believe increasing market awareness of our products and solutions is an important initiative for future growth and improved profitability and cash flow. 26

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In fiscal 2014, we expanded and improved our product and solution offerings, with emphasis on software solutions, branded disk systems, next generation object storage, virtual offerings and cloud solutions. Notable new product introductions included StorNext 5 software, DXi 4700 disk systems, additional StorNext appliances, expansion of our Lattus Object Storage offerings and adding new high availability and management features to our Scalar i6000 enterprise library. In addition, we expanded our strategic partnerships to combine Lattus with products and solutions from various partners to expand data center environment solutions, to provide an object storage based private cloud solution and to create an archiving solution that reduces the burden of unstructured data growth on primary storage. We also introduced a new program enabling managed service providers and VARs to expand their businesses with a cloud backup service powered by our DXi appliances and vmPRO backup software that has capacity-based subscription pricing. In addition, we received industry recognition during fiscal 2014 with an award for our channel sales program and award nominations for products in each of our major product lines including Lattus Object Storage solutions, DXi6800, DXiV4000, Scalar i6000 and StorNext products. During 2014 we continued our focus to strengthen our balance sheet by balancing growth areas with generating cash from operations and ended the fiscal year with the highest cash balance in four years. In addition, in April 2014, we completed an amendment to our Wells Fargo credit agreement which increased our line of credit by $20 million to $75 million and provided additional flexibility by allowing the line of credit to be utilized to pay outstanding amounts under the November 2010 convertible subordinated notes, which are due in November 2015.



Results

We had total revenue of $553.2 million in fiscal 2014, a 6% decrease from fiscal 2013 primarily due to the combination of the changing storage environment, including reduced demand for tape products and increased market demand for scale-out storage and archive solutions, and our actions to reduce our investment in sales while improving the efficiency of our sales model. We had record revenue for scale-out storage solutions largely due to increased revenue from sales in North America. Service revenue increased slightly from fiscal 2013 primarily due to increased revenue from branded service contracts associated with our StorNext appliances, and royalty revenue increased 30% from fiscal 2013 due to a $15.0 million royalty received in connection with finalizing an intellectual property agreement in the first quarter of fiscal 2014. The proportion of non-royalty revenue from branded products and services continued to increase, growing to 84% in fiscal 2014 compared to 83% in fiscal 2013 and 81% in fiscal 2012. Our gross margin percentage increased 230 basis points from fiscal 2013 to 43.3%, largely due to the increased royalty revenue followed by improvements in our service delivery model. Operating expenses decreased $31.3 million, or 11% from fiscal 2013, primarily from lower compensation and benefits as a result of headcount reductions implemented over the past year and a half. We had a $30.7 million improvement in the loss from operations, decreasing to $11.8 million in fiscal 2014 compared to $42.5 million in fiscal 2013. Interest expense increased $1.4 million to $9.8 million primarily due to refinancing the balance on the line of credit with convertible subordinated notes in fiscal 2013. Net loss decreased 59% to $21.5 million in fiscal 2014, despite a 6% decrease in revenue from fiscal 2013. We more than quadrupled cash generated from operating activities in fiscal 2014 to $35.5 million compared to $7.7 million in fiscal 2013. We attribute the improved cash from operations and decreased net loss to improved operational effectiveness and efficiency in our business model.



RESULTS OF OPERATIONS FOR FISCAL 2014, 2013, and 2012

Revenue

For the year ended March 31, Change (dollars in thousands) 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 % of % of % of revenue revenue revenue



Product revenue $ 348,318 63.0 % $ 398,910 67.9 %

$ 451,469 69.3 % $ (50,592 ) (12.7 )% $ (52,559 ) (11.6 )% Service revenue

147,199 26.6 % 144,037 24.5 % 144,364 22.1 % 3,162 2.2 % (327 ) (0.2 )% Royalty revenue 57,648 10.4 % 44,492 7.6 % 56,154 8.6 % 13,156 29.6 % (11,662 ) (20.8 )% Total revenue $ 553,165 100.0 % $ 587,439 100.0 % $ 651,987 100.0 % $ (34,274 ) (5.8 )% $ (64,548 ) (9.9 )% The decrease in total revenue in fiscal 2014 compared to fiscal 2013 was due to decreased tape automation systems revenue and disk systems revenue, partially offset by increased royalty revenue and revenue from StorNext software and related appliances. We believe this is due to the changing storage environment including reduced demand for tape products and increased market demand for scale-out storage and archive solutions in addition to our actions related to reducing our investments in sales while improving our sales model. Prevailing economic conditions in major geographies also impacted our results during the fiscal year, including economic uncertainty and its impact on the European business climate. We also believe sales to the U.S. federal government were negatively impacted in the second and third quarters of fiscal 2014 by the U.S. federal government shut down, causing delays and cancelations of orders. 27 --------------------------------------------------------------------------------



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Data protection products include our tape automation systems, disk systems and devices and media offerings. Revenue from branded data protection products and services decreased $41.5 million, or 10%, from fiscal 2013 largely due to a decrease in sales of enterprise solutions in both tape automation and disk systems products. Revenue from branded scale-out storage and archive products and services increased $6.5 million, or 12%, from fiscal 2013 primarily due to increased sales of our Q-Series and StorNext appliance offerings. Branded scale-out storage and archive products include StorNext software, StorNext and Q-Series appliances and Lattus Object Storage solutions. OEM product and service revenue decreased $12.4 from fiscal 2013, largely due to decreased midrange and enterprise tape automation product sales. Royalty revenue increased $13.2 million from fiscal 2013 primarily due to a $15.0 million royalty received in connection with finalizing an intellectual property agreement in the first quarter of fiscal 2014. Total revenue in fiscal 2013 decreased from fiscal 2012, reflecting a decline in the tape automation market, economic uncertainty and a decrease in large orders, which we define as orders over $200,000. These factors impacted revenue from branded data protection products and services the most, with a $40.1 million, or 9%, decrease from fiscal 2012. The market for end-to-end scale-out storage solutions continued to grow in fiscal 2013, and revenue from branded scale-out storage products and services increased 18%, or $7.8 million, from fiscal 2012, partially offsetting the decreased revenue from data protection products. In addition, OEM product and service revenue decreased $20.6 million, or 19%, and royalty revenue decreased $11.7 million, or 21%, from fiscal 2012.



Product Revenue

Total product revenue decreased 13% from fiscal 2013, primarily due to decreased sales of tape automation systems followed by lower revenue from disk systems and software solutions, partially offset by increased revenue from devices and media. Revenue from sales of branded products decreased 12% primarily due to lower sales of disk systems followed by tape automation systems decreases and OEM product revenue decreased 14% in fiscal 2014 compared to fiscal 2013 largely due to decreased tape automation revenue. Product revenue decreased 12% in fiscal 2013 compared to fiscal 2012, primarily due to decreased sales of tape automation systems followed by lower revenue from devices and media, partially offset by increased revenue from disk systems and software solutions. Revenue from sales of branded products decreased 10% and OEM product revenue decreased 18% in fiscal 2013 compared to fiscal 2012, both primarily due to lower sales of tape automation systems. For the year ended March 31, Change (dollars in thousands) 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 % of % of % of revenue revenue revenue Disk systems and software solutions



$ 103,200 18.7 % $ 124,074 21.1 % $ 119,044 18.3 % $ (20,874 ) (16.8 )% $ 5,030 4.2 % Tape automation systems

174,438 31.5 % 206,112 35.1 % 245,030



37.6 % (31,674 ) (15.4 )% (38,918 ) (15.9 )% Devices and media

70,680 12.8 % 68,724 11.7 % 87,395



13.4 % 1,956 2.8 % (18,671 ) (21.4 )% Total product revenue

$ 348,318 63.0 % $ 398,910 67.9 % $ 451,469 69.3 % $ (50,592 ) (12.7 )% $ (52,559 ) (11.6 )%

Fiscal 2014 Compared to Fiscal 2013

Disk systems and software solutions revenue decreased 17% from fiscal 2013 primarily due to decreased sales of enterprise DXi systems in addition to decreased midrange disk revenue. Partially offsetting these decreases were increased revenue from Q-Series disk and StorNext appliances compared to fiscal 2013. We had lower enterprise and midrange disk system revenue primarily due to fewer large orders, or orders over $200,000, during fiscal 2014. 28 --------------------------------------------------------------------------------



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Product revenue from tape automation systems revenue decreased 15% in fiscal 2014 compared to fiscal 2013, primarily due to decreased enterprise tape automation system sales, with a 24% decrease in branded enterprise sales followed by a 20% decline OEM enterprise revenue. Midrange and entry-level tape automation sales also contributed to the decrease due to declines in both OEM and branded revenue from these products. Product revenue from devices and media, which includes tape drives, removable hard drives and non-royalty media, increased modestly from fiscal 2013 primarily due to increased branded media sales in addition to increased revenue from devices.



Fiscal 2013 Compared to Fiscal 2012

Our disk systems and software solutions revenue increased 4% from 2012, resulting in record annual revenue in this revenue category. Revenue increases were primarily from sales of our StorNext appliances leading to record revenue for branded software solutions, and we also had record revenue from sales of midrange DXi products. The first StorNext appliances were introduced in fiscal 2012 and we added a number of products to the StorNext appliance family during fiscal 2013. Revenue from midrange disk systems increased 8% from the prior year; however, we believe our midrange disk systems cannibalized some revenue from enterprise disk solutions due to the capabilities of our newest midrange disk product. We had lower enterprise disk system revenue primarily due to fewer large orders, or orders over $200,000, during fiscal 2013. The decrease in tape automation systems revenue in fiscal 2013 compared to fiscal 2012 was due to approximately $20 million decreases in both branded and OEM tape automation system sales. Midrange tape automation sales decreased the most, with 15% and 17% decreases, respectively, of branded midrange and OEM midrange tape automation systems revenue. Enterprise systems and entry-level sales of tape automation systems had similar revenue decreases from fiscal 2012. As we noted in fiscal 2013, demand for tape automation products decreased approximately 20% during the first half of fiscal 2013. Revenue from OEM tape automation systems decreased 20% while branded tape automation systems revenue decreased 13%, an indication that we gained market share in the branded tape business during fiscal 2013. Product revenue from devices and media, which includes tape drives, removable hard drives and non-royalty media, decreased as expected from fiscal 2012 largely due to decreased media sales in addition to lower revenue from devices. These revenue decreases were primarily due to overall market declines. Higher than typical media sales during fiscal 2012 due to inventories being increased in response to concerns of supply disruptions following the March 2011 earthquake and tsunami in Japan also contributed to the decreased media revenue in fiscal 2013 compared to the prior year.



Service Revenue

Service revenue is primarily comprised of hardware service contracts which are typically purchased by our customers to extend the warranty or to provide faster service response time, or both. Service revenue increased 2% from fiscal 2013 primarily due to increased revenue from branded service contracts associated with our StorNext appliances. Service revenue was relatively unchanged in fiscal 2013 compared to fiscal 2012 primarily due to a decreased volume of OEM product repair services that was offset by growth in revenue from branded service contracts associated with our StorNext appliances.



Royalty Revenue

Royalty revenue increased $13.2 million, or 30%, from fiscal 2013 primarily due to a $15.0 million royalty received in connection with finalizing an intellectual property agreement in the first quarter of fiscal 2014. This was partially offset by expected decreases in DLT« media royalties as customers chose to not use this older technology. Tape media royalties decreased 21% in fiscal 2013 from fiscal 2012 due to lower media unit sales sold by media licensees, largely due to decreased market demand for LTO« media. In addition, royalties from the older technology DLT media continued to decrease as expected. 29 --------------------------------------------------------------------------------

Table of Contents Gross Margin For the year ended March 31, Change (dollars in thousands) 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 Margin Margin Margin Basis Basis Margin Rate Margin Rate Margin Rate Margin points Margin points Product margin $ 111,242 31.9 % $ 131,636 33.0



% $ 161,093 35.7 % $ (20,394 ) (110 ) $ (29,457 )

(270 ) Service margin 71,269 48.4 % 64,433 44.7 % 55,898 38.7 % 6,836 370 8,535



600

Royalty margin 57,648 100.0 % 44,492 100.0



% 56,154 100.0 % 13,156 - (11,662 )

-

Gross margin $ 239,620 * 43.3 % $ 240,561 41.0 % $ 273,445 * 41.9 % $ (941 ) 230 $ (32,884 ) (90 )



* Fiscal 2014 total gross margin includes $0.5 million of restructuring expense related to cost of revenue and fiscal 2012 includes $0.3 million of restructuring benefit related to cost of revenue.

Over half of the 230 basis point increase in gross margin percentage compared to fiscal 2013 was due to the $13.2 million net increase in royalty revenue and the next largest portion of the increase was attributable to the improvements in our service delivery model. These increases were partially offset by decreases in our product margin, largely as a result of decreased product revenue. The 90 basis point decrease in gross margin percentage in fiscal 2013 compared to fiscal 2012 was primarily due to decreased product revenue and a corresponding lower product gross margin as well as an $11.7 million decrease in royalty revenue, partially offset by increased service gross margin. Some of our costs of goods sold are relatively fixed in the short term; therefore, revenue increases or decreases can have a material impact on the gross margin rate.



Product Margin

Fiscal 2014 Compared to Fiscal 2013

Product gross margin dollars decreased $20.4 million, or 15%, compared to fiscal 2013, and our product gross margin rate decreased 110 basis points primarily due to a 13% decrease in product revenue. The decreased product revenue was mostly offset in fiscal 2014 by decreased costs as a result of several items. Product material costs decreased the most, commensurate with the decrease in product revenue, and we also had decreased freight costs as a result of fewer shipments. A number of expenses decreased compared to fiscal 2013 as a result of cost reduction initiatives that began in the second half of fiscal 2013 and continued throughout fiscal 2014. The most significant decreased cost as a result of these initiatives was compensation and benefits expense from reduced staffing levels in addition to decreased facility expenses from additional reductions to our warehouse footprint. We also had lower intangible amortization in fiscal 2014 from certain intangible assets becoming fully amortized.



Fiscal 2013 Compared to Fiscal 2012

Product gross margin dollars decreased $29.5 million, or 18%, compared to fiscal 2012, and our product gross margin rate decreased 270 basis points primarily due to a 12% decrease in product revenue. As noted above, some of our product costs of goods sold are relatively fixed in the short term; therefore, product revenue increases or decreases impact the product gross margin rate. The change in the mix of products sold, as described above in product revenue, also contributed to decreased product margins in fiscal 2013. In addition, we had an increase in compensation and benefits in fiscal 2013 compared to fiscal 2012 primarily due to investment in our software support team. We also had an increase in the manufacturing inventory allowance in fiscal 2013 compared to the prior year largely due to more products nearing end of life. Partially offsetting these factors was lower intangible amortization in fiscal 2013 due to certain intangible assets becoming fully amortized in fiscal 2013 and fiscal 2012, decreased facility expense from reducing our warehouse footprint and lower freight expense as a result of fewer shipments compared to fiscal 2012.



Service Margin

Fiscal 2014 Compared to Fiscal 2013

Service gross margin dollars increased $6.8 million, or 11%, compared to fiscal 2013, and service gross margin percentage increased 370 basis points on a 2% increase in service revenue. The increase in service margin was primarily due to lower costs across our service delivery model largely due to reduced compensation and benefits from lower staffing levels, including outsourcing geographies with lower service and repair volumes and improving utilization of our service team. In addition, our service activities continue to reflect a larger proportion of branded products under contract, which have relatively higher margins than margins for OEM repair services. 30 --------------------------------------------------------------------------------



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Fiscal 2013 Compared to Fiscal 2012

Service gross margin dollars increased $8.5 million, or 15%, compared to fiscal 2012, and service gross margin percentage increased 600 basis points while service revenue was unchanged. The increase in service margin was primarily due to reduced costs across our service delivery model from a decreased volume of repairs and in part due to bringing repair of certain product lines in-house. The more significant cost decreases in fiscal 2013 compared to fiscal 2012 were for compensation and benefits, external service providers, third party warehouse and service materials. Compensation and benefits decreased due to reduced staffing requirements from decreased repair volumes. External service provider expense decreased due to a combination of having repair of certain product lines in-house for the full fiscal year, decreased repair volumes and negotiating lower rates on the renewals of contracts with certain service providers in fiscal 2012. Third party warehouse expenses decreased due to efforts to reduce service parts inventory levels including reduced usage of third party warehouses. Service material decreases were primarily due to lower repair volumes compared to the prior year. Additionally, our service activities continue to reflect a larger proportion of branded products under contract, which have relatively higher margins than margins for OEM repair services.



Research and Development Expenses

For the year ended March 31, Change (dollars in thousands) 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 % of % of % of revenue revenue revenue Research and development $ 64,375 11.6% $ 73,960 12.6% $ 74,365 11.4% $ (9,585) (13.0)% $ (405) (0.5)%



Fiscal 2014 Compared to Fiscal 2013

The decrease in research and development expenses compared to fiscal 2013 was primarily due to cost reduction measures that resulted in a $6.6 million decrease in compensation and benefits from reduced staffing levels due to focusing investments in scale-out storage technology while continuing to invest in targeted future generation tape and disk technology. We also had a decrease of $1.5 million in external service provider expense and a decrease of $0.9 million in depreciation expense due to equipment becoming fully depreciated. Additionally, there was a $0.3 million decrease in project material expenses due to the nature of projects under development and specific development activities in the prior year periods that were not repeated at the same levels and a $0.3 million decrease in expensed equipment.



Fiscal 2013 Compared to Fiscal 2012

The decrease in research and development expenses compared to fiscal 2012 was the net result of several factors. Due to the implementation of cost reduction measures in the second half of fiscal 2013, including restructuring actions that decreased headcount, we had a decrease of $0.8 million in compensation and benefits and also had smaller decreases in several other areas including travel expenses, dues and subscriptions and facilities expense. In addition, we had a $0.6 million decrease in project materials as a result of the types of products under development and related testing material requirements compared to the prior year. Mostly offsetting these decreases, we had a $0.9 million increase in depreciation expense due to laboratory testing equipment purchases and a $0.6 million increase in use of external service providers, primarily for next generation LTO product development. Sales and Marketing Expenses For the year ended March 31, Change (dollars in thousands) 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 % of % of % of revenue revenue revenue Sales and marketing $ 118,771 21.5% $ 136,873 23.3% $ 131,239 20.1% $ (18,102) (13.2)% $ 5,634 4.3%



Fiscal 2014 Compared to Fiscal 2013

The decrease in sales and marketing expense compared to fiscal 2013 was primarily due to cost reduction initiatives that resulted in decreases of $12.8 million in compensation and benefits, including commissions, from decreased staffing levels and reduced revenue compared to fiscal 2013. We had a $2.1 million decrease in intangible amortization due to certain intangibles becoming fully amortized in the first half of fiscal 2014. Other decreases from cost reduction initiatives included declines of $1.8 million in travel expenses, $0.8 million in advertising and marketing and $0.7 million in recruiting expenses. These decreases were partially offset by a $1.1 million increase in external service provider expense. 31

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Fiscal 2013 Compared to Fiscal 2012

The increase in sales and marketing expense in fiscal 2013 compared to fiscal 2012 was primarily due to a $5.1 million increase in compensation and benefits from growing our branded sales force and marketing team in the first half of fiscal 2013. In addition, we had a $2.2 million net increase in advertising and marketing expenses and a $0.7 million increase in external service provider expense due to our awareness campaign and expanded advertising programs in the first half of fiscal 2013 intended to increase current and future demand for our products and services. These efforts contributed to stronger new customer acquisition in fiscal 2013. These increases were partially offset by a $3.6 million decrease in intangible amortization due to certain intangibles becoming fully amortized.



General and Administrative Expenses

For the year ended March 31, Change (dollars in thousands) 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 % of % of % of revenue revenue revenue General and administrative $ 57,865 10.5% $ 62,017 10.6% $ 62,666 9.6% $ (4,152) (6.7)% $ (649) (1.0)%



Fiscal 2014 Compared to Fiscal 2013

The decrease in general and administrative expense was largely due to a $1.4 million decrease in compensation and benefits, largely as a result of decreased staffing as well as reduced stock compensation expense due to a modification to extend the post-retirement exercise period for certain options in the first quarter of fiscal 2013 that was not repeated. Other cost decreases included $0.8 million in facility expenses from consolidating facilities during fiscal 2014, $0.5 million due to a refund of prior IT claims, $0.4 million in depreciation expense, $0.3 million in external service provider expense and $0.3 million in expensed IT equipment.



Fiscal 2013 Compared to Fiscal 2012

The decrease in general and administrative expenses from fiscal 2012 was primarily due to a $0.8 million decrease in compensation and benefits from reduced headcount as a result of restructuring actions taken in the second half of fiscal 2013.

Restructuring Charges For the year ended March 31, Change (dollars in thousands) 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 % of % of % of revenue revenue revenue Restructuring charges (benefit) related to cost of revenue $



539 0.1 % $ - - % $ (300 ) 0.0 % $

539 n/a $ 300 100.0 % Restructuring charges in operating expenses



10,675 1.9 % 10,171 1.7 % 1,930 0.3 %

504 5.0 % 8,241 n/m Total restructuring charges $ 11,214 2.0 % $ 10,171 1.7 % $ 1,630 0.3 % $ 1,043 10.3 % $ 8,541 n/m Our restructuring plans have been undertaken in an effort to return to consistent profitability and generate cash from operations. Restructuring actions in fiscal 2014 were largely due to strategic management decisions to outsource our manufacturing and further consolidate repair and service operations, in addition to reducing research and development, sales and marketing and administrative activities and teams to align our workforce with our continuing operations plans. The increase in fiscal 2013 compared to fiscal 2012 was primarily in response to the tape revenue decrease in the first half of fiscal 2013, its impact on operating profit and the use of cash in operations. As a result, we recognized the need for and implemented restructuring plans in the second half of fiscal 2013. For additional information and disclosure of restructuring charges refer to Note 9 "Restructuring Charges" to the Consolidated Financial Statements. Until we achieve consistent and sustainable levels of profitability, we may incur restructuring charges in the future from additional strategic cost reduction efforts. 32 --------------------------------------------------------------------------------



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Fiscal 2014 Compared to Fiscal 2013

Restructuring charges increased in fiscal 2014 compared to fiscal 2013 primarily due to increased facility restructuring and other restructuring charges, largely attributable to our decision to outsource our manufacturing operations. Facility restructuring charges increased $2.4 million from fiscal 2013 primarily due to vacating a majority of our manufacturing and warehouse facilities, all of which are in the U.S. Other restructuring charges increased $0.8 million primarily due to restructuring charges related to cost of sales incurred as a result of our manufacturing outsource decision. These were partially offset by a $2.1 million decrease in severance charges largely due to a higher average severance charge per position in the prior year as a result of the specific job type, tenure and geographies of the positions eliminated.



Fiscal 2013 Compared to Fiscal 2012

The increase in restructuring charges in fiscal 2013 compared to the prior year was primarily due to a $6.7 million increase in severance and benefits expense from eliminating more positions in both the U.S. and internationally across most functions of the business to align spending with revenue expectations. Facility restructuring expense increased $1.6 million compared to fiscal 2012 primarily due to accruing remaining lease expense related to the portion of a U.S. facility that was vacated in the fourth quarter of fiscal 2013. Gain on Sale of Assets For the year ended March 31, Change (dollars in thousands) 2014 2013

2012 2014 vs. 2013 2013 vs. 2012 % of % of % of revenue revenue revenue



Gain on sale of assets $ 267 0.0% $ - -% $ 1,500 0.2% $ 267 n/a $ (1,500) (100.0)%

During fiscal 2014, we had a $0.3 million gain on the sale of assets. We sold various manufacturing, repair and research and development assets in connection with our restructuring plans. During fiscal 2012, we had a $1.5 million gain on the sale of patents. Under the patent sale agreement, we retain a royalty-free license for these patents. We may enter into similar transactions in the future. Other Income and Expense For the year ended March 31, Change (dollars in thousands) 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 % of % of % of revenue revenue revenue



Other income and (expense) $ 1,296 0.2% $ (216) 0.0% $ (118) 0.0% $ 1,512 n/m $ (98) (83.1)%

Other income in fiscal 2014 was primarily attributable to an $0.8 million increase from foreign currency gains in fiscal 2014 compared to foreign currency losses in fiscal 2013. The foreign currency gains in fiscal 2014 were primarily attributable to a strengthening of the US dollar against the Australian dollar. The foreign currency losses in fiscal 2013 were largely due to strengthening of the US dollar against the euro. Other expense in fiscal 2013 was relatively unchanged from fiscal 2012. Interest Expense For the year ended March 31, Change (dollars in thousands) 2014 2013

2012 2014 vs. 2013 2013 vs. 2012 % of % of % of revenue revenue revenue Interest expense $ 9,754 1.8% $ 8,342 1.4% $ 10,686 1.6% $ 1,412 16.9% $ (2,344) (21.9)%



Interest expense includes the amortization of debt issuance costs for debt facilities. For further information, refer to Note 8 "Convertible Subordinated Debt and Long-term Debt" to the Consolidated Financial Statements.

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Fiscal 2014 Compared to Fiscal 2013

Interest expense increased from fiscal 2013 primarily due to refinancing our revolving debt balance in the third quarter of fiscal 2013 with 4.50% convertible subordinated notes. These convertible subordinated notes have a higher interest rate and a larger principal balance.

Fiscal 2013 Compared to Fiscal 2012

Interest expense decreased from fiscal 2012 primarily due to principal payments that reduced the outstanding debt balance in fiscal 2013 compared to fiscal 2012. We also had a lower average interest rate during fiscal 2013 than the prior year that contributed to decreased interest expense. In addition, the debt refinancing in March 2012 to a revolving credit facility that had lower debt issuance costs than the prior credit facility decreased amortization of debt issuance costs in fiscal 2013 compared to fiscal 2012. Loss on Debt Extinguishment For the year ended March 31, Change (dollars in thousands) 2014 2013

2012 2014 vs. 2013 2013 vs. 2012 % of % of % of revenue revenue revenue



Loss on debt extinguishment $ - -% $ - -% $ (2,310) (0.4)% $ - -% $ 2,310 100.0%

During the fourth quarter of fiscal 2012, we fully repaid our senior secured term loan with Credit Suisse. In connection with this debt extinguishment, we wrote off $2.3 million of unamortized debt costs related to the Credit Suisse credit agreement. Income Taxes For the year ended March 31, Change (dollars in thousands) 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 % of % of % of pre-tax loss pre-tax loss pre-tax loss Income tax provision $ 1,217 (6.0)% $ 1,161 (2.3)% $ 887 (10.6)% $ 56 4.8% $ 274 30.9% Income tax provision was essentially unchanged in fiscal 2014 compared to fiscal 2013. The $0.3 million increase in tax expense in fiscal 2013 compared to fiscal 2012 was primarily due to higher foreign taxes. Tax expense in fiscal 2014, 2013 and 2012 was primarily comprised of foreign income taxes and state taxes. For additional information, including a reconciliation of the effective tax rate, refer to Note 12 "Income Taxes" to the Consolidated Financial Statements.



Amortization of Intangible Assets

The following table details intangible asset amortization expense by classification within our Consolidated Statements of Operations (in thousands): For the year ended March 31, Change 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 Cost of revenue $ 1,476$ 3,775$ 7,583$ (2,299 ) (60.9 )% $ (3,808 ) (50.2 )% Sales and marketing 7,426 9,524 13,128 (2,098 ) (22.0 )% (3,604 ) (27.5 )% General and administrative - - 32 - - % (32 ) (100.0 )% $ 8,902$ 13,299$ 20,743$ (4,397 ) (33.1 )% $ (7,444 ) (35.9 )% The decreased intangible asset amortization in fiscal 2014 and 2013 compared to the respective prior years was due to certain intangible assets becoming fully amortized. Refer to Note 6 "Intangible Assets and Goodwill" to the Consolidated Financial Statements for further information regarding our amortizable intangible assets. 34 --------------------------------------------------------------------------------



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Share-Based Compensation

The following table summarizes share-based compensation within our Consolidated Statements of Operations (in thousands):

For the year ended March 31, Change 2014 2013 2012 2014 vs. 2013 2013 vs. 2012 Cost of revenue $ 1,963$ 2,389$ 2,203



$ (426 ) (17.8 )% $ 186 8.4 % Research and development 3,430

3,665 3,250 (235 ) (6.4 )% 415 12.8 % Sales and marketing 4,097 4,699 4,048 (602 ) (12.8 )% 651 16.1 % General and administrative 3,969 4,386 4,236 (417 ) (9.5 )% 150 3.5 % $ 13,459$ 15,139$ 13,737$ (1,680 ) (11.1 )% $ 1,402 10.2 %



Fiscal 2014 Compared to Fiscal 2013

The decrease in share-based compensation in fiscal 2014 was primarily due to a $0.9 million decrease in option expense due to option modifications in fiscal 2013 that were not repeated in addition to existing options becoming fully vested during fiscal 2014. We also had a $0.6 million decrease in expense related to the employee stock purchase plan ("ESPP") due to a combination of decreased employee contributions as a result of reduced staffing from fiscal 2013 and lower stock prices.



Fiscal 2013 Compared to Fiscal 2012

The increase in share-based compensation in fiscal 2013 was primarily due to $2.5 million of incremental RSU expense largely for merit awards granted in 2013 to sales and marketing and research and development team members. This increase was partially offset by a $0.9 million decrease in option expense from fiscal 2012 due to existing options becoming fully vested during fiscal 2013 and a $0.2 million decrease in expense related to the ESPP due to lower stock prices than fiscal 2012.



LIQUIDITY AND CAPITAL RESOURCES

As of or for the year ended March 31, (In thousands) 2014 2013 2012 Cash and cash equivalents $ 99,125$ 68,976$ 51,261 Net loss (21,474 ) (52,179 ) (9,256 ) Net cash provided by operating activities 35,474 7,735 45,660 Net cash used in investing activities (6,649 ) (10,908 ) (21,974 ) Net cash provided by (used in) financing activities 1,285 20,975 (48,353 ) Fiscal 2014 The $56.9 million difference between reported net loss and cash provided by operating activities during fiscal 2014 was primarily due to $47.0 million in non-cash items, the largest of which were share-based compensation, service parts lower of cost or market adjustment, depreciation and amortization. In addition, we had a $13.4 million decrease in manufacturing inventories primarily due to outsourcing our manufacturing operations and an $8.7 million increase in deferred revenue primarily due to increased service contract revenue deferred at March 31, 2014 compared to March 31, 2013. These were partially offset by a $6.1 million decrease in accrued compensation due to decreased staffing and timing of payroll payments, and a $5.9 million decrease in accounts payable primarily due to decreased purchases. Cash used in investing activities was primarily due to $6.0 million of property and equipment purchases. Equipment purchases were primarily for engineering equipment to support product development activities, IT equipment and software, largely related to an ERP system upgrade, leasehold improvements in locations we started leasing in the second quarter of fiscal 2014 and the purchase of permanent demo units. Cash provided by financing activities during fiscal 2014 was primarily due to receipt of $4.4 million from the exercise of stock options and issuance of shares under the employee stock purchase plan, partially offset by $1.9 million paid for taxes due upon vesting of restricted stock and the repurchase of $1.3 million of convertible subordinated debt. 35 --------------------------------------------------------------------------------



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Fiscal 2013

The $59.9 million difference between reported net loss and cash provided by operating activities during fiscal 2013 was primarily due to $52.1 million in non-cash items, the largest of which were share-based compensation, amortization, depreciation and service parts lower of cost or market adjustment. In addition, we had an $11.9 million decrease in accounts receivable primarily due to lower revenue and service billings in the fourth quarter of fiscal 2013 than the fourth quarter of fiscal 2012. This was partially offset by an $8.6 million decrease in accounts payable primarily due to decreased purchases and the timing of payments. Cash used in investing activities was primarily due to $10.1 million of property and equipment purchases and $2.2 million used to purchase other investments. Equipment purchases were primarily for engineering equipment and testing hardware to support product development activities and equipment to update our network. We also made leasehold improvements to a location we started leasing in the first quarter of fiscal 2013. Other investment purchases we made were in private technology companies with products or features complementary to Quantum products and our strategy. Cash provided by financing activities during fiscal 2013 was primarily due to $18.2 million in net borrowings from issuing convertible subordinated debt and repaying our line of credit balance from a portion of the convertible debt proceeds. In addition, we received $4.8 million from the exercise of stock options and issuance of shares under the employee stock purchase plan, partially offset by $2.0 million paid for taxes due upon vesting of restricted stock.



Fiscal 2012

The $54.9 million difference between reported net loss and cash provided by operating activities in fiscal 2012 was primarily due to $60.4 million of non-cash expenses, including amortization, share-based compensation, depreciation and service parts lower of cost or market adjustment. In addition, we had an $8.1 million increase in deferred revenue primarily due to increased sales of service contracts. Partially offsetting these was a $21.4 million use of cash from increased manufacturing inventories primarily due to purchasing materials to build and configure new products and securing hard disk drives in light of supply constraints from flooding in Thailand earlier in the fiscal year. Cash used in investing activities during fiscal 2012 was primarily due to $11.4 million in purchases of property and equipment and $8.2 million of cash paid, net of cash acquired, for our acquisition of Pancetera. Equipment purchases were primarily for engineering equipment and testing hardware to support product development activities. Cash used in financing activities during fiscal 2012 was primarily due to net debt repayments of $55.8 million, including $104.3 million to fully repay our senior secured term debt. We refinanced a portion of the senior secured term debt with a new revolving credit facility in fiscal 2012. Partially offsetting cash used in financing activities was $10.4 million in proceeds received from the exercise of stock options and issuance of shares under the employee stock purchase plan.



Capital Resources and Financial Condition

We continue to focus on improving our operating performance, including efforts to increase revenue and to continue to control costs in order to improve margins, return to consistent profitability and generate positive cash flows from operating activities. We believe that our existing cash and capital resources will be sufficient to meet all currently planned expenditures, debt service, contractual obligations and sustain operations for at least the next 12 months. This belief is dependent upon our ability to achieve gross margin projections and to control operating expenses in order to provide positive cash flow from operating activities. Although we recorded facility restructuring charges in the fourth quarter of fiscal 2014 and anticipate another nominal charge in the first quarter of fiscal 2015, payments for the accrued facility restructuring will be made monthly in accordance with the lease agreements, which continue through February 2021. As a result, the facility restructuring is not expected to change our cash requirements. Our cash outlay for these lease payments could be reduced in the future if we are able to sublease facilities. Should any of the above assumptions prove incorrect, either in combination or individually, it would likely have a material negative effect on our cash balances and capital resources.



The following is a description of our existing capital resources including outstanding balances, funds available to borrow and primary repayment terms including interest rates. For additional information, see Note 8 "Convertible Subordinated Debt and Long-term Debt" to the Consolidated Financial Statements.

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We have $203.7 million of convertible subordinated debt outstanding in addition to a line of credit under a Wells Fargo Credit agreement, inclusive of amendments ("WF credit agreement"). We have no outstanding balance on the line of credit. The $203.7 million of convertible subordinated debt is comprised of $133.7 million outstanding principal of 3.50% convertible subordinated notes due November 15, 2015 ("3.50% notes") and $70 million outstanding principal of 4.50% convertible subordinated notes due November 15, 2017 ("4.50% notes"). The terms of the 3.50% notes are governed by an agreement dated November 15, 2010 between Quantum and U.S. Bank National Association and the terms of the 4.50% notes are governed by an agreement dated October 31, 2012 between Quantum and U.S. Bank National Association. Both the 3.50% notes and the 4.50% notes have required semi-annual interest payments and no early call provisions. Under the WF credit agreement, as amended, we have the ability to borrow the lesser of $75 million or the amount of the monthly borrowing base under a senior secured revolving credit facility. The WF credit agreement matures March 29, 2017 so long as an amount sufficient to repay the 3.50% notes is available for borrowing under the WF credit agreement or is deposited in an escrow account prior to August 16, 2015. Otherwise, the WF credit agreement matures on August 16, 2015. Quarterly, we are required to pay a 0.375% commitment fee on undrawn amounts under the revolving credit facility. There is a blanket lien on all of our assets under the WF credit agreement in addition to certain financial and reporting covenants. We have letters of credit totaling $1.0 million, reducing the maximum amount available to borrow to $74.0 million at April 30, 2014. As of April 30, 2014, and during fiscal 2014, we were in compliance with all covenants and had no outstanding balance on the line of credit. The interest rate on amounts borrowed is based on an election by us of an annual rate equal to (1) a base rate established by Wells Fargo plus an applicable margin of 1.0% to 1.5%, based on availability levels under the WF credit agreement or (2) the LIBOR rate plus an applicable margin ranging from 2.0% and 2.5%, based on availability levels under the WF credit agreement. The base rate is defined in the WF credit agreement. The WF credit agreement contains customary covenants, including cross-default provisions, as well as financial covenants. Average liquidity must exceed $15 million each month. The fixed charge coverage ratio is required to be greater than 1.2 for the 12 month period ending on the last day of any month in which the covenant is applicable. This covenant is applicable only in months in which borrowings exceed $5 million at any time during the month and was not applicable in fiscal 2014. To avoid triggering mandatory field audits and Wells Fargo controlling our cash receipts, we must maintain liquidity of at least $20 million at all times. Repurchases of the subordinated convertible notes is allowed as long as we have a proforma fixed coverage ratio of 1.5 and liquidity of $25 million. The fixed charge coverage ratio, average liquidity and liquidity are defined in the WF credit agreement and/or amendments. Certain schedules in the compliance certificate must be filed monthly if borrowings exceed $5 million; otherwise they are to be filed quarterly. Generation of positive cash flow from operating activities has historically been, and will continue to be, an important source of cash to fund operating needs and meet our current and long-term obligations. We anticipate the combination of our current cash balance and availability on the line of credit provides us with the ability to repay the 3.50% notes while maintaining sufficient cash to fund operating needs and other obligations. In addition, we plan to generate cash from operating activities in the future, which would provide us with additional operational flexibility. We have taken many actions in recent years to offset the negative impact of economic uncertainty and slow economic growth and their impact on the data protection and scale-out storage and archive markets. We cannot provide assurance that the actions we have taken in the past or any actions we may take in the future will ensure a consistent, sustainable and sufficient level of net income and positive cash flow from operating activities to fund, sustain or grow our business. Certain events that are beyond our control, including prevailing economic, competitive and industry conditions, as well as various legal and other disputes, may prevent us from achieving these financial objectives. Any inability to achieve consistent and sustainable net income and cash flow could result in:



(i) Restrictions on our ability to manage or fund our existing operations,

which could result in a material and adverse effect on our future results

of operations and financial condition. (ii) Unwillingness on the part of the lenders to do any of the following: ║ Provide a waiver or amendment for any covenant violations we may experience in future periods, thereby triggering a default under, or termination of, the revolving credit line, or



║ Approve any amendments to the credit agreement we may seek to obtain in

the future. Any lack of renewal, waiver, or amendment, if needed, could result in the revolving credit line becoming unavailable to us and any amounts outstanding becoming immediately due and payable.



(iii) Further impairment of our financial flexibility, which could require us to

raise additional funding in the capital markets sooner than we otherwise

would, and on terms less favorable to us, if available at all. 37

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Any of the above mentioned items, individually or in combination, could have a material and adverse effect on our results of operations, available cash and cash flows, financial condition, access to capital and liquidity.



Off Balance Sheet Arrangements

Lease Commitments

We lease certain facilities under non-cancelable lease agreements. Some of the leases have renewal options ranging from one to ten years and others contain escalation clauses and provisions for maintenance, taxes or insurance. We also have equipment leases for computers and other office equipment. Future minimum lease payments under these operating leases are shown below in the "Contractual Obligations" section.



Commitments to Purchase Inventory

We use contract manufacturers for our manufacturing operations. Under these arrangements, the contract manufacturer procures inventory to manufacture products based upon our forecast of customer demand. We have similar arrangements with certain other suppliers. We are responsible for the financial impact on the supplier or contract manufacturer of any reduction or product mix shift in the forecast relative to materials that the third party had already purchased under a prior forecast. Such a variance in forecasted demand could require a cash payment for inventory in excess of current customer demand or for costs of excess or obsolete inventory. As of March 31, 2014, we had issued non-cancelable commitments for $50.4 million to purchase inventory from our contract manufacturers and suppliers.



Stock Repurchases

During fiscal 2000, the Board of Directors authorized us to repurchase up to $700 million of our common stock in open market purchases or private transactions. As of March 31, 2014, there was $87.9 million remaining under our authorization to repurchase Quantum common stock. No stock repurchases were made during the fiscal years ended March 31, 2014, 2013 and 2012. Our ability to repurchase our common stock is restricted unless we meet certain thresholds under the terms of the WF credit agreement.



Contractual Obligations

The table below summarizes our contractual obligations as of March 31, 2014 (in thousands): Payments Due by Period Less than More than 1 year 1 - 3 years 3 -5 years 5 years Total Convertible subordinated debt $ 7,831$ 144,716$ 73,150 $ - $ 225,697 Purchase obligations 50,377 - - - 50,377 Operating leases 10,919 14,765 11,243 8,471 45,398



Total contractual cash obligations $ 69,127$ 159,481$ 84,393$ 8,471$ 321,472

The contractual commitments shown above include $22.0 million in interest payments on our various debt obligations. As of March 31, 2014, we had $5.0 million of long-term tax liabilities for uncertain tax positions, for which we cannot make a reasonably reliable estimate of when payments are likely to occur.

Recent Accounting Pronouncements

See Recent Accounting Pronouncements in Note 3 "Summary of Significant Accounting Policies" to the Consolidated Financial Statements for a full description of recent accounting pronouncements including the respective expected dates of adoption and effects on our results of operations and financial condition.

CRITICAL ACCOUNTING ESTIMATES AND POLICIES

Our discussion and analysis of the financial condition and results of operations is based on the accompanying Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these statements requires us to make significant estimates and judgments about future uncertainties that affect reported assets, liabilities, revenues and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions believed to be reasonable under the circumstances. Our significant accounting policies are presented within Note 3 to the Consolidated Financial Statements. Our critical accounting estimates require the most difficult, subjective or complex judgments and are described below. An accounting estimate is considered critical if it requires estimates about the effect of matters that are inherently uncertain when the estimate is made, if different estimates reasonably could have been used or if changes in the estimate that are reasonably possible could materially impact the financial statements. We have discussed the development, selection and disclosure of our critical accounting policies with the Audit Committee of our Board of Directors. We believe the assumptions and estimates used and the resulting balances are reasonable; however, actual results may differ from these estimates under different assumptions or conditions. 38 --------------------------------------------------------------------------------



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Revenue Recognition

Application of the various accounting principles related to measurement and recognition of revenue requires us to make judgments and estimates in the following related areas: determining estimated selling prices and allocating revenue based on the relative selling prices in arrangements with multiple deliverables, including assessing whether we have vendor-specific objective evidence ("VSOE") or third-party evidence of selling price ("TPE") for each deliverable; the interpretation of non-standard terms and conditions in sales agreements; assessments of future price adjustments, such as rebates, price protection and future product returns and estimates for contractual licensee fees. When we enter into sales arrangements with customers that contain multiple deliverables such as hardware, software and services, these arrangements require us to identify each deliverable and determine its estimated selling price following the relative selling price hierarchy. Additionally, we sometimes use judgment in order to determine the appropriate timing of revenue recognition and to assess whether any software and non-software components function together to deliver a tangible product's essential functionality in order to ensure the arrangement is properly accounted for as software or hardware revenue. When we enter into multiple deliverable revenue arrangements with customers which are not subject to software revenue guidance, we use judgment to (1) separate the deliverables based on specific criteria, (2) assign an estimated selling price to each deliverable based on the selling price hierarchy using VSOE, TPE or best estimate of selling price ("BESP") and (3) allocate the total arrangement consideration using the relative selling price method. When VSOE cannot be established we attempt to establish the selling price of each element based on TPE. TPE is determined based on competitor prices for largely interchangeable products when sold separately. When we are unable to establish selling price using VSOE or TPE, we use BESP. We use judgment to determine BESP, which is the price at which we would transact a sale if the product or service were regularly sold on a standalone basis. In this determination we consider our discounting and internal pricing practices, external market conditions and competitive positioning for similar offerings. While the majority of our sales arrangements contain standard terms and conditions, we sometimes apply judgment when interpreting complex arrangements with non-standard terms and conditions to determine the appropriate accounting and timing of revenue recognition. An example of such a judgment is deferring revenue related to significant post-delivery obligations and customer acceptance criteria until such obligations are fulfilled. We license certain software to customers under licensing agreements that allow those customers to embed the software into specific products they offer. As consideration, licensees pay us a fee based on the amount of sales of their products that incorporate our software. On a periodic and timely basis, the licensees provide us with reports listing their sales to end users for which they owe us license fees. Similarly, royalty revenue is estimated from licensee reports of units sold to end users subject to royalties under master contracts. In both cases, these reports are used to substantiate delivery and we recognize revenue based on the information in these reports or when amounts can be reasonably estimated.



Inventory Allowances

Our manufacturing and service parts inventories are stated at the lower of cost or market, with cost computed on a first-in, first-out ("FIFO") basis. Adjustments to reduce the carrying value of both manufacturing and service parts inventories to their net realizable value are made for estimated excess, obsolete or impaired balances. Factors influencing these adjustments include significant estimates and judgments about the future of product life cycles, product demand, rapid technological changes, development plans, product pricing, physical deterioration, quality issues, end of service life plans and volume of enhanced or extended warranty service contracts. 39 --------------------------------------------------------------------------------



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Impairment of Long-lived Assets and Goodwill

We apply judgment when reviewing amortizable intangible and other long-lived assets ("long-lived assets") and goodwill for impairment, including when evaluating potential impairment indicators. Indicators we consider include adverse changes in the economy or business climate that could affect the value of our long-lived assets or goodwill, overall financial performance such as negative or declining cash flows or operating income, changes in our business strategy, product mix or to the long-term economic outlook, a sustained decrease in our stock price and, in the case of goodwill, testing long-lived assets for recoverability. In addition, we evaluate on the basis of the weight of evidence the significance of identified events and circumstances along with how they could affect the relationship between the reporting unit's fair value and carrying amount, including positive mitigating events and circumstances. We use an undiscounted cash flow approach to evaluate our long-lived assets for recoverability when there are impairment indicators. Estimates of future cash flows require significant judgments about the future and include company forecasts and our expectations of future use of our long-lived assets, both of which may be impacted by market conditions. Other critical estimates include determining the asset group or groups within our long-lived assets, the primary asset of an asset group and the primary asset's useful life. In addition to comparing the carrying value of the reporting unit to its fair value, because we have negative book value, we perform a qualitative analysis to determine whether it is not more likely than not that the fair value of goodwill is less than its carrying amount. If we determine it is more likely than not that the fair value of goodwill is less than its carrying amount, then a second step must be performed to quantify the amount of goodwill impairment, if any, requiring additional assumptions and judgments. If the second step of a goodwill impairment test is required, the following assumptions and estimates may be used by management in an income approach analysis. We derive discounted cash flows using estimates and assumptions about the future. Other significant assumptions may include: expected future revenue growth rates, operating profit margins, working capital levels, asset lives used to generate future cash flows, a discount rate, a terminal value multiple, income tax rates and utilization of net operating loss tax carryforwards. These assumptions are developed using current market conditions as well as internal projections. Inherent in our development of cash flow projections for the income approach used in an impairment test are assumptions and estimates derived from a review of our operating results, approved business plans, expected growth, cost of capital and income tax rates. We also make certain assumptions about future economic conditions, applicable interest rates and other market data.



Accrued Warranty

We estimate future product failure rates based upon historical product failure trends as well as anticipated future failure rates if believed to be significantly different from historical trends. Similarly, we estimate future costs of repair based upon historical trends and anticipated future costs if they are expected to significantly differ, for example due to negotiated agreements with third parties. We use a consistent model and exercise considerable judgment in determining the underlying estimates. Our model requires an element of subjectivity for all of our products. For example, historical return rates are not completely indicative of future return rates and we must therefore exercise judgment with respect to future deviations from our historical return rates. When actual failure rates differ significantly from our estimates, we record the impact in subsequent periods and update our assumptions and forecasting models accordingly. As our newer products mature, we are able to improve our estimates with respect to these products.



Income Taxes

A number of estimates and judgments are necessary to determine deferred tax assets, deferred tax liabilities and valuation allowances. We recognize the benefit from a tax position only if it is more-likely-than-not that the position would be sustained upon audit based solely on the technical merits of the tax position. The calculation of our tax liabilities requires judgment related to uncertainties in the application of complex tax regulations. It is inherently difficult and subjective to estimate such amounts, as we have to determine the probability of various possible outcomes. We reevaluate these uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit and new audit activity. We have provided a full valuation allowance against our U.S. net deferred tax assets due to our history of net losses, difficulty in predicting future results and our conclusion that we cannot rely on projections of future taxable income to realize the deferred tax assets. In addition, we have provided a full valuation allowance against certain of our international net deferred tax assets. Due to reorganizations in these jurisdictions, it is unclear whether we will be able to realize a benefit from these deferred tax assets. Also, certain changes in stock ownership could result in a limitation on the amount of net operating loss and tax credit carryovers that can be utilized each year. Should we undergo such a change in stock ownership, it would severely limit the usage of these carryover tax attributes against future income, resulting in additional tax charges. 40

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Significant management judgment is required in determining our deferred tax assets and liabilities and valuation allowances for purposes of assessing our ability to realize any future benefit from our net deferred tax assets. We intend to maintain this valuation allowance until sufficient evidence exists to support the reversal of the valuation allowance. Future income tax expense will be reduced to the extent that we have sufficient evidence to support a reversal or decrease in this allowance. We also have deferred tax assets and liabilities due to prior business acquisitions with corresponding valuation allowances after assessing our ability to realize any future benefit from these acquired net deferred tax assets.



Fair Value of Assets Acquired and Liabilities Assumed in a Business Combination

We use judgment when applying the various accounting principles to measure the fair value of assets acquired and liabilities assumed in a business combination. There are matters that are inherently uncertain when making estimates used to determine fair value where there are not active markets for these assets and liabilities. In addition, different estimates reasonably could be used and changes in the estimate that are reasonably possible could materially impact the resulting valuation and the financial statements. For example, judgments have been required to determine fair values of amortizable intangible assets, in-process research and development and the resulting amount of goodwill. Significant estimates and assumptions we make to estimate fair value of these acquired assets include:



║ Planned product roadmaps, including the primary feature sets of new

products;

║ Expected efforts and associated costs required to integrate technologies

acquired into new products;

║ Assessed importance of in-process research and development to our overall

development plan; ║ Estimated values and rates of a market participant; ║ Estimated future cash flows of current and future products; and ║ Estimated discount rate applied to future cash flows.



In addition, the estimated future life of purchased technology intangibles impacts future financial statements. We believe the assumptions and estimates used and the resulting fair values are reasonable.


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