Aruba Networks 10-Q 2010
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended April 30, 2010
For the transition period from to
Commission file number: 001-33347
Aruba Networks, Inc.
(Exact name of registrant as specified in its charter)
1344 Crossman Ave.
Sunnyvale, California 94089-1113
(Address, including zip code, and telephone number,
including area code, of registrants principal executive offices)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
The number of shares of the registrants common stock, par value $0.0001, outstanding as of June 1, 2010 was 92,658,395.
ARUBA NETWORKS INC.
Item 1. Consolidated Financial Statements
ARUBA NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS
See Notes to Consolidated Financial Statements.
ARUBA NETWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See Notes to Consolidated Financial Statements.
ARUBA NETWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See Notes to Consolidated Financial Statements.
ARUBA NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. The Company and its Significant Accounting Policies
Aruba Networks, Inc. (the Company) was incorporated in the state of Delaware on February 11, 2002. The Company securely delivers the enterprise network to users with user-centric networks that expand the reach of traditional port-centric networks. The products the Company licenses and sells include the ArubaOS modular operating system, optional value-added software modules, a centralized mobility management system, high-performance programmable Mobility Controllers, wired and wireless access points, wireless intrusion detection tools, spectrum analyzers, and endpoint compliance solutions. The Company has offices in North America, Europe, the Middle East and the Asia Pacific region and employs staff around the world.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated. The accompanying statements are unaudited and should be read in conjunction with the audited consolidated financial statements and related notes contained in the Companys Annual Report on Form 10-K filed on October 6, 2009. The July 31, 2009 consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States (U.S.).
The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP), pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). They do not include all of the financial information and footnotes required by GAAP for complete financial statements. The Company believes the unaudited consolidated financial statements have been prepared on the same basis as its audited financial statements as of and for the year ended July 31, 2009 and include all adjustments necessary for the fair statement of the Companys financial position as of April 30, 2010, its results of operations for the three and nine months ended April 30, 2010 and 2009, and its cash flows for the nine months ended April 30, 2010 and 2009. The results for the three and nine months ended April 30, 2010 are not necessarily indicative of the results to be expected for any subsequent quarter or for the fiscal year ending July 31, 2010.
Certain prior period balances have been reclassified to conform to the current year presentation. The reclassifications did not affect previously reported net loss.
2. Intangible Assets
The following table presents details of the Companys total purchased intangible assets:
The Company recorded approximately $1.2 million and $3.7 million of amortization expense related to its purchased intangible assets during the three and nine months ended April 30, 2010, respectively, and $1.2 million and $3.7 million during the three and nine months ended April 30, 2009, respectively.
The estimated future amortization expense of purchased intangible assets as of April 30, 2010 is as follows:
3. Net Loss Per Common Share
Basic net loss per common share is calculated by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per common share is calculated by giving effect to all potentially dilutive common shares, including options and common stock subject to repurchase unless the result is anti-dilutive. The following table sets forth the computation of net loss per share:
Common shares subject to repurchase are included in other accrued liabilities in the consolidated balance sheets.
The following outstanding options, common stock subject to repurchase, and restricted stock awards were excluded from the computation of diluted net loss per common share for the periods presented because including them would have had an anti-dilutive effect:
Short-term investments consist of the following:
The cost basis and fair value of debt securities as of April 30, 2010, by contractual maturity, are presented below:
The Company reviews the individual securities in its portfolio to determine whether a decline in a securitys fair value below the amortized cost basis is other than temporary. The Company determined that there were no investments in its portfolio, related to credit losses or otherwise, that were other-than temporarily impaired during the three months ended April 30, 2010.
The following table summarizes the fair value and gross unrealized losses of the Companys investments with unrealized losses aggregated by type of investment instrument and length of time that individual securities have been in a continuous unrealized loss position as of April 30, 2010:
There were no short-term investments in a continuous unrealized loss position for more than 12 months as of April 30, 2010.
Fair Value of Financial Instruments
Cash and cash equivalents consist primarily of bank deposits with third-party financial institutions and highly liquid money market securities with remaining maturities at date of purchase of 90 days or less. The carrying value of cash and cash equivalents as of April 30, 2010 and July 31, 2009 was approximately $29.5 million and $41.3 million, respectively, and approximated their fair value.
Short-term investments consist of corporate bonds and notes, U.S government agency securities, U.S. treasury bills, commercial paper, and certificates of deposit and is recorded at fair value. The Company defines fair value as the exit price in the principal market in which the Company would transact representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Level 1 instruments are valued based on quoted market prices in active markets for identical instruments and include the Companys investments in money market funds. Level 2 instruments are valued based on quoted prices in markets that are not active or alternative pricing sources with reasonable levels of price transparency and include the Companys investments in corporate bonds and notes, U.S. government agency securities, treasury bills, commercial paper and certificates of deposit. Level 3 instruments are valued based on unobservable inputs that are supported by little or no market activity and reflect the Companys own assumptions in measuring fair value. The Company has no level 3 instruments.
As of April 30, 2010, the fair value measurements of the Companys cash, cash equivalents and short-term investments consisted of the following:
Level 2 securities are priced using quoted market prices for similar instruments, nonbinding market prices that are corroborated by observable market data, or discounted cash flow techniques.
5. Balance Sheet Components
The following tables provide details of selected balance sheet items:
Property and equipment, net consists of the following:
7. Deferred Revenue
Deferred revenue consists of the following:
Deferred product revenue relates to arrangements where not all revenue recognition criteria have been met. The increase in deferred product revenue was primarily due to increases in the amount of products stocked by the Companys value-added distributors (VADs), offset by the recognition of revenue on previously deferred transactions that included acceptance criteria from the related customers. The Company will not recognize revenue for the deferred product revenue held by the VADs until it receives persuasive evidence from the VADs of a sale to an end customer.
Deferred professional services and support revenue primarily represents customer payments made in advance for support contracts. Support contracts are typically billed on an annual basis in advance and revenue is recognized ratably over the support period.
Deferred ratable product and related services and support revenue consists of revenue on transactions where vendor-specific objective evidence (VSOE) of fair value of support has not been established and the entire arrangement is being recognized ratably over the support period, which typically ranges from one year to five years.
8. Income Taxes
For the three and nine months ended April 30, 2010 and 2009, the Company generated operating losses. However, while the Company generated consolidated book and U.S. jurisdiction tax losses for the three and nine months ended April 30, 2010, it generated taxable income in certain foreign jurisdictions. For the three months and nine months ended April 30, 2009, the Company generated consolidated book losses but generated taxable income in most U.S. and foreign jurisdictions.
The Company uses the asset and liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Based on the available objective evidence, including the fact that the Company has generated losses since inception and continues to incur a loss, management believes it is more likely than not that the deferred tax assets will not be realized. Accordingly, management has applied a full valuation allowance against its deferred tax assets generated primarily in the U.S.
The Company files annual income tax returns in the U.S. federal jurisdiction, various U.S. state and local jurisdictions, and in various foreign jurisdictions. The Company remains subject to tax authority review for all jurisdictions for all years.
9. Equity Incentive Plans and Common Stock
In April 2002, the Companys board of directors adopted the 2002 Stock Plan (2002 Plan). In December 2006, the Companys board of directors approved the 2007 Equity Incentive Plan (2007 Plan) and the Employee Stock Purchase Plan (ESPP). As provided by the 2007 Plan, all remaining shares reserved for issuance under the 2002 Plan were transferred to the 2007 Plan upon the closing of the Companys initial public offering.
In December 2009, the Compensation Committee of the Board of Directors approved the Executive Officer Bonus Plan and the Employee Bonus Program (the Bonus Plans), which offers the Companys executive officers and employees the opportunity to earn bonuses based on the achievement of specified performance targets during each performance period. The Bonus Plans consists of two performance periods per fiscal year. Each performance period lasts for two consecutive fiscal quarters, with a new performance period beginning on the first day of the first and third quarters. Under the Bonus Plans a bonus pool, in an amount determined by the Board of Directors (the Board), is funded based upon the extent to which the Company meets or exceeds internal operating plan revenue and profit targets set by the Board at the start of the Companys fiscal year. Beginning with fiscal 2011, the Board may, in its discretion, determine that different performance metrics will be used to fund the bonus pool. The Bonus Plans award payout will be based on a percentage of the participants eligible base pay for the applicable performance period. Any bonus payment under the Bonus Plans will be made in the form of a restricted stock unit award granted under the Companys 2007 Plan and will be subject to the terms and conditions of the 2007 Plan and an award agreement between the Company and the participant. Each restricted stock unit award will be scheduled to vest in full approximately one year following the date of grant.
Stock Option Activity
The following table summarizes information about shares available for grant and outstanding stock option activity for the period indicated:
The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying stock option awards and the fair value of the Companys common stock on the date of each option exercise. Stock-based compensation expense recognized for stock options was $4.6 million and $11.8 million for the three and nine months ended April 30, 2010, respectively, and $2.8 million and $8.7 million for the three and nine months ended April 30, 2009, respectively.
Restricted Stock Award Activity
The following table summarizes the non-vested restricted stock awards activity for the period indicated:
The estimated fair value of restricted stock awards is based on the market price of the Companys stock on the grant date. Stock-based compensation expense recognized for restricted stock awards was $4.3 million and $12.2 million for the three and nine months ended April 30, 2010, respectively, and $2.0 million and $7.5 million for the three and nine months ended April 30, 2009, respectively.
Employee Stock Purchase Plan Activity
During the three months ended April 30, 2010, the Company sold 955,801 shares at an average per share price of $2.64 under the ESPP. Compensation expense recognized in connection with the ESPP was $1.1 million and $2.8 million for the three and nine months ended April 30, 2010, respectively, and $0.7 million and $1.9 million for the three and nine months ended April 30, 2009, respectively.
Fair Value Disclosures
The fair value of each option grant is estimated on the date of grant using the Black-Scholes model with the following weighted average assumptions:
Employee Stock Options
Employee Stock Purchase Plan
The expected term of the stock-based awards represents the period of time that the Company expects such stock-based awards to be outstanding, giving consideration to the contractual term of the awards, vesting schedules and expectations of future employee behavior. The Company gave consideration to its historical exercises, the vesting term of its options, the post vesting cancellation history of its options and the options contractual terms. The contractual term of options granted from inception of the Company through August 16, 2007 was generally 10 years. On August 17, 2007, the Companys Compensation Committee revised the 2007 Plan to provide for a contractual term of seven years on all option grants on or after such date. Given the Companys limited operating history, the Company then compared this estimated term to those of comparable companies from a representative peer group, the selection of which was based on industry data to determine the expected term. Similarly, the Company computes expected volatility based on its historical volatility and the historical volatility of these comparable companies. The Company made an estimate of expected forfeitures, and is recognizing stock-based compensation only for those equity awards that it expects to vest. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury Constant Maturity rate as of the date of grant.
Stock Repurchase Program
On February 26, 2008, the Company announced a stock repurchase program for up to $10.0 million worth of the Companys common stock. The Company was authorized until February 26, 2010, to make purchases in the open market and any such purchases were funded from available working capital. The number of shares purchased and the timing of purchases was based on the price of the Companys common stock, general business and market conditions, and other investment considerations, and did not exceed $2.5 million per quarter. Shares were retired upon repurchase. Over the life of the program, the Company purchased a total of 598,200 shares for a total purchase price of $3.1 million. The Companys policy related to repurchases of its common stock is to charge any excess of cost over par value entirely to additional paid-in capital. This program expired on February 26, 2010.
Total stock-based compensation was $10.0 million and $26.8 million for the three and nine months ended April 30, 2010, respectively, and $5.5 million and $18.2 million for the three and nine months ended April 30, 2009, respectively. The Company did not capitalize stock-based compensation during the three and nine months ended April 30, 2010, due to the amount qualifying for capitalization being immaterial.
10. Comprehensive Loss
Comprehensive loss includes the following:
11. Segment Information and Significant Customers
The Company operates in one industry segment selling fixed and modular mobility controllers, wired and wireless access points, and related software and services.
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Companys chief operating decision maker is its Chief Executive Officer. The Companys Chief Executive Officer reviews financial information presented on a consolidated basis for purposes of allocating resources and evaluating financial performance. The Company has one business activity, and there are no segment managers who are held accountable for operations, operating results and plans for products or components below the consolidated unit level. Accordingly, the Company reports as a single operating segment. The Company and its Chief Executive Officer evaluate performance based primarily on revenue in the geographic locations in which the Company operates. Revenue is attributed by geographic location based on the ship-to location of the Companys customers. The Companys assets are primarily located in the U.S. and not allocated to any specific region. Therefore, geographic information is presented only for total revenue.
The following presents total revenue by geographic region:
The following table presents significant channel partners as a percentage of total revenues:
12. Commitments and Contingencies
On August 27, 2007, Symbol Technologies, Inc. and Wireless Valley Communications, Inc., both Motorola subsidiaries, filed suit against the Company in the Federal District Court of Delaware asserting infringement of U.S. Patent Nos. 7,173,922; 7,173,923; 6,625,454; and 6,973,622. The Company filed its response on October 17, 2007, denying the allegations and asserting counterclaims. The complaint sought unspecified monetary damages and injunctive relief. On September 8, 2008, the Company filed an amended answer and counterclaims, asserting infringement of Arubas U.S. Patent Nos. 7,295,524 and 7,376,113 against Motorola, Inc. as well as its subsidiaries, Symbol Technologies, Inc. and Wireless Valley Communications, Inc (collectively Motorola). The counterclaims sought unspecified monetary damages and injunctive relief. On November 13, 2008, Motorola filed an amended complaint asserting infringement of U.S. Patent No. 7,359, 676 owned by AirDefense, Inc., another Motorola subsidiary. On November 4, 2009, the Company entered into a Patent Cross License and Settlement Agreement (the Settlement Agreement) with Motorola. Pursuant to the Settlement Agreement, the Company and Motorola agreed to:
As part of the Settlement Agreement, the Company agreed to pay Motorola $19.8 million.
The determination of the appropriate accounting treatment for the Settlement Agreement depends to a large extent upon the ability to reliably value the benefits received. This, in turn, requires that significant judgment be exercised in arriving at certain estimates and assumptions. The elements of the Settlement Agreement that potentially represented benefits to the Company were comprised of 1) a general release of any and all asserted and potential infringement claims, 2) license grants to each asserted patent, and 3) a dismissal of the litigation between the two parties. The Company concluded that there was no potential future use of the subject license grants as the Company does not plan to utilize the license grants in any current or future products, and the general release and litigation dismissal benefits were period costs with no future use. Therefore, the Company ascribed no future value to the Settlement Agreement. As a result, the Company recorded a $19.8 million charge during the first quarter of fiscal 2010 for book and tax purposes and made the corresponding payment to Motorola during the second quarter of fiscal 2010.
During the third quarter of fiscal 2010, the Company recorded a reserve totaling $1.7 million related to legal matters.
From time to time, the Company is involved in claims and legal proceedings that arise in the ordinary course of business. If management believes that a loss arising from these matters is probable and can be reasonably estimated, the Company records the amount of the loss. As additional information becomes available, any potential liability related to these matters is assessed and the estimates revised. Based on currently available information, management does not believe that the ultimate outcomes of these unresolved matters, individually and in the aggregate, are likely to have a material adverse effect on the Companys financial position, liquidity or results of operations. However, litigation is subject to inherent uncertainties, and managements view of these matters may change in the future.
The Company leases office space under non-cancelable operating leases with various expiration dates through July 2016. The terms of certain operating leases provide for rental payments on a graduated scale. The Company recognizes rent expense on a straight-line basis over the respective lease periods and has accrued for rent expense incurred but not paid.
Future minimum lease payments under non-cancelable operating leases are as follows:
Non-cancelable purchase commitments
The Company outsources the production of its hardware to third-party contract manufacturers. In addition, the Company enters into various inventory related purchase commitments with its contract manufacturers and other suppliers. The Company had $20.9 million and $14.9 million in non-cancelable purchase commitments with these providers as of April 30, 2010 and July 31, 2009, respectively. The Company expects to sell all products that it has committed to purchase from these providers.
The Company provides for future warranty costs upon product delivery. The specific terms and conditions of those warranties vary depending upon the product sold and country in which the Company does business. In the case of hardware, the warranties are generally for 12-15 months from the date of purchase. Beginning in the fourth quarter of fiscal year 2009, the Company announced a lifetime warranty program on certain access points, in which customers are entitled to a lifetime warranty on certain access points purchased subsequent to the announcement of the program.
The Company warrants that any media on which its software products are recorded will be free from defects in materials and workmanship under normal use for a period of 90 days from the date the products are delivered to the end customer. In addition, the Company warrants that its hardware products will substantially conform to the Companys published specifications. Historically, the Company has experienced minimal warranty costs. Factors that affect the Companys warranty liability include the number of installed units, historical experience and managements judgment regarding anticipated rates of warranty claims and cost per claim. The Company assesses the adequacy of its recorded warranty liabilities every period and makes adjustments to the liability as necessary.
The warranty liability is included as a component of accrued liabilities on the balance sheet. Changes in the warranty liability are as follows:
In its sales agreements, the Company may agree to indemnify its indirect sales channels and end user customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date the Company has not paid any amounts to settle claims or defend lawsuits brought against its indirect sales channels and end user customers. The Company is unable to reasonably estimate the maximum amount that could be payable under these arrangements since these obligations are not capped but are conditional to the unique facts and circumstances involved. Accordingly, the Company has no liabilities recorded for these agreements as of April 30, 2010 and July 31, 2009.
13. Recent Accounting Pronouncements
In October 2009, FASB issued Accounting Standards Update (ASU) No. 2009-14, Topic 985: Certain Revenue Arrangements That Include Software Elements (a Consensus of the FASB Emerging Issues Task Force Issue (EITF)). ASU No. 2009-14 modifies ASC 985-605, Software Revenue, such that the following products would be considered non-software deliverables and therefore excluded from the scope of ASC 985-605:
In October 2009, FASB issued ASU No. 2009-13, Revenue Recognition (Topic 605): Multiple Deliverable Revenue Arrangements (a Consensus of the FASB EITF). ASU No. 2009-13 modifies ASC 605-25, Revenue Recognition Multiple-Element Arrangements (formerly EITF 00-21). ASU No. 2009-13 requires an entity to allocate the revenue at the inception of an arrangement to all of its deliverables based on their relative selling prices. This guidance eliminates the residual method of allocation of revenue in multiple deliverable arrangements and requires the allocation of revenue based on the relative-selling-price method. The determination of the selling price for each deliverable requires the use of a hierarchy designed to maximize the use of available objective evidence, including, VSOE, third party evidence of selling price (TPE), or estimated selling price (ESP).
ASU No. 2009-13 and ASU No. 2009-14 must be adopted no later than the beginning of the Companys fiscal year 2011 and early adoption is allowed and may be adopted either under the prospective method, whereby the guidance will apply to all revenue arrangements entered into or materially modified after the effective date, or under the retrospective application, whereby the guidance will apply to all revenue arrangements for all periods presented. An entity may elect to adopt ASU No. 2009-13 and ASU No. 2009-14 in a period other than their first reporting period of a fiscal year under the prospective method but must adjust the revenue of prior reported periods such that all new revenue arrangements entered into, or materially modified, during the fiscal year of adoption are accounted for under this guidance.
The adoption of ASU No. 2009-13 and ASU No. 2009-14 will allow the separation of deliverables under more arrangements which may result in less revenue deferral. For such arrangements, the application of the relative-selling price method of allocating the revenue of an arrangement and the elimination of the residual method of allocation may result in a different reallocation of revenue from product revenue, which is recognized upon delivery, to support revenue, which is recognized ratably over the support period.
The Company is currently evaluating the impact of these pronouncements on its financial position and results of operations.
14. Subsequent Events
On May 7, 2010, the Company entered into a definitive agreement to purchase Azalea Networks (Azalea). Under the terms of the agreement, the Company will acquire Azalea in exchange for total consideration of approximately $27.0 million of the Companys common stock subject to certain adjustments and up to $13.5 million in cash to be paid over two years. The acquisition is expected to close in the first quarter of fiscal 2011, and is subject to standard closing conditions.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
In addition to historical information, this report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements include, among other things, statements concerning our expectations:
as well as other statements regarding our future operations, financial condition and prospects and business strategies. These forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this report, and in particular, the risks discussed under the heading Risk Factors in Part II, Item 1A of this report and those discussed in other documents we file with the Securities and Exchange Commission. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.
The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included elsewhere in this report
We securely deliver the enterprise network to users, wherever they work or roam, using a combination of solutions. Our adaptive 802.11n solutions optimize themselves to ensure that users are always within reach of mission-critical information. By rightsizing expensive wired LANs with our high-speed 802.11n solution, users can potentially reduce both capital and operating expenses. Identity-based security assigns access policies to users, enforcing those policies whenever and wherever a network is accessed. Our Virtual Branch Networking solutions for branch offices, fixed telecommuters, and satellite facilities ensure uninterrupted remote access to applications. Finally, our multi-vendor network management solutions provide a single point of control while managing both legacy and new wireless networks from us and our competitors. The products we license and sell include the ArubaOS operating system, optional value-added software modules, a centralized and vendor neutral mobility management system, high-performance programmable Mobility Controllers, wired and wireless access points, wireless intrusion detection tools, spectrum analyzers, and endpoint compliance solutions.
Our products have been sold to over 10,000 end customers worldwide (not including customers of Alcatel-Lucent, our largest channel partner), including some of the largest and most complex global organizations. We have implemented a two-tier distribution model in most areas of the world, including the United States, with value-added distributors( VADs) selling our portfolio of products, including a variety of our support services, to a diverse number of value-added resellers (VARs). Our focus continues to be management of our channel including selection and growth of high prospect partners, activation of our VARs and VADs through active training and field collaboration, and evolution of our channel programs in consultation with our partners.
Our ability to increase our product revenues will depend significantly on continued growth in the market for enterprise mobility and remote networking solutions, continued acceptance of our products in the marketplace, our ability to continue to attract new customers, our ability to compete, the willingness of customers to displace wired networks with wireless LANs, in particular, wireless LANs that utilize our 802.11n solution, and our ability to continue to sell into our installed base of existing customers. Our growth in support revenues is dependent upon increasing the number of products under support contracts, which is dependent on both growing our installed base of customers and renewing existing support contracts. Our future profitability and rate of growth, if any, will be directly affected by the continued acceptance of our products in the marketplace, as well as the timing and size of orders, product and channel mix, average selling prices, costs of our products and general economic conditions. Our future profitability will also be affected by our ability to effectively implement and generate incremental business from our two-tier distribution model, the extent to which we invest in our sales and marketing, research and development, and general and administrative resources to grow our business, and current economic conditions.
While we have seen improvements in the overall macroeconomic environment and our revenues have increased, economic conditions worldwide have negatively impacted our business in our recent history. While we believe in the long-term growth prospects of the WLAN market, the deterioration in overall economic conditions and in particular, tightening in the credit markets and reduced spending by both enterprises and consumers have significantly impacted various industries on which we rely for purchasing our products. This has led to our customers deferring purchases in response to tighter credit, negative financial news and delayed budget approvals.
While we have seen signs of stabilization and improved visibility in the first nine months of fiscal 2010 relative to fiscal 2009, the economic conditions in the United States and the European Union, the continuing credit crisis that has affected worldwide financial markets, the continued volatility in the stock markets and other current negative macroeconomic indicators, such as the global recession, or uncertainty or further weakening in key vertical or geographic markets, have resulted in reductions in capital expenditures by end user customers for our products, longer sales cycles, the deferral or delay of purchase commitments for our products and increased competition. These factors could create significant and increasing uncertainty for the future as they could continue to negatively impact technology spending for the products and services we offer and materially adversely affect our business, operating results and financial condition.
The revenue growth that we have experienced has been driven primarily by an expansion of our customer base coupled with increased purchases from existing customers. We believe the growth we have experienced is the result of business enterprises needing to provide secure mobility to their users in a manner that we believe is more cost effective than the traditional approach of using port-centric networks. While we have experienced both longer sales cycles and seasonality, both of which have slowed our revenue growth, we believe that our product offerings, in particular our products that incorporate 802.11n wireless LAN standard technologies, will enable broader networking initiatives by both our current and potential customers.
Each quarter, our ability to meet our product revenue expectations is dependent upon (1) new orders received, shipped, and recognized in a given quarter, (2) the amount of orders booked but not shipped in the prior quarter that are shipped in the current quarter, and (3) the amount of deferred revenue entering a given quarter. Our product deferred revenue is comprised of:
We typically ship products within a reasonable time period after the receipt of an order.
Our ability to meet our forecasted revenue is dependent on our ability to convert our sales pipeline into product revenues from orders received and shipped within the same fiscal quarter, as well as the amount of revenue that we recognize for our products from our deferred revenue.
On May 7, 2010, we entered into a definitive agreement to purchase Azalea Networks. Under the terms of the agreement, we will acquire Azalea in exchange for total consideration of approximately $27.0 million of our common stock subject to certain adjustments and up to $13.5 million in cash to be paid over two years. The acquisition is expected to close in the first quarter of fiscal 2011, and is subject to standard closing conditions.
Revenues, Cost of Revenues and Operating Expenses
We derive our revenues from sales of our ArubaOS operating system, controllers, wired and wireless access points, application software modules, multi-vendor management solution software, and professional services and support. Professional services revenues consist of consulting and training services. Consulting services primarily consist of installation support services. Training services are instructor led courses on the use of our products. Support services typically consist of software updates, on a when and if available basis, telephone and internet access to technical support personnel and hardware support. We provide customers with rights to unspecified software product upgrades and to maintenance releases and patches released during the term of the support period.
We sell our products directly through our sales force and indirectly through VADs, VARs, and original equipment manufacturers (OEMs). We expect revenues from indirect channels to continue to constitute a significant majority of our future revenues.
We sell our products to channel partners and end customers located in the Americas, Europe, the Middle East, Africa and Asia Pacific. Shipments to our channel partners that are located in the United States are classified as U.S. revenue regardless of the location of the end customer. We continue to expand into international locations and introduce our products in new markets, and we expect international revenues to increase in absolute dollars and remain consistent with fiscal 2009 as a percentage of total revenues in future periods. For more information about our international revenues, see Note 11 of Notes to Consolidated Financial Statements.
Cost of Revenues
Cost of product revenues consists primarily of manufacturing costs for our products, shipping and logistics costs, and expenses for inventory obsolescence and warranty obligations. We utilize third parties to manufacture our products and perform shipping logistics. We have outsourced the substantial majority of our manufacturing, repair and supply chain operations. Accordingly, the substantial majority of our cost of revenues consists of payments to Flextronics, our largest contract manufacturer. Flextronics manufactures our products in China and Singapore using quality assurance programs and standards that we jointly established. Manufacturing, engineering and documentation controls are conducted at our facilities in Sunnyvale, California and Bangalore, India. Cost of product revenues also includes amortization expense from our purchased intangible assets.
Cost of professional services and support revenues is primarily comprised of the personnel costs, including stock-based compensation, of providing technical support, including personnel costs associated with our internal support organization. In addition, we employ a third-party support vendor to complement our internal support resources, the costs of which are included within costs of professional services and support revenues.
Our gross margin has been, and will continue to be, affected by a variety of factors, including:
Due to higher net effective discounts for products sold through our indirect channel, our overall gross margins for indirect channel sales are typically lower than those associated with direct sales. We expect product revenues from our indirect channel to continue to constitute a significant majority of our total revenues, which, by itself, negatively impacts our gross margins. Further, we expect that within our indirect channel, sales through our VADs will grow which will negatively impact our gross margins as VADs experience a larger net effective discount than our other channel partners.
Operating expenses consist of research and development, sales and marketing, and general and administrative expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of salaries, benefits and incentive compensation for our employees, including commissions for sales personnel and stock-based compensation for all employees.
Our headcount increased to 635 at April 30, 2010, from 598 at January 31, 2010, 560 at October 31, 2009 and 545 at July 31, 2009. Going forward, we expect to continue to strategically hire employees throughout the company as well as invest in research and development.
Research and development expenses primarily consist of personnel costs and facilities costs. We expense research and development expenses as incurred. We are devoting substantial resources to the continued development of additional functionality for existing products and the development of new products. We intend to continue to invest significantly in our research and development efforts because we believe it is essential to maintaining our competitive position. For fiscal 2010, we expect research and development expenses to increase on an absolute dollar basis and remain consistent or decrease as a percentage of revenue compared to fiscal 2009.
Sales and marketing expenses represent the largest component of our operating expenses and primarily consist of personnel costs, sales commissions, marketing programs and facilities costs. Marketing programs are intended to generate revenue from new and existing customers and are expensed as incurred.
We plan to continue to invest strategically in sales and marketing with the intent to add new customers and increase penetration within our existing customer base, expand our domestic and international sales and marketing activities, build brand awareness and sponsor additional marketing events. We expect future sales and marketing expenses to continue to be our most significant operating expense. Generally, sales personnel are not immediately productive, and thus, the increase in sales and marketing expenses that we experience as we hire additional sales personnel is not expected to immediately result in increased revenues and reduces our operating margins until such sales personnel become productive and generate revenue. Accordingly, the timing of sales personnel hiring and the rate at which they become productive will affect our future performance. For fiscal 2010, we expect sales and marketing expenses to increase on an absolute dollar basis and decrease as a percentage of revenue compared to fiscal 2009.
General and administrative expenses primarily consist of personnel and facilities costs related to our executive, finance, human resource, information technology and legal organizations, as well as insurance, investor relations, and information technology (IT) infrastructure costs related to our ERP system. Further, our general and administrative expenses include professional services consisting of outside legal, audit, Sarbanes-Oxley and information technology consulting costs. We have incurred in the past, and continue to incur, significant legal costs defending ourselves against claims made by third parties. These expenses are expected to continue as part of our ongoing operations and depending on the timing and outcome of lawsuits and the legal process, can have a significant impact on our financial statements. For fiscal 2010, we expect general and administrative expenses to increase on an absolute dollar basis and increase or remain consistent as a percentage of revenue compared to fiscal 2009.
Other Income (Expense), net
Other income (expense), net includes interest income on cash balances, accretion of discount or amortization of premium on short-term investments, and losses or gains on remeasurement of non-U.S. dollar transactions into U.S. dollars. Cash has historically been invested in money market funds and marketable securities.
Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with U.S. GAAP. These accounting principles require us to make estimates and judgments that affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, as well as the reported amounts of revenues and expenses during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our consolidated financial statements will be affected. The accounting policies that reflect our more significant estimates and judgments and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include revenue recognition, stock-based compensation, inventory valuation, allowances for doubtful accounts, income taxes, and goodwill and purchased intangible assets.
Our critical accounting policies are disclosed in our Form 10-K for the year ended July 31, 2009. There were no material changes to our critical accounting policies during the third quarter of fiscal 2010.
Recent Accounting Pronouncements
See Note 13 of Notes to Consolidated Financial Statements for recent accounting pronouncements that could have an effect on us.
Results of Operations
The following table presents our historical operating results as a percentage of revenues for the periods indicated:
During the third quarter of fiscal 2010, total revenues increased 50.5% over the third quarter of fiscal 2009 due to a $23.3 million increase in product and professional services and support revenues. Demand was strong across our core verticals, and across all of our major geographies. Our customer base also increased as we added approximately 2,800 new customers since the third quarter of fiscal 2009 and over 700 new customers in the third quarter of fiscal 2010 alone. Additionally, we saw solid growth in the broader enterprise as mobility is becoming a critical driver for enterprise productivity. For the first nine months of fiscal 2010, total revenues increased 29.7% over the first nine months of fiscal 2009, due to a $43.7 million increase in product and related professional services and support revenues that was driven by the same factors.
Our product revenues were bolstered by an increase in revenue related to our 802.11n access points due to the ratification of 802.11n. Further, product revenues have grown as a result of our right-sizing initiative. We are seeing companies continue to move toward a low-cost IT infrastructure solution by funding wireless projects rather than wired LANs, which we believe is due in part to the recent economic downturn.
The increase in professional services and support revenues is a result of increased product and first year support sales combined with the renewal of support contracts by existing customers. Further, during the third quarter of fiscal 2010, we recognized several large renewals through one of our partners. As our customer base grows over time, we expect the proportion of our revenues represented by support revenues to increase because substantially all of our customers purchase support when they purchase our products.
Ratable product and related professional services and support revenues decreased in the third quarter of fiscal 2010 compared to the third quarter of fiscal 2009 due to the run-off in the amortization of deferred revenue associated with those customer contracts that we entered into prior to our establishment of VSOE of fair value. We expect ratable product and related professional services and support revenues to continue to decrease in absolute dollars and as a percentage of total revenues in future periods.
In the third quarter of fiscal 2010, we derived 94.9% of our total revenues from indirect channels, which consist of VADs, VARs and OEMs. In the same period of fiscal 2009, we derived 83.2% of our total revenues from indirect channels. For the first nine months of fiscal 2010, we derived 92.4% of our total revenues from indirect channels compared to 82.0% for the first nine months of fiscal 2009. Overall, the percentage of revenue from our indirect channels continues to grow as we see increased leverage from partner relationships. Going forward, we expect to continue to derive a significant majority of our total revenues from indirect channels as we continue to focus on improving the efficiency of marketing and selling our products through these channels.
Revenues from shipments to locations outside the United States increased $10.4 million during the third quarter of fiscal 2010 compared to the third quarter of fiscal 2009 largely due to the strength of the VADs in the international markets. Most notably, revenue in our Asia Pacific region grew 135.9% year over year due to significantly improved market presence by one of our VADs, especially in the education vertical. During the first nine months of fiscal 2010, international revenues increased $23.4 million compared to the same period in fiscal 2009. We continue to expand into international locations and introduce our products in new markets, and we expect international revenues to increase in absolute dollars compared to fiscal 2009, and remain consistent or decrease as a percentage of total revenues in future periods compared with fiscal 2009.
Cost of Revenues and Gross Margin
During the third quarter of fiscal 2010 cost of revenues increased 39.1% compared to the third quarter of fiscal 2009 primarily due to the corresponding increase in our product revenue. The substantial majority of our cost of product revenues consists of payments to Flextronics, our largest contract manufacturer. For the third quarter of fiscal 2010, payments to Flextronics and Flextronics-related costs constituted more than 75% of our cost of product revenues. In the first nine months of fiscal 2010, cost of revenues increased 22.3% compared to the first nine months of fiscal 2009, also due to the corresponding increase in our product revenues.
Cost of professional services and support revenues increased 21.3% during the third quarter of fiscal 2010 compared to the third quarter of fiscal 2009 due to the increase in professional services and support revenues. For the first nine months of fiscal 2010, cost of professional services and support revenues increased 15.3% compared to the same period in fiscal 2009. We have benefitted from economies of scale within our professional services department which has kept our costs down despite the large increase in professional services and support revenues.
Cost of ratable product and related professional services and support revenues decreased during these periods consistent with the decrease in ratable product and related professional services and support revenues.
As we expand internationally, we may incur additional costs to conform our products to comply with local laws or local product specifications. In addition, we plan to continue to hire additional technical support personnel to support our growing international customer base.
Gross margins increased 2.7% during the third quarter of fiscal 2010 compared to the third quarter of fiscal 2009 primarily due to the renewal of several large support contracts with higher gross margin profiles during the third quarter of fiscal 2010. For the first nine months of fiscal 2010, gross margins increased 1.9% compared to the same period in fiscal 2009 due to product mix of sales on higher-margin controllers and software and better mix of sales with higher-margin channel partners. Further, we have benefitted from economies of scale within our professional services department which has kept our costs down despite the large increase in professional services and support revenues.
Research and Development Expenses
During the third quarter of fiscal 2010, research and development expenses increased 42.5% compared to the third quarter of fiscal 2009, primarily due to an increase of $3.2 million in personnel and related costs as we added 59 new employees to our research and development team. Facilities expenses increased $0.4 million related to the increase in our headcount. Expenses for consulting and outside agencies increased $0.4 million due to design and compliance work for our new low-priced access point and our new controllers.
During the first nine months of fiscal 2010, research and development expenses increased 24.0% compared to the first nine months of fiscal 2009, primarily due to an increase of $5.1 million in personnel and related costs as a result of an increase in headcount. Expenses for consulting and outside agencies increased by $0.9 million and facilities expenses increased $0.8 million due to reasons described above. Depreciation expense increased $0.5 million due to an increase in fixtures, machinery and equipment used to design and test new products.
Sales and Marketing Expenses
Sales and marketing expenses increased 36.8% during the third quarter of fiscal 2010 compared to the third quarter of fiscal 2009. Personnel and related costs increased $4.3 million due to the addition of 30 new employees to our sales and marketing team and an increase in stock-based compensation of $1.7 million. Marketing expenses increased $0.7 million due to several new marketing programs initiated in the third quarter of fiscal 2010 including a user-group convention we hosted, online advertising and partner events. Commission expense increased $2.1 million corresponding with the increase in revenues. Facilities expenses increased $0.3 million due to the movement of equipment to our inventory depots.
During the first nine months of fiscal 2010, sales and marketing expenses increased 18.8% compared to the first nine months of fiscal 2009. Personnel and related costs increased $6.5 million primarily due to an increase in stock-based compensation of $2.7 million. Marketing expenses increased $2.1 million related to new product launches, website redesign fees and a user-group convention we hosted. Sales and marketing expenses were also impacted by an increase in commission expense of $2.9 million and an increase in facilities expenses of $0.6 million for the reasons described above. Finally, demonstration equipment increased $0.3 million due to the increase in headcount as each new sales representative is provided demonstration equipment.
General and Administrative Expenses
During the third quarter of fiscal 2010, general and administrative expenses increased 51.0% compared to the third quarter of fiscal 2009, primarily due to an increase of $1.9 million in personnel expenses, including $1.5 million in stock-based compensation. Expenses for outside services increased $0.4 million due to design work associated with our headquarters building as well as fees paid to consultants working on our internal systems. Legal fees increased $0.5 million as a result of ongoing litigation and recent merger and acquisition activity. Finally, facilities expenses increased $0.2 million due to an increase in our headcount.
During the first nine months of fiscal 2010, general and administrative expenses increased 37.6% compared to the first nine months of fiscal 2009, primarily due to an increase of $5.6 million in personnel expenses, including $4.1 million in stock-based compensation. Facilities expenses increased $0.3 million and expenses for outside services increased $0.5 million for the reasons described above.
On November 14, 2008, as a result of the macroeconomic downturn, our board of directors approved a plan to reduce our costs and streamline operations through a combination of a reduction in our work force and the closing of certain facilities. The majority of the reduction in our work force was completed in the third quarter of fiscal 2009. The reduction in our work force resulted in the termination of 46 employees worldwide, or about 8% of our global work force. Expenses associated with the work force reduction, which were comprised primarily of severance and benefits payments as well as professional fees associated with career transition services, totaled $1.1 million. Additionally, we closed facilities in California and North Carolina and incurred facility exit costs of $0.3 million as a result. These cost reduction efforts, when added to our other cost control measures, resulted in savings of $7.0 million during fiscal 2009.
During the third quarter of fiscal 2010, we recorded a reserve totaling $1.7 million related to legal matters. There were no such expenses in the third quarter of fiscal 2009.
On November 4, 2009, we entered into a Patent Cross License and Settlement Agreement (the Settlement Agreement) with Motorola. Pursuant to the Settlement Agreement, we and Motorola agreed to:
As part of the Settlement Agreement, we agreed to pay Motorola $19.8 million in the first quarter of fiscal 2010. The one-time expense is shown on the Consolidated Statement of Operations within litigation reserves. The subsequent payment was made during the second quarter of fiscal 2010. See Note 12 of our Notes to Consolidated Financial Statements for further discussion.
Other Income (Expense), Net
Other income (expense), net consists primarily of interest income and foreign currency exchange gains and losses.
Interest income during the third quarter of fiscal 2010 decreased 40.8% from the third quarter of fiscal 2009, primarily due to declining interest rates. Our average yield-to-maturity rate decreased from 1.5% in the third quarter of fiscal 2009 to 0.7% in the third quarter of fiscal 2010. Our average yield-to-maturity rate decreased from 2.3% during the first nine months of fiscal 2009 to 0.7% during the first nine months of fiscal 2010.
Other income (expense), net decreased during the third quarter of fiscal 2010 compared to the third quarter of fiscal 2009 due to foreign currency losses driven by the remeasurement of foreign currency transactions into U.S. dollars. For the first nine months of fiscal 2010, other income (expense) net, remained relatively flat compared to the same period in fiscal 2009.
Provision for Income Taxes
Since inception, we have incurred operating losses. However, while we generated book losses, we generated operating income for foreign tax purposes resulting in tax provisions during the third quarter of fiscal 2010. As of July 31, 2009, we had net operating loss carryforwards of $84.1 million and $71.1 million for federal and state income tax purposes, respectively. We also had research and credit carryforwards of $6.0 million for federal and $5.7 million for state income tax purposes as of July 31, 2009. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, all federal and state deferred tax assets have been fully offset by a valuation allowance. If not utilized, the federal and state net operating loss and tax credit carryforwards will expire between 2013 and 2022. Utilization of these net operating losses and credit carryforwards may be subject to an annual limitation due to provisions of the Internal Revenue Code of 1986, as amended, that are applicable if we have experienced an ownership change in the past, or if an ownership change occurs in the future. See Note 8 of Notes to Consolidated Financial Statements.
Liquidity and Capital Resources
At April 30, 2010, our principal sources of liquidity were our cash, cash equivalents and short-term investments. Cash and cash equivalents are comprised of cash, sweep funds and money market funds with an original maturity of 90 days or less at the time of the purchase. Short-term investments include corporate bonds, U.S. government agency securities, U.S. treasury bills, commercial paper, and certificates of deposit. Cash, cash equivalents and short-term investments increased $21.3 million during the first nine months of fiscal 2010 from $123.1 million in cash, cash equivalents and short-term investments as of July 31, 2009 to $144.4 million as of April 30, 2010. Most of our sales contracts are denominated in United States dollars including sales contracts with international customers. As such, changes in our revenues derived from international customers have not affected our cash flows from operations as these are not affected by movement in exchange rates. However, as we fund our international operations, our cash and cash equivalents are affected by changes in exchange rates.
Cash Flows from Operating Activities
Our cash flows from operating activities will continue to be affected principally by our working capital requirements and the extent to which we increase spending on personnel. The timing of hiring sales personnel in particular affects cash flows as there is a lag between the hiring of sales personnel and the generation of revenue and cash flows from sales personnel. Our largest source of operating cash flows is cash collections from our customers. Our primary uses of cash from operating activities are for personnel related expenditures, purchases of inventory, and rent payments.
During the first nine months of fiscal 2010, operating activities provided $15.4 million of cash compared to $9.1 million of cash provided in operating activities during the first nine months of fiscal 2009. A decrease in accounts receivable, and increases in accounts payable, deferred revenue, accrued liabilities, and non-cash adjustments relating to stock-based compensation and depreciation and amortization contributed to the overall cash inflow. These inflows were partially offset by cash outflows due to increases in inventory, and prepaid and other assets as well as our net loss for the first nine months of fiscal 2010. Further, in November 2009, pursuant to the Settlement Agreement with Motorola, we made a one-time payment to Motorola for $19.8 million. See Note 12 of our Notes to Consolidated Financial Statements for further discussion.
Cash Flows from Investing Activities
Cash used in investing activities during the first nine months of fiscal 2010 increased $21.0 million compared to the first nine months of fiscal 2009. We purchased more short-term investments during the first nine months of fiscal 2010 compared to the corresponding period in fiscal 2009 as we reinvested cash flow from operations. We also sold fewer short-term investments in the first nine months of fiscal 2010 compared to the corresponding period in fiscal 2009. Purchases of property and equipment in the first nine months of fiscal 2010 were slightly down compared to the first nine months of fiscal 2009.
Cash Flows from Financing Activities
Cash provided by financing activities increased $5.7 million in the first nine months of fiscal 2010 compared to the first nine months of fiscal 2009. The cash proceeds from the issuance of common stock in conjunction with our 2007 Equity Incentive Plan and Employee Stock Purchase Plan increased substantially in the first nine months of fiscal 2010 compared to the first nine months of fiscal 2009 primarily due to the increase in our stock price and the increase in the number of contributions in our Employee Stock Purchase Plan. In the first nine months of fiscal 2009 we repurchased shares of our common stock under our stock repurchase program in the amount of $1.0 million.
Based on our current cash, cash equivalents and short-term investments we expect that we will have sufficient resources to fund our operations for the next 12 months. However, we may need to raise additional capital or incur additional indebtedness to continue to fund our operations in the future. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of expansion into new territories, the timing of introductions of new products and enhancements to existing products, and the continuing market acceptance of our products.
On May 7, 2010, we entered into a definitive agreement to purchase Azalea Networks. Under the terms of the agreement, we will acquire Azalea in exchange for total consideration of approximately $27.0 million of our stock subject to certain adjustments and up to $13.5 million in cash will be paid over two years. The acquisition is expected to close in the first quarter of fiscal year 2011, and is subject to standard closing conditions. Other than this agreement, we currently have no other agreements, commitments, plans, proposals or arrangements, written or otherwise, with respect to any material acquisitions. We may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all.
The following is a summary of our contractual obligations:
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Foreign Currency Risk
Most of our sales contracts are denominated in United States dollars, and therefore, our revenue is not subject to significant foreign currency risk. Our operating expenses and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the British Pound, Euro and Japanese Yen. To date, we have not entered into any hedging contracts because expenses in foreign currencies have been insignificant to date, and exchange rate fluctuations have had little impact on our operating results and cash flows.
Interest Rate Sensitivity
We had cash, cash equivalents and short-term investments totaling $144.4 million and $123.1 million at April 30, 2010 and July 31, 2009, respectively. The cash, cash equivalents and short-term investments are held for working capital purposes. We do not use derivative financial instruments in our investment portfolio. We have an investment portfolio of fixed income securities that are classified as available-for-sale securities. These securities, like all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase. We attempt to limit this exposure by investing primarily in short-term securities. Due to the short duration and conservative nature of our investment portfolio, a movement of 10% in market interest rates would not have a material impact on our operating results and the total value of the portfolio over the next fiscal year. If overall interest rates had fallen by 10% in the third quarter of fiscal 2010, our interest income on cash, cash equivalents and short-term investments would have declined immaterially assuming consistent investment levels.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934 as amended (the Exchange Act). In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.
Based on our evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of April 30, 2010, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the third quarter of fiscal 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Internal control over financial reporting means a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
From time to time, we are involved in claims and legal proceedings that arise in the ordinary course of business. We expect that the number and significance of these matters will increase as our business expands. Any claims or proceedings against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time, result in the diversion of significant operational resources, or require us to enter into royalty or licensing agreements which, if required, may not be available on terms favorable to us or at all. If management believes that a loss arising from these matters is probable and can be reasonably estimated, we record the amount of the loss. As additional information becomes available, any potential liability related to these matters is assessed and the estimates revised. Based on currently available information, management does not believe that the ultimate outcomes of these unresolved matters, individually and in the aggregate, are likely to have a material adverse effect on our financial position, liquidity or results of operations. However, litigation is subject to inherent uncertainties, and our view of these matters may change in the future. Were an unfavorable outcome to occur, there exists the possibility of a material adverse impact on our financial position and results of operations or liquidity for the period in which the unfavorable outcome occurs or becomes probable, and potentially in future periods.
Item 1A. Risk Factors
Risks Related to Our Business and Industry
Our business, operating results and growth rates may be adversely affected by unfavorable economic and market conditions.
While we have seen improvements in the overall macroeconomic environment and our revenues have increased, economic conditions worldwide have negatively impacted our business in our recent history. While we believe in the long-term growth prospects of the WLAN market, the deterioration in overall economic conditions and, in particular, tightening in the credit markets and reduced spending by both enterprises and consumers have significantly impacted various industries on which we rely for purchasing our products. This has led to reductions in capital expenditures by end user customers for our products, longer sales cycles, the deferral or delay of purchase commitments for our products, increased competition, and the deferral or delay of reviews by end user customers of their existing infrastructure that could have otherwise driven demand for our products. These factors have impacted our operating results and could create uncertainty for the future. For example, as the U.S. and global economies weakened, in the second and third quarters of fiscal 2009, our total revenues decreased sequentially over the same period. In addition, our business depends on the overall demand for IT and on the economic health of our current and prospective customers. We cannot be assured of the level of IT spending, the deterioration of which could have a material adverse effect on our results of operations and growth rates. The purchase of our products or willingness to replace existing infrastructure in some vertical markets may be discretionary and may involve a significant commitment of capital and other resources. Therefore, weak economic conditions, or a reduction in IT spending would likely adversely impact our business, operating results and financial condition in a number of ways, including longer sales cycles, lower prices for our products and services, and reduced unit sales. In addition, if interest rates rise or foreign exchange rates weaken for our international customers, overall demand for our products and services could be further dampened, and related IT spending may be reduced.
We compete in new and rapidly evolving markets and have a limited operating history, which makes it difficult to predict our future operating results.
We were incorporated in February 2002 and began commercial shipments of our products in June 2003. As a result of our limited operating history, it is very difficult to forecast our future operating results. In addition, we operate in an industry characterized by rapid technological change. Our prospects should be considered and evaluated in light of the risks and uncertainties frequently encountered by early stage companies in rapidly evolving markets characterized by rapid technological change, changing customer needs, evolving industry standards and frequent introductions of new products and services. These risks and difficulties include challenges in accurate financial planning as a result of limited historical data and the uncertainties resulting from having had a relatively limited time period in which to implement and evaluate our business strategies as compared to older companies with longer operating histories.
In addition, our products are designed to be compatible with industry standards for secure communications over wireless and wireline networks. As we encounter changing standards, customer requirements and competitive pressures, we likely will be required to reposition our product and service offerings and introduce new products and services. We may not be successful in doing so in a timely and appropriately responsive manner, or at all. Our failure to address these risks and difficulties successfully could materially harm our business and operating results.
Our operating results may fluctuate significantly, which makes our future results difficult to predict and could cause our operating results to fall below expectations.
Our annual and quarterly operating results have fluctuated in the past and may fluctuate significantly in the future due to a variety of factors, many of which are outside of our control.
Furthermore, our product revenues generally reflect orders shipped in the same quarter they are received, and a substantial portion of our orders are often received in the last month of each fiscal quarter, a trend that may continue. As a result, if we are unable to ship orders received in the last month of each fiscal quarter, even though we may have business indicators about customer demand during a quarter, we may experience revenue shortfalls, and such shortfalls may materially adversely affect our earnings because we may not be able to adequately and timely adjust our expense levels.
In addition to other risk factors listed in this Risk Factors section, factors that may cause our operating results to fluctuate include:
Our quarterly operating results are difficult to predict even in the near term. In one or more future quarterly periods, our operating results may fall below the expectations of securities analysts and investors. In this event, the trading price of our common stock could decline significantly.
We have a history of losses and may not achieve profitability in the future.
We have a history of losses and have not achieved profitability on a quarterly or annual basis. We experienced net losses of $5.3 million and $34.4 million for the third quarter and first nine months of fiscal 2010, respectively. We experienced net losses of $5.8 million and $18.9 million for the third quarter and first nine months of fiscal 2009, respectively. As of April 30, 2010 and July 31, 2009, our accumulated deficit was $176.1 million and $141.6 million, respectively. We expect to incur operating losses in the near future as a result of the expenses associated with the continued development and expansion of our business, including expenditures to hire additional personnel relating to sales and marketing and technology development. If we fail to increase revenues or manage our cost structure, we may not achieve or sustain profitability in the future. As a result, our business could be harmed, and our stock price could decline.
Our sales cycles can be long and unpredictable, and our sales efforts require considerable time and expense. As a result, our sales are difficult to predict and may vary substantially from quarter to quarter, which may cause our operating results to fluctuate significantly.
The timing of our revenues is difficult to predict. Our sales efforts involve educating our customers about the use and benefits of our products, including the technical capabilities of our products and the potential cost savings achieved by organizations that utilize our products. Customers typically undertake a significant evaluation process, which frequently involves not only our products but also those of our competitors and can result in a lengthy sales cycle, which typically averages four to nine months in length but can be as long as 18 months. We spend substantial time, effort and money in our sales efforts without any assurance that our efforts will produce any sales. Over the last year, we have experienced longer sales cycles in connection with customers evaluating our new 802.11n solution and in light of general economic conditions in certain verticals. In addition, product purchases are frequently subject to budget constraints, multiple approvals, and unplanned administrative, processing and other delays. For example, during the second quarter of fiscal 2008, we experienced a significant decrease in revenue in our federal vertical market, which represents sales to United States governmental entities. We view the federal vertical as highly dependent on large transactions, and therefore we could experience fluctuations from period to period in this vertical. If sales expected from a specific customer for a particular quarter are not realized in that quarter or at all, our business, operating results and financial condition could be materially adversely affected.
The market in which we compete is highly competitive, and competitive pressures from existing and new companies may have a material adverse effect on our business, revenues, growth rates and market share.
The market in which we compete is highly competitive and is influenced by the following competitive factors:
We expect competition to intensify in the future as other companies introduce new products in the same markets we serve or intend to enter and as the market continues to consolidate. This competition could result in increased pricing pressure, reduced profit margins, increased sales and marketing expenses and failure to increase, or the loss of, market share, any of which would likely seriously harm our business, operating results or financial condition. If we do not keep pace with product and technology advances, there could be a material adverse effect on our competitive position, revenues and prospects for growth.
A number of our current or potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, sales, marketing and other resources than we do. Potential customers may prefer to purchase from their existing suppliers rather than a new supplier, regardless of product performance or features. Currently, we compete with a number of large and well established public companies, including Cisco Systems (primarily through its Wireless Networking Business Unit), Motorola and Hewlett-Packard, as well as smaller companies and new market entrants, any of which could reduce our market share, require us to lower our prices, or both.
We expect increased competition from other established and emerging companies if our market continues to develop and expand. Our channel partners could market products and services that compete with our products and services. In addition, some of our competitors have made acquisitions or entered into partnerships or other strategic relationships with one another to offer a more comprehensive solution than they individually had offered. We expect this trend to continue as companies attempt to strengthen or maintain their market positions in an evolving industry and as companies enter into partnerships or are acquired. Many of the companies driving this consolidation trend have significantly greater financial, technical and other resources than we do and are better positioned to acquire and offer complementary products and technologies. The companies resulting from these possible consolidations may create more compelling product offerings and be able to offer greater pricing flexibility, making it more difficult for us to compete effectively, including on the basis of price, sales and marketing programs, technology or product functionality. Continued industry consolidation may adversely impact customers perceptions of the viability of smaller and even medium-sized technology companies and, consequently, customers willingness to purchase from such companies. These pressures could materially adversely affect our business, operating results and financial condition.
We sell a majority of our products through VADs, VARs, and OEMs. If these channel partners on which we rely do not perform their services adequately or efficiently, or if they exit the industry or have financial difficulties, there could be a material adverse effect on our revenues and our cash flow.
Our future success is highly dependent upon establishing and maintaining successful relationships with a variety of VADs, VARs, and OEMs, which we refer to as our indirect channel. In recent quarters, we have dedicated a significant amount of effort to increase the use of our VADs and VARs in each of our theatres of operations. The percentage of our total revenues fulfilled from sales through our indirect channel was 94.9% and 92.4% for the third quarter and first nine months of fiscal 2010, respectively. The percentage of our total revenues fulfilled from sales through our indirect channel was 83.2% and 82.0% for the third quarter and first nine months of fiscal 2009, respectively. We expect that over time, indirect channel sales will continue to constitute a significant majority of our total revenues. Accordingly, our revenues depend in large part on the effective performance of our channel partners. Several of our channel partners accounted for more than 10% of total revenues for the third quarter of fiscal 2010. The table below represents the percentage of total revenues our top channel partners contributed:
Our agreements with our partners provide that they use reasonable commercial efforts to sell our products on a perpetual basis unless the agreement is otherwise terminated by either party. Finally, the agreement with Alcatel-Lucent contains a most-favored nations clause, pursuant to which we agreed to lower the price at which we sell products to Alcatel-Lucent in the event that we agree to sell the same or similar products at a lower price to a similar customer on the same or similar terms and conditions. However, the specific terms of this most-favored nations clause are narrow and specific, and we have not to date incurred any obligations related to this term in the agreement.
Some of our indirect channel partners may have insufficient financial resources and may not be able to withstand changes in worldwide business conditions, including economic downturns, abide by our inventory and credit requirements, or have the ability to meet their financial obligations to us. As of April 30, 2010, three of our channel partners individually accounted for more than 10% of accounts receivable. Partner A accounted for 26.9%, Partner B accounted for 20.7%, and Partner D accounted for 12.6% of total accounts receivable. As of July 31, 2009, Partner C accounted for 23.0% and Partner D accounted for 19.1% of total accounts receivable. If the indirect channel partners on which we rely do not perform their services adequately or efficiently, fail to meet their obligations to us, or if they exit the industry and we are not able to quickly find adequate replacements, there could be a material adverse effect on our revenues, cash flow and market share. By relying on these indirect channels, we may have less contact with the end users of our products, thereby making it more difficult for us to establish brand awareness, ensure proper delivery and installation of our products, service ongoing customer requirements and respond to evolving customer needs. In addition, our indirect channel partners may receive pricing terms that allow for volume discounts off of list prices for the products they purchase from us, which reduce our margins to the extent revenues from such channel partners increase as a proportion of our overall revenues.
Recruiting and retaining qualified channel partners and training them in our technology and product offerings requires significant time and resources. In order to develop and expand our distribution channel, we must continue to scale and improve our processes and procedures that support our channel partners, including investment in systems and training, and those processes and procedures may become increasingly complex and difficult to manage. We have no minimum purchase commitments with any of our VADs, VARs, or OEMs, and our contracts with these channel partners do not prohibit them from offering products or services that compete with ours or from terminating our contract on short notice. Our competitors may be effective in providing incentives to existing and potential channel partners to favor their products or to prevent or reduce sales of our products. Our channel partners may choose not to focus primarily on the sale of our products or offer our products at all. Our failure to establish and maintain successful relationships with indirect channel partners would likely materially adversely affect our business, operating results and financial condition.
We depend upon the development of new products and enhancements to our existing products. If we fail to predict and respond to emerging technological trends and our customers changing needs, we may not be able to remain competitive.
We may not be able to anticipate future market needs or be able to develop new products or product enhancements to meet such needs. For example, we anticipate a need to continue to increase the mobility of our solution, and certain customers have delayed, and may in the future delay, purchases of our products until either new versions of those products are available or the customer evaluations are completed. If we fail to develop new products or product enhancements, our business could be adversely affected, especially if our competitors are able to introduce solutions with such increased functionality. In addition, as new mobile applications are introduced, our success may depend on our ability to provide a solution that supports these applications.
We are active in the research and development of new products and technologies and enhancing our current products. However, research and development in the enterprise mobility industry is complex and filled with uncertainty. If we expend a significant amount of resources on research and development and our efforts do not lead to the successful introduction of products that are competitive in the marketplace, there could be a material adverse effect on our business, operating results, financial condition and market share. In addition, it is common for research and development projects to encounter delays due to unforeseen problems, resulting in low initial volume production, fewer product features than originally considered desirable and higher production costs than initially budgeted, which may result in lost market opportunities. In addition, any new products or product enhancements that we introduce may not achieve any significant degree of market acceptance or be accepted into our sales channel by our channel partners. There could be a material adverse effect on our business, operating results, financial condition and market share due to such delays or deficiencies in the development, manufacturing and delivery of new products.
Once a product is in the marketplace, its selling price often decreases over the life of the product, especially after a new competitive product is publicly announced. To lessen the effect of price decreases, our product management team attempts to reduce development and manufacturing costs in order to maintain or improve our margins. However, if cost reductions do not occur in a timely manner, there could be a material adverse effect on our operating results and market share. Further, the introduction of new products may decrease the demand for older products currently sitting in our inventory balances. As a result, we may need to record incremental inventory reserves for the older products that we do not expect to sell. This may have a material adverse effect on our operating results and market share.
We manufacture our products to comply with standards established by various standards bodies, including the Institute of Electrical and Electronics Engineers, Inc. (IEEE). If we are not able to adapt to new or changing standards that are ratified by these bodies, our ability to sell our products may be adversely affected. For example, as of July 31, 2009, we had been developing and were offering for sale products that complied with the draft 802.11n wireless LAN standard (11n) that the IEEE had not yet ratified. Although subsequent to our fiscal year end, the IEEE ratified the 11n standard and did not modify the draft of the 11n standard, the IEEE could modify the standard in the future. We remain subject to any changes adopted by various standards bodies, which would require us to modify our products to comply with the new standards, require additional time and expense and could cause a disruption in our ability to market and sell the affected products.
We may engage in future acquisitions that could disrupt our business, cause dilution to our stockholders and harm our business, operating results and financial condition.
In March 2008, we completed our acquisition of AirWave Wireless, Inc. We continue to integrate the acquired AirWave products into our secure mobility solutions, as well as provide products and continuing support to existing AirWave customers and partners. In May 2010, we entered into a definitive agreement to purchase Azalea Networks. The acquisition is expected to close in the first quarter of fiscal 2011, and is subject to standard closing conditions. Further, in the future we may acquire other businesses, products or technologies. When the acquisition of Azalea is completed, and upon the completion of any future acquisitions, we may not ultimately strengthen our competitive position or achieve our goals. This acquisition and future acquisitions may be viewed negatively by customers, financial markets or investors. In addition, this acquisition and any future acquisitions that we make could lead to difficulties in integrating personnel and operations from the acquired businesses and in retaining and motivating key personnel from these businesses. Acquisitions may disrupt our ongoing operations, divert management from day-to-day responsibilities, increase our expenses and adversely impact our business, operating results and financial condition. Future acquisitions may reduce our cash available for operations and other uses and could result in an increase in amortization expense related to identifiable assets acquired, potentially dilutive issuances of equity securities or the incurrence of debt, which could harm our business, operating results and financial condition.
As a result of the fact that we outsource the manufacturing of our products to contract manufacturers, including Flextronics, we do not have the ability to ensure quality control over the manufacturing process. Furthermore, if there are significant changes in the financial or business condition of Flextronics or our other contract manufacturers, our ability to supply quality products to our customers may be disrupted.
As a result of the fact that we outsource the manufacturing of our products to Flextronics and other contract manufacturers, we are subject to the risk of supplier failure and customer dissatisfaction with the quality or performance of our products. Quality or performance failures of our products or changes in the financial or business condition of our contract manufacturers could disrupt our ability to supply quality products to our customers and thereby have a material adverse effect on our business, revenues and financial condition.
Our orders with our contract manufacturers represent a relatively small percentage of the overall orders received by them from their customers. As a result, fulfilling our orders may not be considered a priority in the event our contract manufacturers are constrained in their abilities to fulfill all of its customer obligations in a timely manner. We provide demand forecasts to our contract manufacturers. If we overestimate our requirements, our contract manufacturers may assess charges, or we may have liabilities for excess inventory, each of which could negatively affect our gross margins. Conversely, because lead times for required materials and components vary significantly and depend on factors such as the specific supplier, contract terms and the demand for each component at a given time, if we underestimate our requirements, our contract manufacturers may have inadequate materials and components required to produce our products. This could result in an interruption of the manufacturing of our products, delays in shipments and deferral or loss of revenue. In addition, on occasion we have underestimated our requirements, and, as a result, we have been required to pay additional fees to our contract manufacturers in order for manufacturing to be completed and shipments to be made on a timely basis.
If any of our contract manufacturers suffer an interruption in its business, or experiences delays, disruptions or quality control problems in their manufacturing operations, or we have to change or add additional contract manufacturers, our ability to ship products to our customers would be delayed, and our business, operating results and financial condition would be adversely affected.
Our contract manufacturers purchase some components, subassemblies and products from a single supplier or a limited number of suppliers, and with respect to some of these suppliers, we have entered into license agreements that allow us to use their components in our products. The loss of any of these suppliers or the termination of any of these license agreements may cause us to incur additional set-up costs, result in delays in manufacturing and delivering our products, or cause us to carry excess or obsolete inventory.
Shortages in components that we use in our products are possible, and our ability to predict the availability of such components may be limited. While components and supplies are generally available from a variety of sources, we currently depend on a single or limited number of suppliers for several components for our equipment and certain subassemblies and products. We rely on our contract manufacturers to obtain the components, subassemblies and products necessary for the manufacture of our products, including those components, subassemblies and products that are only available from a single supplier or a limited number of suppliers.
For example, our solution incorporates both software products and hardware products, including a series of high-performance programmable mobility controllers and a line of wired and wireless access points. The chipsets that our contract manufacturers source and incorporate in our hardware products are currently available only from a limited number of suppliers, with whom neither we nor our contract manufacturers have entered into supply agreements. All of our access points incorporate components from Atheros Corporation (Atheros), and some of our mobility controllers incorporate components from Broadcom Corporation (Broadcom) and Netlogic Microsystems Corporation (Netlogic). We have entered into license agreements with Atheros, Broadcom and Netlogic, the termination of which could have a material adverse effect on our business. Our license agreements with Atheros, Broadcom and Netlogic have perpetual terms in that they will automatically be renewed for successive one-year periods unless the agreement is terminated prior to the end of the then-current term. As there are no other sources for identical components, in the event that our contract manufacturers are unable to obtain these components from Atheros, Broadcom or Netlogic, we would be required to redesign our hardware and software in order to incorporate components from alternative sources. All of our product revenues are dependent upon the sale of products that incorporate components from Atheros, Broadcom or Netlogic.
In addition, for certain components, subassemblies and products for which there are multiple sources, we are still subject to potential price increases and limited availability due to market demand for such components, subassemblies and products. In the past, unexpected demand for communication products caused worldwide shortages of certain electronic parts. If such shortages occur in the future, our business would be adversely affected. We carry very little to no inventory of our product components, and we and Flextronics rely on our suppliers to deliver necessary components in a timely manner. We and our contract manufacturers rely on purchase orders rather than long-term contracts with these suppliers. As a result, even if available, we or our contract manufacturers may not be able to secure sufficient components at reasonable prices or of acceptable quality to build products in a timely manner and, therefore, may not be able to meet customer demands for our products, which would have a material adverse effect on our business, operating results and financial condition.
Our international sales and operations subject us to additional risks that may adversely affect our operating results.
We derive a significant portion of our revenues from customers outside the United States. We have sales and technical support personnel in numerous countries worldwide. In addition, a portion of our engineering efforts are currently handled by personnel located in India, and we expect to expand our offshore development efforts within India and possibly in other countries. We expect to continue to add personnel in additional countries. Our international operations subject us to a variety of risks, including:
As we continue to expand our business globally, our success will depend, in large part, on our ability to anticipate and effectively manage these and other risks associated with our international operations. Our failure to manage any of these risks successfully could harm our international operations and reduce our international sales, adversely affecting our business, operating results and financial condition.
If we are unable to protect our intellectual property rights, our competitive position could be harmed or we could be required to incur significant expenses to enforce our rights.
We depend on our ability to protect our proprietary technology. We protect our proprietary information and technology through licensing agreements, third-party nondisclosure agreements and other contractual provisions, as well as through patent, trademark, copyright and trade secret laws in the United States and similar laws in other countries. There can be no assurance that these protections will be available in all cases or will be adequate to prevent our competitors from copying, reverse engineering or otherwise obtaining and using our technology, proprietary rights or products. For example, the laws of certain countries in which our products are manufactured or licensed do not protect our proprietary rights to the same extent as the laws of the United States. In addition, third parties may seek to challenge, invalidate or circumvent our patents, trademarks, copyrights and trade secrets, or applications for any of the foregoing. There can be no assurance that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology or design around our proprietary rights. In each case, our ability to compete could be significantly impaired. To prevent substantial unauthorized use of our intellectual property rights, it may be necessary to prosecute actions for infringement and/or misappropriation of our proprietary rights against third parties. Any such action could result in significant costs and diversion of our resources and managements attention, and there can be no assurance that we will be successful in such action. Furthermore, many of our current and potential competitors have the ability to dedicate substantially greater resources to enforce their intellectual property rights than we do. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property.
Claims by others that we infringe their proprietary technology could harm our business.
Third parties have asserted and may in the future assert claims of infringement of intellectual property rights against us or against our customers or channel partners for which we may be liable. For example, in August 2007, Symbol Technologies, Inc. and Wireless Valley Communications, Inc., both subsidiaries of Motorola, Inc., filed suit against us asserting infringement of certain U.S. patents, and, in November 2009, we entered into a settlement agreement with Motorola, Inc., Symbol Technologies, Inc. and Wireless Valley Communications, Inc. (collectively Motorola), pursuant to which we paid Motorola $19.8 million. Due to the rapid pace of technological change in our industry, much of our business and many of our products rely on proprietary technologies of third parties, and we may not be able to obtain, or continue to obtain, licenses from such third parties on reasonable terms. As our business expands and the number of products and competitors in our market increases and overlaps occur, we expect that infringement claims may increase in number and significance. Intellectual property lawsuits are subject to inherent uncertainties due to the complexity of the technical issues involved, and we cannot be certain that we will be successful in defending ourselves against intellectual property claims. Furthermore, a successful claimant could secure a judgment that requires us to pay substantial damages or prevents us from distributing certain products or performing certain services. In addition, we might be required to seek a license for the use of such intellectual property, which may not be available on commercially acceptable terms or at all. Alternatively, we may be required to develop non-infringing technology, which could require significant effort and expense and may ultimately not be successful. Any claims or proceedings against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time, result in the diversion of significant operational resources, or require us to enter into royalty or licensing agreements.
Impairment of our goodwill or other assets would negatively affect our results of operations.
Our acquisition of AirWave Wireless, Inc. resulted in goodwill of $7.7 million. Together with our purchase of certain assets of Network Chemistry, Inc., we have purchased intangible assets of $10.4 million as of April 30, 2010. This represents a significant portion of the assets recorded on our balance sheet. Goodwill is reviewed for impairment at least annually or sooner under certain circumstances. Other intangible assets that are deemed to have finite useful lives will continue to be amortized over their useful lives but must be reviewed for impairment when events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Screening for and assessing whether impairment indicators exist, or if events or changes in circumstances have occurred, including market conditions, operating fundamentals, competition and general economic conditions, requires significant judgment. Therefore, we cannot assure you that a charge to operations will not occur as a result of future goodwill and intangible asset impairment tests. If impairment is deemed to exist, we would write down the recorded value of these intangible assets to their fair values. If and when these write-downs do occur, they could harm our business, financial condition, and results of operations.
If we lose members of our senior management or are unable to recruit and retain key employees on a cost-effective basis, we may not be able to successfully grow our business. If we fail to effectively integrate new officers into our organization, our business could be harmed.
Our success is substantially dependent upon the performance of our senior management. All of our executive officers are at-will employees, and we do not maintain any key-man life insurance policies. The loss of the services of any members of our management team may significantly delay or prevent the achievement of our product development and other business objectives and could harm our business. Our success also is substantially dependent upon our ability to attract additional personnel for all areas of our organization, particularly in our sales, research and development, and customer service departments. For example, unless and until we hire a Vice President of Worldwide Sales, our Chief Executive Officer will fill this role in addition to his other responsibilities. Experienced management and technical, sales, marketing and support personnel in the IT industry are in high demand, and competition for their talents is intense. We may not be successful in attracting and retaining such personnel on a timely basis, on competitive terms, or at all. The loss of, or the inability to recruit, such employees could have a material adverse effect on our business.
Some of our current officers have recently joined us. As a result, our executive team has not worked together as a group for a significant period of time. Our future performance will depend in part on our ability to successfully integrate our newly hired executive officers into our management team and develop an effective working relationship among senior management. If we fail to integrate these individuals and create effective working relationships among them and other members of management, our business operating results and financial condition could be adversely affected.
If we fail to manage future growth effectively, our business would be harmed.
We have expanded our operations significantly since inception and anticipate that further significant expansion will be required. We intend to increase our market penetration and extend our geographic reach through our network of channel partners. We also plan to increase offshore operations by establishing additional offshore capabilities for certain engineering functions. This future growth, if it occurs, will place significant demands on our management, infrastructure and other resources. To manage any future growth, we will need to hire, integrate and retain highly skilled and motivated employees. If we do not effectively manage our growth, our business, operating results and financial condition could be adversely affected.
To accommodate the growth of our business, we implemented an Enterprise Resource Planning (ERP) system in November 2008. Accordingly, we may experience problems commonly experienced by other companies in connection with such implementations, including but not limited to, potential bugs in the system, component or supply delays, training requirements and other integration challenges and delays. Any difficulties we might experience in connection with our ERP system could have a material adverse effect on our financial reporting system and internal controls.
Our ability to sell our products is highly dependent on the quality of our support and services offerings, and our failure to offer high quality support and services would have a material adverse effect on our sales and results of operations.
Once our products are deployed within our end customers networks, they depend on our support organization to resolve any issues relating to our products. A high level of support is critical for the successful marketing and sale of our products. If we or our channel partners do not effectively assist our end customers in deploying our products, succeed in helping our end customers quickly resolve post-deployment issues, or provide effective ongoing support, it would adversely affect our ability to sell our products to existing customers and could harm our reputation with potential customers. In addition, as we expand our operations internationally, our support organization will face additional challenges including those associated with delivering support, training and documentation in languages other than English. As a result, our failure, or the failure of our channel partners, to maintain high quality support and services would have a material adverse effect on our business, operating results and financial condition.
Enterprises are increasingly concerned with the security of their data, and to the extent they elect to encrypt data between the end user and the server, our products will become less effective.
Our products depend on the ability to identify applications. Our products currently do not identify applications if the data is encrypted as it passes through our mobility controllers. Since most organizations currently encrypt most of their data transmissions only between sites and not on the LAN, the data is not encrypted when it passes through our mobility controllers. If more organizations elect to encrypt their data transmissions from the end user to the server, our products will offer limited benefits unless we have been successful in incorporating additional functionality into our products that address those encrypted transmissions. At the same time, if our products do not provide the level of network security expected by our customers, our reputation and brand would be damaged, and we would expect to experience decreased sales. Our failure to provide such additional functionality and expected level of network security could adversely affect our business, operating results and financial condition.
Our products are highly technical and may contain undetected hardware errors or software bugs, which could cause harm to our reputation and adversely affect our business.
Our products are highly technical and complex and, when deployed, are critical to the operation of many networks. Our products have contained and may contain undetected errors, bugs or security vulnerabilities. Some errors in our products may only be discovered after a product has been installed and used by customers. Any errors, bugs, defects or security vulnerabilities discovered in our products after commercial release could result in loss of revenues or delay in revenue recognition, loss of customers, damage to our brand and reputation, and increased service and warranty cost, any of which could adversely affect our business, operating results and financial condition. In addition, we could face claims for product liability, or breach of warranty, including claims relating to changes to our products made by our channel partners. Our contracts with customers contain provisions relating to warranty disclaimers and liability limitations, which may not be upheld. Defending a lawsuit, regardless of its merit, is costly and may divert managements attention and adversely affect the markets perception of us and our products. In addition, if our business liability insurance coverage proves inadequate or future coverage is unavailable on acceptable terms or at all, our business, operating results and financial condition could be adversely impacted.
Our use of open source software could impose limitations on our ability to commercialize our products.
We incorporate open source software into our products. Although we monitor our use of open source closely, the terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that such licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our products. In such event, we could be required to seek licenses from third parties in order to continue offering our products, to re-engineer our products or to discontinue the sale of our products in the event re-engineering cannot be accomplished on a timely basis, any of which could adversely affect our business, operating results and financial condition.
We rely on the availability of third-party licenses.
Many of our products are designed to include software or other intellectual property licensed from third parties. It may be necessary in the future to seek or renew licenses relating to various aspects of these products. There can be no assurance that the necessary licenses would be available on acceptable terms, if at all. The inability to obtain certain licenses or other rights or to obtain such licenses or rights on favorable terms, or the need to engage in litigation regarding these matters, could have a material adverse effect on our business, operating results, and financial condition. Moreover, the inclusion in our products of software or other intellectual property licensed from third parties on a nonexclusive basis could limit our ability to protect our proprietary rights in our products.
Enterprises may have slow WAN connections between some of their locations that may cause our products to become less effective.
Our mobility controllers and network management software were initially designed to function at LAN-like speeds in an office building or campus environment. In order to function appropriately, our mobility controllers synchronize with each other over network links. The ability of our products to synchronize may be limited by slow or congested data-links, including DSL and dial-up. Our failure to provide such additional functionality could adversely affect our business, operating results and financial condition.
New safety regulations or changes in existing safety regulations related to our products may result in unanticipated costs or liabilities, which could have a material adverse effect on our business, results of operations and future sales, and could place additional burdens on the operations of our business.
Radio emissions are subject to regulation in the United States and in other countries in which we do business. In the United States, various federal agencies including the Center for Devices and Radiological Health of the Food and Drug Administration, the Federal Communications Commission, the Occupational Safety and Health Administration and various state agencies have promulgated regulations that concern the use of radio/electromagnetic emissions standards. Member countries of the European Union (EU) have enacted similar standards concerning electrical safety and electromagnetic compatibility and emissions standards.
If any of our products becomes subject to new regulations or if any of our products becomes specifically regulated by additional government entities, compliance with such regulations could become more burdensome, and there could be a material adverse effect on our business and our results of operations.
In addition, our wireless communication products operate through the transmission of radio signals. Currently, operation of these products in specified frequency bands does not require licensing by regulatory authorities. Regulatory changes restricting the use of frequency bands or allocating available frequencies could become more burdensome and could have a material adverse effect on our business, results of operations and future sales.
Compliance with environmental matters and worker health and safety laws could be costly, and noncompliance with these laws could have a material adverse effect on our results of operations, expenses and financial condition.
Some of our operations use substances regulated under various federal, state, local and international laws governing the environment and worker health and safety, including those governing the discharge of pollutants into the ground, air and water, the management and disposal of hazardous substances and wastes, and the cleanup of contaminated sites. Some of our products are subject to various federal, state, local and international laws governing chemical substances in electronic products. We could be subject to increased costs, fines, civil or criminal sanctions, third-party property damage or personal injury claims if we violate or become liable under environmental and/or worker health and safety laws.
In January 2003, the EU issued two directives relating to chemical substances in electronic products. The Waste Electrical and Electronic Equipment Directive requires producers of electrical goods to pay for specified collection, recycling, treatment and disposal of past and future covered products. EU governments were required to enact and implement legislation that complies with this directive by August 13, 2004 (such legislation together with the directive, the WEEE Legislation), and certain producers are financially responsible under the WEEE Legislation beginning in August 2005. The EU has issued another directive that requires electrical and electronic equipment placed on the EU market after July 1, 2006 to be free of lead, mercury, cadmium, hexavalent chromium (above a threshold limit) and brominated flame retardants. EU governments were required to enact and implement legislation that complies with this directive by August 13, 2004 (such legislation together with this directive, the RoHS Legislation). If we do not comply with these directives or related legislation, we may suffer a loss of revenues, be unable to sell our products in certain markets and/or countries, be subject to penalties and enforced fees and/or suffer a competitive disadvantage. Similar legislation could be enacted in other jurisdictions, including in the United States. Costs to comply with the WEEE Legislation, RoHS Legislation and/or similar future legislation, if applicable, could include costs associated with modifying our products, recycling and other waste processing costs, legal and regulatory costs and insurance costs. We have recorded and may also be required to record additional expenses for costs associated with compliance with these regulations. We cannot assure you that the costs to comply with these new laws, or with current and future environmental and worker health and safety laws will not have a material adverse effect on our results of operation, expenses and financial condition.
We are subject to governmental export and import controls that could subject us to liability or impair our ability to compete in international markets.
Because we incorporate encryption technology into our products, our products are subject to U.S. export controls and may be exported outside the United States only with the required level of export license or through an export license exception. In addition, various countries regulate the import of certain encryption technology and radio frequency transmission equipment and have enacted laws that could limit our ability to distribute our products or could limit our customers ability to implement our products in those countries. Changes in our products or changes in export and import regulations may create delays in the introduction of our products in international markets, prevent our customers with international operations from deploying our products throughout their global systems or, in some cases, prevent the export or import of our products to certain countries altogether. Any change in export or import regulations or related legislation, shift in approach to the enforcement or scope of existing regulations, or change in the countries, persons or technologies targeted by such regulations, could result in decreased use of our products by, or in our decreased ability to export or sell our products to, existing or potential customers with international operations.
Our business is subject to the risks of earthquakes, fire, floods and other natural catastrophic events, and to interruption by manmade problems such as computer viruses or terrorism.
Our corporate headquarters are located in the San Francisco Bay Area, a region known for seismic activity. A significant natural disaster, such as an earthquake, fire or a flood, occurring at our headquarters or in either China or Singapore, where our largest contract manufacturer, Flextronics, is located, could have a material adverse impact on our business, operating results and financial condition. In addition, our servers are vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems. In addition, acts of terrorism could cause disruptions in our or our customers businesses or the economy as a whole. To the extent that such disruptions result in delays or cancellations of customer orders, or the deployment of our products, our business, operating results and financial condition would be adversely affected.
Risks Related to Ownership of our Common Stock
Our stock price may be volatile.
The trading price of our common stock has been and may continue to be volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. Factors that could affect the trading price of our common stock could include:
In addition, the stock market in general, and the market for technology companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Broad market and industry factors may seriously affect the market price of our common stock, regardless of our actual operating performance. In addition, in the past, following periods of volatility in the overall market and the market price of a particular companys securities, securities class action litigation has often been instituted against these companies. This litigation, if instituted against us, could result in substantial costs and a diversion of our managements attention and resources.
If securities or industry analysts do not publish research or reports about our business, or if they issue an adverse or misleading opinion regarding our stock, our stock price and trading volume could decline.
The trading market for our common stock will be influenced by the research and reports that industry or securities analysts publish about us or our business. If any of the analysts who cover us issue an adverse or misleading opinion regarding our stock, our stock price would likely decline. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.
Insiders have substantial control over us and will be able to influence corporate matters.
As of April 30, 2010, our directors and executive officers and their affiliates beneficially owned, in the aggregate, approximately 25.3% of our outstanding common stock. As a result, these stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, such as a merger or other sale of our company or its assets. This concentration of ownership could limit stockholders ability to influence corporate matters and may have the effect of delaying or preventing a third party from acquiring control over us.
We may choose to raise additional capital. Such capital may not be available, or may be available on unfavorable terms, which would adversely affect our ability to operate our business.
We expect that our existing cash balances will be sufficient to meet our working capital and capital expenditure needs for the foreseeable future. If we choose to raise additional funds, due to unforeseen circumstances or material expenditures, we cannot be certain that we will be able to obtain additional financing on favorable terms, if at all, and any additional financings could result in additional dilution to our existing stockholders.
Provisions in our charter documents, Delaware law, employment arrangements with certain of our executive officers, and our OEM supply agreement with Alcatel-Lucent could discourage a takeover that stockholders may consider favorable.
Provisions in our certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include but are not limited to the following:
As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. Our board of directors could rely on Delaware law to prevent or delay an acquisition of us.
Certain of our executive officers may be entitled to accelerated vesting of their options pursuant to the terms of their employment arrangements upon a change of control of Aruba. In addition to the arrangements currently in place with some of our executive officers, we may enter into similar arrangements in the future with other officers. Such arrangements could delay or discourage a potential acquisition of Aruba.
In addition, our OEM supply agreement with Alcatel-Lucent provides that, in the event of a change of control that would cause Alcatel-Lucent to purchase our products from an entity that is an Alcatel-Lucent competitor, we must, without additional consideration, (1) provide Alcatel-Lucent with any information required by Alcatel-Lucent to make, test and support the products that we distribute through our OEM relationship with Alcatel-Lucent, including all hardware designs and software source code, and (2) otherwise cooperate with Alcatel-Lucent to transition the manufacturing, testing and support of these products to Alcatel-Lucent. We are also obligated to promptly inform Alcatel-Lucent if and when we receive an inquiry concerning a bona fide proposal or offer to effect a change of control and will not enter into negotiations concerning a change of control without such prior notice to Alcatel-Lucent. Each of these provisions could delay or result in a discount to the proceeds our stockholders would otherwise receive upon a change of control or could discourage a third party from making a change of control offer.
We have incurred and will continue to incur significant increased costs as a result of operating as a public company, and our management will be required to devote substantial time to new compliance initiatives.
The Sarbanes-Oxley Act of 2002, as well as rules subsequently implemented by the Securities and Exchange Commission and the Nasdaq Stock Market, have imposed various requirements on public companies, including requiring changes in corporate governance practices. Our management and other personnel devote a substantial amount of time to these compliance initiatives. Moreover, these rules and regulations have increased our legal and financial compliance costs and will make some activities more time-consuming and costly. For example, we expect these rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantial costs to maintain the same or similar coverage. These rules and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers.
In addition, the Sarbanes-Oxley Act requires us to furnish a report by our management on our internal control over financial reporting. Such report contains, among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. While we were able to assert in our Form 10-K for the fiscal year ended July 31, 2009 filed on October 6, 2009, that our internal control over financial reporting was effective as of July 31, 2009, we must continue to monitor and assess our internal control over financial reporting. If we are unable to assert in any future reporting period that our internal control over financial reporting is effective (or if our independent registered public accounting firm is unable to express an opinion on the effectiveness of our internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(a) Sales of Unregistered Securities
(b) Purchases of Equity Securities by the Issuer and Affiliated Purchasers
Item 3. Defaults Upon Senior Securities
Item 4. [Reserved]
Item 5. Other Information
Item 6. Exhibits
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: June 4, 2010
Dated: June 4, 2010