|
|
 | | | |
- close
- close
- close
- close
| |||||||||
Brocade Communications Systems 10-K 2007 Documents found in this filing:Table of Contents
UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
Washington, D.C.
20549
Commission file number:
000-25601
1745 Technology Drive
San Jose, CA 95110
(408) 333-8000
(Address, including zip code, of
Registrant’s principal executive offices and
Securities registered pursuant to Section 12(b) of the
Act:
Securities registered pursuant to Section 12(g) of the
Act:
None
Indicate by check mark whether the registrant is a well-known
seasoned issuer, as defined in Rule 405 of the Securities
Act. Yes þ No o
Indicated by check mark whether the registrant is not required
to file reports pursuant to Section 13 or
Section 15(d) of the Act. Yes
o No þ
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 if disclosure of delinquent filers
pursuant to Item 405 of
Regulation S-K
is not contained herein, and will not be contained, to the best
of the Registrant’s knowledge, in definitive proxy or
information statements incorporated by reference to
Part III of this
Form 10-K
or any amendment to this
Form 10-K. þ
Indicate by check mark whether the registrant is a large
accelerated filer, an accelerated filer, or a non-accelerated
filer. See definition of “accelerated filer and large
accelerated filer” in
Rule 12b-2
of the Exchange Act. (Check one):
Large accelerated
filer þ Accelerated
filer o Non-accelerated
filer o
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 aggregate market value of voting and non-voting common
equity held by non-affiliates of the Registrant was
approximately $1,670,727,000 as of April 29, 2006 based
upon the closing price on the Nasdaq National Market reported
for such date. This calculation does not reflect a determination
that certain persons are affiliates of the Registrant for any
other purpose.
The number of shares outstanding of the Registrant’s Common
Stock on December 22, 2006, was 277,359,000 shares.
Portions of the Registrant’s Proxy Statement for its 2007
Annual Meeting of Stockholders (the “Proxy
Statement”), to be filed with the Securities and Exchange
Commission, are incorporated by reference into Part III of
this
Form 10-K.
BROCADE
COMMUNICATIONS SYSTEMS, INC.
FORM 10-K
Table of Contents
PART I
Brocade develops, markets, sells, and supports data storage
networking and data management solutions, offering a line of
storage networking products, software and services that enable
companies to implement highly available, scalable, manageable,
and secure environments for shared data storage applications in
enterprise data centers. The Brocade family of Storage Area
Network (“SAN”) switches and directors is designed to
help companies reduce the cost and complexity of managing
business information within a data storage environment, ensure
high availability of mission critical applications and serve as
a platform for corporate data backup and disaster recovery. The
Brocade family of file data management solutions addresses a
range of additional information technology challenges within the
data center and across a distributed enterprise, both within and
around the SAN, through software systems and professional
service offerings that complement and utilize a shared storage
environment. Brocade products are installed around the world at
companies, institutions, and other entities ranging from large
enterprises to small and medium size businesses. Brocade
products and services are marketed, sold, and supported
worldwide to end-user customers through distribution partners,
including Original Equipment Manufacturers (“OEMs”),
distributors, systems integrators, value-added resellers and by
Brocade directly.
Brocade was incorporated in California on August 24, 1995,
and re-incorporated in Delaware on May 14, 1999.
Brocade’s mailing address and executive offices are located
at 1745 Technology Drive, San Jose, California 95110.
Brocade’s telephone number is
(408) 333-8000.
Brocade’s corporate website is www.brocade.com.
Brocade’s Annual Report on
Form 10-K,
Quarterly Reports on
Form 10-Q,
Current Reports on
Form 8-K,
and amendments to reports filed pursuant to Sections 13(a)
and 15(d) of the Securities Exchange Act of 1934, as amended,
are available free of charge on Brocade’s website when such
reports are available on the SEC website. The public may read
and copy any materials filed by Brocade with the SEC at the
SEC’s Public Reference Room at 100 F Street, NE,
Washington, DC 20549. The public may obtain information on the
operation of the Public Reference Room by calling the SEC at
1-800-SEC-0330.
The SEC maintains an Internet site that contains reports, proxy
and information statements and other information regarding
issuers that file electronically with the SEC at
http://www.sec.gov. The contents of these websites are not
incorporated into this filing. Further, Brocade’s
references to the URLs for these websites are intended to be
inactive textual references only.
Brocade’s products and services are designed to help
companies reduce the cost and complexity of managing business
information within a shared data storage environment while
enabling high levels of availability of mission critical
business applications. In addition, its products and services
assist companies in the development and delivery of storage
consolidation and disaster recovery programs, and in meeting
compliance issues regarding data management. Brocade’s
products are generally used in conjunction with servers and
storage subsystems, SAN interconnection components such as host
bus adapters, and storage management software applications and
tools. By utilizing a shared storage, or networked storage
solution, companies can more easily share and consolidate server
and storage resources; centralize and simplify data management;
scale and provision storage resources more effectively; and
improve application efficiency, performance and availability. As
a result, companies are able to better utilize information
technology assets, improve productivity of information
technology personnel, reduce capital and operational
expenditures, and more reliably and securely store, manage, and
administer business information.
Brocade believes that as the need for data storage grows,
companies will look to further simplify the tasks of storing,
managing, and administering their data, while looking to
maximize their information technology investments and reduce
both capital and operational expenditures. SANs, which have been
installed at many of the world’s leading companies since
the mid-1990s, provide a platform that helps companies optimize
their information technology assets and support future data
growth. Brocade also believes companies will continue to expand
the size and scope of their SANs and the number and types of
applications that their storage networks support.
Table of Contents
Since Brocade’s inception, Brocade has been a pioneer and
innovator in developing the market for shared storage solutions,
and has grown to be a market leader in storage networking
infrastructure. Brocade believes that the future evolution of
the storage networking and data management markets will be led
by the providers of products and services that simplify the
management of heterogeneous storage environments and maximize
end-users’ information technology investments on an ongoing
basis. Brocade also believes that storage networking
infrastructure and data management solutions will evolve to
provide increased capabilities that enable new types of storage
management applications that simplify storage management,
increase operational efficiencies, and reduce operating expense.
As a result, many of Brocade’s initiatives and investments
are aimed at expanding the capabilities enabled by storage
networks, increasing
end-to-end
interoperability, protecting end-user investments in existing
and new information technology resources, and making it easier
for Brocade and its partners to deliver solutions that provide
efficiencies in managing large and growing enterprise storage
environments.
Brocade’s family of SAN fabric switches, directors and
bladed switch products are predominantly based on the Fibre
Channel protocol, and provide bandwidth and high-speed routing
of data between servers and storage devices. They range from low
cost
entry-level 8-port
switches to 384-port enterprise-class director switches and are
available in different form-factors, including fixed-port
services, modular chassis, and embedded blades. Brocade SAN
directors are highly reliable solutions for deploying
enterprise-class SANs in mission-critical environments. All
switches support key applications such as data backup, remote
mirroring, and high-availability clustering as well as
high-volume transaction processing applications such as
enterprise resource planning, or ERP, and data warehousing. They
have been designed to meet the storage networking needs of
end-users in environments ranging from small and medium-size
businesses to large enterprises with SAN fabrics that scale to
thousands of ports, spread across multiple locations around the
world.
Brocade Fabric Operating System, or Fabric OS, is the operating
system that provides the core infrastructure for deploying SANs.
As the foundation for Brocade’s family of SAN switches,
Fabric OS helps ensure the reliable and high-performance data
transport which is critical for scalable SAN fabrics
interconnecting multiple servers and storage devices.
Brocade’s SAN management operating system also includes a
common set of optional advanced fabric services that build upon
the foundation of Fabric OS and help improve performance,
availability, scalability, and the overall functionality of the
network. These fabric services include the ability to
proactively monitor the health and performance of the SAN, the
ability to aggregate bandwidth between fabric switches to
deliver higher performance for storage applications, and the
ability to securely control data access in multi-vendor SAN
environments. In addition, Brocade offers management tools that
enable end-users to manage and administer their SANs. Brocade
believes that its Fabric OS provides it with an advantage in the
storage networking market, enabling differentiation and
increasing optional licensable features and services.
Brocade believes that some of the next generation storage
management applications will be fabric-based, rather than server
or storage array-based. In general, this means that elements of
certain storage related applications will reside in the network
of storage area network switches, commonly referred to as the
“fabric”, rather than in the server or storage array.
Brocade believes this will allow for increased centralization of
storage management functions and higher performance of storage
related applications. Brocade also believes that these
fabric-based applications, such as fabric-based routing
services, storage volume management, data replication, and data
migration, will accelerate the migration of intelligence into
the SAN fabric and minimize operational cost and complexity for
the end-user. The Brocade AP7420 is an intelligent switching
platform designed to host SAN fabric-based storage management
applications while integrating with existing Brocade SAN
infrastructures. As a result, Brocade believes this platform can
provide a highly scalable solution for managing server and
storage environments much more efficiently. Brocade is working
closely with certain of its OEM partners and independent
software vendors to create new fabric-based applications and
migrate existing storage management applications to these
intelligent fabric application platforms. In addition, Brocade
has invested in the internal development of certain types of
applications which will run on these intelligent platforms.
Table of Contents
In fiscal year 2005, Brocade began introducing certain file data
management solutions. These solutions are composed of software
and/or
systems that are typically connected to, or help to manage, a
customer’s shared storage environment to provide new
capabilities for the customer that extend and complement the
efficiencies of a customer’s storage network and include
the following categories: Application Resource Services, Data
Migration Services and File Services.
Brocade Application Resource Manager, or ARM, provides the
ability for customers to rapidly and flexibly provision their
application servers with server operating systems (such as
Microsoft Windows or Linux), applications, important software
drivers, and application data that resides in a storage network.
Brocade believes that this capability saves staff and
operational time, provides for more flexible use of servers, and
allows companies to better manage and track their software usage.
Brocade Data Migration Manager, or DMM, is a system that
provides a fast and predictable way to migrate data across
heterogeneous storage devices that are connected to a SAN.
Brocade File Services solutions are designed to help
organizations consolidate access to file data while simplifying
the availability and recovery of that data as part of a
strategic File Area Network (FAN). As a result, these solutions
help optimize server and storage assets, increase operational
flexibility, and significantly reduce overall data management
and storage costs. These solutions include the following:
Brocade also offers a range of professional and support services
to facilitate customer projects, to assist customers in the
design, implementation, and operation of their SAN, and to
provide extended customer support. These services address a
number of customer risk factors that must be managed during the
life cycle of a storage network, and are valued because they
bring valuable experience and expertise to a customer challenge.
Brocade services may be delivered directly to end-user
customers, or via partners as a component of a broader service
and support offering.
Brocade works with industry-leading companies to facilitate the
development of standards, technologies, products, and services
that focus on the simplification of heterogeneous storage
management, and the implementation and management of storage
networking environments. Brocade has an open approach to SAN
management and works with nearly every leading provider of
storage and SAN management applications and technologies.
Table of Contents
Brocade is continuing this commitment with regard to its file
related products. Brocade is actively involved with key file
product partners and competitors to develop an industry based
technical working group around the common architecture
definitions for the File Area Network (FAN).
Since Brocade’s inception, it has been a major contributor
to the evolution of industry standards ranging from Fibre
Channel communication technology to SAN interoperability to
storage and SAN management. Brocade contributes to related
industry standards committees, and has authored or co-authored
the majority of the Fibre Channel protocol standards in
existence today.
As SANs have increased in size and comprise more and different
types of server, storage, and interconnection devices, the need
for interoperability among those devices has similarly
increased. Brocade has invested a significant amount of
resources for purposes of providing interoperability among
Brocade solutions and the servers, storage, and storage
management applications that run in the Brocade environment, as
well as in driving standards for interoperability among SAN
interconnection devices. Brocade also certifies its solutions in
operational storage environments through its testing programs,
its partners’ testing and qualification initiatives, and
through certification programs for third party products, such as
the Brocade Fabric Aware program, which it offers as a resource
to its application and technology partners. Through
Brocade’s testing initiatives, Brocade also certifies
interoperability configurations of common customer environments,
such as remote data backup in a multi-vendor server and storage
environment.
An important aspect of managing storage environments is the
management software used to administer, manage, and provision
storage resources and data. Brocade products offer advanced
fabric services that allow third-party developers of storage
software applications to gain additional functionality and
simplify the development of their applications.
Brocade’s education and training organization delivers
high-quality, technical education and training on Brocade
technology that encompasses design, implementation, and
management solutions to its partners and their customers.
Brocade curriculum is delivered worldwide using diverse
methodologies, which include instructor led classes and a robust
online web based training portfolio as well as a
“live” virtual classroom capability. Brocade Education
Services trains over 14,000 information technology professionals
annually in this way. The Brocade SAN Certification Program
offers certification on Brocade SANs for information technology
professionals who have completed certain tests administered by
an independent testing organization. This certification program
is designed to measure the knowledge and proficiency of
information technology professionals in SAN and FAN solutions
and technologies, and to help ensure that Brocade’s
customers receive superior customer service and support. Over
6,700 information technology professionals are now certified on
Brocade solutions. Brocade’s education and training
services are made available through its own education facilities
and through its worldwide training provider network.
Brocade’s products are marketed, sold, and supported
worldwide primarily through a wide range of distribution
partners, including OEM partners, distributors, system
integrators and value-added resellers, or VARs, and directly by
Brocade.
Table of Contents
Brocade has OEM or distribution agreements with most of the
major companies that sell enterprise storage systems and
subsystems. In addition, Brocade employs a worldwide overlay
sales force to assist its distribution partners in marketing
Brocade solutions, assessing customer requirements and
designing, implementing, and maintaining Brocade-based solutions.
Brocade’s major OEM customers for the fiscal year ended
October 28, 2006 included Dell Computer Corporation, EMC
Corporation, or EMC, Fujitsu Siemens, Hitachi Data Systems,
Inc., Hewlett-Packard Company, or HP, IBM Corporation, or IBM,
Network Appliance, Inc., Siemens AG, Sun Microsystems, Inc., and
Unisys Corporation. Brocade’s primary non-OEM
customers for the fiscal year ended October 28, 2006,
included Bell Microproducts, GE Access Distribution, Tokyo
Electron Limited, and XIOTech.
For the years ended October 28, 2006, October 29,
2005, and October 30, 2004, EMC, HP, and IBM each
represented greater than ten percent of Brocade’s total
revenues for combined totals of 73 percent,
71 percent, and 70 percent, of its total revenues,
respectively. The level of sales to any OEM customer may vary
from quarter to quarter, and Brocade expects that significant
customer concentration will continue for the foreseeable future.
The loss of, or a decrease in the level of sales to, or a change
in the ordering pattern of, any one of these customers could
have a material adverse impact on Brocade’s financial
condition or results of operations. In addition, its OEM
partners experience seasonal revenue patterns which Brocade
experiences as well. These patterns are generally in-line with
its OEMs on a calendar quarter basis. Historically,
Brocade’s first and fourth fiscal quarters are seasonally
stronger quarters than its second and third fiscal quarters.
Historically, domestic revenues have been between
60 percent and 75 percent of total revenues. For the
year ended October 28, 2006, domestic and international
revenues were approximately 64 and 36 percent of total
revenues, respectively. For the year ended October 29,
2005, domestic and international revenues were approximately
63 percent and 37 percent of Brocade’s total
revenues, respectively, and for the year ended October 30,
2004, domestic and international revenues were approximately
65 percent and 35 percent of its total revenues,
respectively. Revenues are attributed to geographic areas based
on the location of the customer to which Brocade’s products
are shipped rather than where the products are ultimately used.
International revenues primarily consist of sales to customers
in Western Europe and the greater Asia Pacific region. For the
year ended October 28, 2006, revenues in Europe have
increased primarily as a result of faster growth in that region
relative to North America and Asia Pacific region. For the years
ended October 29, 2005 and October 30, 2004,
international revenues decreased as a result of faster growth in
the North America region. However, certain OEM customers take
possession of Brocade’s products domestically and then
distribute these products to their international customers.
Because Brocade accounts for all of those OEM revenues as
domestic revenues, Brocade cannot be certain of the extent to
which its domestic and international revenue mix is impacted by
the practices of its OEM customers. Nevertheless, data provided
by OEM customers indicates that international customers may
account for a higher percentage of end-user demand than that
indicated by Brocade’s mix of domestic and international
revenues (see Note 14 “Segment Information”, of
the Notes to Consolidated Financial Statements).
Brocade’s acquisition and investment strategy is focused on
facilitating the evolution and expansion of shared storage and
data management. Brocade has made equity investments in
companies that develop technology or provide services that are
complementary to or broaden the markets for its products and
further its business objectives. On January 27, 2003,
Brocade completed its acquisition of Rhapsody Networks, Inc., or
Rhapsody, a privately held technology company based in Fremont,
California. This acquisition resulted in the addition of the
Brocade AP7420.
Table of Contents
On May 3, 2005, Brocade completed its acquisition of
Therion Software Corporation, or Therion, a privately held
developer of software management solutions for the automated
provisioning of servers over a storage network based in Redmond,
Washington. As of the acquisition date, Brocade owned
approximately 13% of Therion’s equity interest through
investments totaling $1.0 million. Therion was a
development stage company with no recognized revenue and a core
technology that had not yet reached technological feasibility.
Accordingly, the acquisition of Therion was accounted for as an
asset purchase. Subsequently, the Therion technology came to
market as Brocade Application Resource Manager, or ARM.
On May 3, 2005 Brocade announced a strategic relationship
to deliver Wide Area File Services, or WAFS, to enterprise
customers on Microsoft’s Windows Server 2003 platform with
Tacit Networks, Inc., or Tacit, a leader in enterprise-wide
remote office information technology solutions. Tacit was
subsequently acquired by Packeteer, Inc. in May 2006 and
Brocade’s equity investment in Tacit was recovered. The
WAFS solution is part of Brocade’s File Services product
portfolio. Under agreements entered into with Tacit, and
subsequently Packeteer, the solutions are marketed by Brocade to
its partners and customers worldwide, and Brocade is partnered
with Packeteer in customer support and on product development
programs.
On March 6, 2006, Brocade completed its acquisition of
NuView, Inc., a privately held provider of a family of
standards-based enterprise file management products based in
Houston, Texas. The acquisition expanded Brocade’s File
Services solutions to include software solutions that extend the
benefits of shared storage architectures to file data
environments.
On August 8, 2006, Brocade announced that it had entered
into a definitive agreement to acquire McDATA Corporation,
or McDATA, in an all stock transaction valued at approximately
$634 million as of that date. Under the terms of the
agreement, McDATA stockholders will receive 0.75 shares of
Brocade common stock for each share of McDATA class A
common stock and each share of McDATA class B common stock
they hold. The acquisition is subject to obtaining approval from
both Brocade and McDATA stockholders, regulatory approvals and
certain other closing conditions.
As of October 28, 2006, October 29, 2005, and
October 30, 2004, the carrying value of Brocade’s
investments in non-publicly traded companies was
$0.8 million, $3.8 million and $0.5 million,
respectively.
The industry in which Brocade competes is subject to rapid
technological developments, evolving industry standards, changes
in customer requirements, and new product introductions. As a
result, Brocade’s success depends, in part, on its ability
to continue to enhance its existing solutions and to develop and
introduce new solutions that improve performance and reduce the
total cost of ownership in the storage environment. Brocade has
invested significantly in product research and development. It
continues to enhance and extend its products, and increase the
speed, performance, and port-density of its switching platform.
Brocade also continues to expand the value-added services of its
intelligent platform to enable more functionality for end
customers, OEM partners, and application partners and to further
simplify storage management.
Brocade products are designed to support current industry
standards and will continue to support emerging standards that
are consistent with its product strategy. Brocade products have
been designed around a common platform architecture, which
facilitates the product design, development, and testing cycle,
and reduces the time to market for new products and features.
Brocade intends to continue to leverage this common architecture
to develop and introduce additional hardware and software
products and enhancements in the future.
Brocade’s product development process includes the
certification of certain of its products by its
OEM partners, which is referred to as the product
qualification process. During this process, Brocade supports its
OEM partners in the testing of its new products to insure
they meet quality and functionality, and inoperability
requirements. The process is completed once the OEM partner has
certified the product and announced general availability of that
product to their customers. This process generally is completed
in a range of two to four months.
For the years ended October 28, 2006, October 29,
2005, and October 30, 2004, Brocade’s research and
development expenses totaled $164.8 million,
$132.4 million, and $142.5 million, respectively. All
expenditures for
Table of Contents
research and development costs have been expensed as incurred.
In fiscal 2007, Brocade expects to increase its level of
investment, in absolute dollars, in research and development.
The markets for storage network and data management solutions
and technologies are competitive and subject to rapid
technological change. Major storage systems and server providers
are continually introducing new solutions and products into
these markets, and enhancing their existing networked storage
and data management solutions and products. Brocade believes its
primary competition is from providers of SAN switching products
for interconnecting servers and storage, including Cisco Systems
Inc., or Cisco, QLogic Corporation, or QLogic, and McDATA (see
Note 10 “Commitments and Contingencies”, of the
Notes to Consolidated Financial Statements), as well as from
other private and public companies who have invested various
aspects of networked storage and data management hardware,
software, and service offerings.
In addition, as the storage network and data management markets
evolve, additional technologies are, and may increasingly become
available for interconnecting servers and storage. To the extent
that products based upon these technologies provide the ability
to network servers and storage and support high-performance,
block-data storage applications, they are likely to compete with
Brocade’s current and future products. Competitive products
include, but are not limited to, non-Fibre Channel emerging
products based on Gigabit Ethernet, 10 Gigabit Ethernet,
InfiniBand, and iSCSI, as well as other storage solutions such
as Network Attached Storage (“NAS”), and Direct
Attached Storage (“DAS”). In addition, networking
companies, manufacturers of networking equipment, and other
companies may develop competitive products and technologies.
Brocade’s OEM partners or other partners could also develop
and introduce products that compete with its product offerings.
Brocade believes the competitive factors in this market include
product performance and features, product reliability, price,
size and extent of installed base, ability to meet delivery
schedules, customer service, technical support, and distribution
channels.
Some of Brocade’s competitors have longer operating
histories and significantly greater human and financial
resources than it does. These competitors may have the ability
to devote a larger number of sales personnel to focus on the
networked storage and data management markets, compete with
Brocade and potentially change the current distribution model.
Brocade’s competitors could also adopt more aggressive
pricing policies and devote greater resources to the
development, promotion, and sale of their products than Brocade.
As a result, they may be able to respond more quickly to changes
in customer or market requirements. Brocade may not have the
financial resources, technical expertise or marketing,
manufacturing, distribution, and support capabilities to compete
successfully against current or future competitors. This could
materially harm Brocade’s business.
Brocade uses a third-party contract manufacturer, Hon Hai
Precision Industry Co., Ltd., or Foxconn, to manufacture its
products. Foxconn invoices Brocade based on prices and payment
terms mutually agreed upon and set forth in purchase orders it
issues to them. Although the purchase orders Brocade places with
its contract manufacturer are cancelable, Brocade could be
required to purchase all unused material not cancelable,
returnable or usable by other customers.
Brocade uses Foxconn for final turnkey product assembly, but
Brocade also maintains key component selection and qualification
expertise internally. Brocade designs and develops the key
components of its products, including application-specific
integrated circuits, or ASICs, and operating system and other
software, as well as certain details in the fabrication and
enclosure of its products. In addition, Brocade determines the
components that are incorporated into its products, and Brocade
selects appropriate suppliers of those components.
Although Brocade uses standard parts and components for its
products where possible, Brocade’s contract manufacturer,
Foxconn, currently purchases, on its behalf, several key
components used in the manufacture of its products from single
and limited supplier sources. Brocade’s principal single
source components are application-specific integrated circuits,
or ASICs. Brocade’s principal limited source components
include ASICs, printed circuit boards, microprocessors, certain
connectors, certain logic chips, small form-factor pluggable
transceivers, or SFPs, power supplies, and programmable logic
devices. In addition, Brocade licenses certain software from
third parties that is incorporated into its fabric operating
system and other software. If Brocade is unable to buy or
license these
Table of Contents
components on a timely basis, it may not be able to deliver its
products to customers in a timely manner. Brocade uses rolling
forecasts based on anticipated product orders to determine
component requirements. If Brocade overestimates component
requirements, it may have excess inventory, which would increase
its costs. If Brocade underestimates component requirements, it
may have inadequate inventory, which could interrupt the
manufacturing process and result in lost or deferred revenue. In
addition, lead times for components vary significantly and
depend on factors such as the specific supplier, contract terms,
and demand for a component at a given time. Brocade also may
experience shortages of certain components from time to time,
which also could delay the manufacturing and sales processes.
Brocade is also subject to various environmental and other
regulations governing product safety, materials usage, packaging
and other environmental impacts in the various countries where
its products are sold. For example, many of Brocade’s
products are subject to laws and regulations that restrict the
use of mercury, hexavalent chromium, cadmium and other
substances, and require producers of electrical and electronic
equipment to assume responsibility for collecting, treating,
recycling and disposing of its products when they have reached
the end of their useful life. In Europe, substance restrictions
apply to products sold. In addition, recycling, labeling,
financing and related requirements apply to products Brocade
sells in Europe. Brocade may be required to redesign its
products to ensure that they comply with any new requirements as
well as related requirements imposed by its OEM customers.
Brocade also continues to work with its suppliers to provide it
with compliant materials, parts and components. If
Brocade’s products do not comply with the European
substance restrictions, it could become subject to fines, civil
or criminal sanctions, and contract damage claims. In addition,
Brocade could be prohibited from shipping non-compliant products
into the European Union, and required to recall and replace any
products already shipped, if such products were found to be
non-compliant, which would disrupt its ability to ship products
and result in reduced revenue, increased obsolete or excess
inventories and harm to its business and customer relationships.
Brocade’s suppliers may also fail to provide it with
compliant materials, parts and components, which could impact
its ability to timely produce compliant products and may disrupt
its business. Various other countries and states in the United
States have issued, or are in the process of issuing, other
environmental regulations that may impose additional
restrictions or obligations and require further changes to its
products.
Brocade relies on a combination of patents, copyrights,
trademarks, trade secrets, confidentiality agreements, and other
contractual restrictions with employees and third parties to
establish and protect its proprietary rights. Despite these
precautions, the measures Brocade undertakes may not prevent
misappropriation or infringement of its proprietary technology.
These measures may not preclude competitors from independently
developing products with functionality or features similar to
its products.
Brocade maintains a program to identify and obtain patent
protection for its inventions. As of December 19, 2006,
Brocade has been issued 22 patents in the United States that are
currently in force and have over 100 patent applications pending
in the United States. The normal expiration dates of its issued
patents in the United States range from 2012 to 2023. It is
possible that Brocade will not receive patents for every
application it files. Furthermore, Brocade’s issued patents
may not adequately protect its technology from infringement or
prevent others from claiming that its products infringe the
patents of those third parties. Brocade’s failure to
protect its intellectual property could materially harm its
business. In addition, Brocade’s competitors may
independently develop similar or superior technology, duplicate
Brocade’s products, or design around its patents. It is
possible that litigation may be necessary in the future to
enforce Brocade’s intellectual property rights, to protect
its trade secrets, or to determine the validity and scope of the
proprietary rights of others. Litigation could result in
substantial costs and diversion of resources and could
materially harm Brocade’s business.
Some of Brocade’s products are designed to include software
or other intellectual property licensed from third parties.
While it may be necessary in the future to seek or renew
licenses relating to various aspects of its products, Brocade
believes that such licenses generally could be obtained on
commercially reasonable terms. However, failure to obtain such
licenses on commercially reasonable terms could materially harm
Brocade’s business.
Brocade has received, and may receive in the future, notice of
claims of infringement of other parties’ proprietary
rights. Infringement or other claims could be asserted or
prosecuted against Brocade in the future, and it
Table of Contents
is possible that past or future assertions or prosecutions could
harm its business. Any such claims, with or without merit, could
be time-consuming, result in costly litigation and diversion of
technical and management personnel, cause delays in the
development and release of its products, or require Brocade to
develop non-infringing technology or enter into royalty or
licensing arrangements. Such royalty or licensing arrangements,
if required, may require Brocade to license back its technology
or may not be available on terms acceptable to Brocade, or at
all. For these reasons, infringement claims could materially
harm Brocade’s business.
Brocade’s business is characterized by short lead-time
orders and fast delivery schedules. Sales of its products are
generally made pursuant to contracts and purchase orders that
are cancelable without significant penalties. These commitments
are subject to price negotiations and to changes in quantities
of products and delivery schedules in order to reflect changes
in customers’ requirements and manufacturing availability.
In addition, actual shipments depend on the manufacturing
capacity of suppliers and the availability of products from such
suppliers. As a result of the foregoing factors, Brocade does
not believe that backlog at any given time is a meaningful
indicator of its ability to achieve any particular level of
revenue or financial performance.
As of October 28, 2006, Brocade had 1,440 employees.
Brocade has not experienced any work stoppages and considers its
relations with employees to be good. Employees are currently
located in our United States headquarters in San Jose,
California; our European headquarters in Geneva, Switzerland;
our Asia Pacific headquarters in Singapore; and offices
throughout North America, Europe, and Asia Pacific. Competition
for technical personnel in the computing industry continues to
be significant. We believe that our success depends in part on
our ability to hire, assimilate, and retain qualified personnel.
We cannot assure you that we will continue to be successful at
hiring, assimilating, and retaining employees in the future.
Brocade believes that the acquisition of McDATA will result in
certain benefits, including certain cost synergies, product
innovations, and operational efficiencies. However,
Brocade’s ability to realize these anticipated benefits
depends on successfully combining the businesses of Brocade and
McDATA. Challenges of integration include the combined
company’s ability to incorporate acquired products and
business technology into its existing product lines, including
consolidating technology with duplicative functionality or
designed on a different technological architecture and provide
for interoperability, and its ability to sell the acquired
products through Brocade’s existing or acquired sales
channels. The combined company may fail to realize the
anticipated benefits of the merger for a variety of reasons,
including the following:
Table of Contents
The integration of McDATA into Brocade will result in
significant expenses and accounting charges that adversely
affect Brocade’s operating results and financial condition.
Additional costs may include: costs of employee redeployment;
relocation and retention, including salary increases or bonuses;
accelerated amortization of deferred equity compensation and
severance payments; reorganization or closure of facilities;
taxes; advisor and professional fees and termination of
contracts that provide redundant or conflicting services. Some
of these costs may have to be accounted for as expenses that
would decrease Brocade’s net income and earnings per share
for the periods in which those adjustments are made. Brocade may
also experience additional and unforeseen expenses or delays.
The price of Brocade’s common stock could decline to the
extent Brocade’s financial results are materially affected
by the foregoing charges and costs, or if the foregoing charges
and costs are larger than anticipated. If Brocade is not able to
successfully integrate McDATA’s business and operations, or
if there are delays in combining the businesses, the anticipated
benefits of the merger may not be realized fully or at all or
may take longer to realize than expected.
Uncertainty about the effect of the merger on customers,
employees, distributors and suppliers may have an adverse effect
on Brocade and, following the merger, on the combined company.
Brocade and McDATA’s customers may, in response to the
announcement of the proposed merger, or due to concerns about
the completion of the proposed merger, delay or defer purchasing
decisions. Further, customer concerns about changes or delays in
Brocade’s product roadmap may negatively affect customer
purchasing decisions. Customers could also be reluctant to
purchase the products and services of McDATA or Brocade due to
uncertainty about the direction of their technology, products
and services, and willingness to support and service existing
products which may be discontinued. This uncertainty may also be
used as a competitive advantage by Brocade’s competitors
during the pendency of the merger and cause customers to
purchase a competitor’s products in lieu of Brocade’s
products. As a result, there may be a loss of revenue
opportunities and market share for Brocade. In addition,
customers, OEMs, distributors, resellers, value added resellers,
or VARs, and others may also seek to change existing agreements
with McDATA or Brocade as a result of the proposed merger,
including possibly reallocating orders between Brocade and its
competitors. OEMs, resellers, distributors, VARs and other third
parties of strategic importance may delay or refuse to certify,
support or promote McDATA’s or Brocade’s
technology, products and services due to uncertainty created by
the proposed merger. If Brocade or McDATA’s customers delay
or defer purchasing decisions, or choose to purchase from a
competitor, the revenues of Brocade and McDATA, respectively,
and the revenues of the combined company, could materially
decline or any anticipated increases in revenue could be lower
than expected.
Completion of the merger is conditioned upon the receipt of
certain governmental approvals, including the expiration or
termination of the applicable waiting periods under the
Hart-Scott-Rodino
Act. Although Brocade and McDATA have agreed in the merger
agreement to use their reasonable best efforts to obtain the
requisite governmental approvals, there can be no assurance that
these approvals will be obtained. In addition, the governmental
entities from which these approvals are required may impose
conditions on the completion of the merger or require changes to
the terms of the merger. While Brocade does not currently expect
that any such conditions or changes would be imposed, there can
be no assurance that they will not be, and such conditions or
changes could have the effect of jeopardizing or delaying
completion of the merger or reducing the anticipated benefits of
the merger. If Brocade becomes subject to any material
conditions in order to obtain any approvals
Table of Contents
required to complete the merger, the business and results of
operations of the combined company may be adversely affected.
Brocade may also elect to challenge and litigate conditions or
changes proposed by governmental authorities. Any such
litigation could be costly and divert management’s
attention from the business. There is also no assurance that
Brocade will be successful in any such litigation.
Completion of the merger is subject to a number of closing
conditions, including obtaining requisite regulatory and
stockholder approvals, and McDATA and Brocade may be unable to
obtain such approvals on a timely basis or at all. If the merger
is not completed, the price of Brocade common stock may decline.
If the merger is not completed, the ongoing business of Brocade
may be adversely affected and without realizing any of the
benefits of having completed the merger. Brocade is also subject
to pay certain fees and costs if the merger is not consummated,
including the following: (i) a termination fee of
$22 million or $60 million if the merger is terminated
under certain circumstances, and (ii) certain costs
relating to the merger, such as legal, accounting, financial
advisor and printing fees whether or not the merger is
completed. Brocade and McDATA could also be subject to
litigation related to any failure to complete the transaction.
If the merger is not completed, these risks may materialize and
may adversely affect Brocade’s and McDATA’s business,
financial results and stock price.
Successful integration of Brocade’s and McDATA’s
operations, products and personnel will place a significant
burden on the combined company’s management and internal
resources. Brocade may also experience difficulty in effectively
integrating the different cultures and practices of McDATA, as
well as in assimilating McDATA’s broad and geographically
dispersed personnel. Further, the difficulties of integrating
McDATA could disrupt the combined company’s ongoing
business, and distract its management focus from other
opportunities and challenges. The diversion of management
attention and any difficulties encountered in the transition and
integration process could harm the combined company’s
business, financial condition and operating results.
Upon the completion of the merger, each share of McDATA
Class A and Class B common stock outstanding
immediately prior to the merger will be converted into the right
to receive 0.75 of a share of Brocade’s common stock.
Because the exchange ratio for Brocade common shares to be
issued in the merger has been fixed, the value of the merger
consideration will depend upon the market price of Brocade
common stock. The value of Brocade’s common stock to be
issued in the merger could be considerably higher or lower than
it was at the time the merger consideration was negotiated. The
share prices of Brocade common stock, McDATA Class A common
stock and McDATA Class B common stock are subject to the
general price fluctuations in the market for publicly-traded
equity securities, and the prices of both companies’ common
stock have experienced significant volatility in the past.
Neither Brocade nor McDATA is permitted to terminate the merger
agreement or resolicit the vote of their respective stockholders
solely because of changes in the market prices of either
company’s stock.
Risks
Related to Brocade’s Business
The market for storage networks and data management is
characterized by rapidly changing technology and accelerating
product introduction cycles. Brocade’s future success
depends upon its ability to address the rapidly changing needs
of its customers by developing and supplying high-quality,
cost-effective products, product enhancements and services on a
timely basis, and by keeping pace with technological
developments and emerging industry standards. This risk will
become more pronounced as the storage network and data
management markets becomes more competitive and as demand for
new and improved technologies increases.
Table of Contents
Brocade has introduced a significant number of new products in
recent history, including products across its SAN product
family, which accounts for a substantial portion of
Brocade’s revenues. Brocade has also launched a number of
File Area Network solutions as well as new service and support
offerings. For example, as of the third quarter of fiscal year
2006, approximately 68% of our products had been in the market
less than six quarters. New offerings in fiscal year 2006
include the Brocade 4900 64-port switch, and the enhanced
Brocade 48000 director, which now supports up to 384
ports in a single chassis as well as the addition of iSCSI
capabilities.
Brocade must achieve widespread market acceptance of
Brocade’s new products and service offerings in order to
realize the benefits of Brocade’s investments. The rate of
market adoption is also critical. The success of Brocade’s
product and service offerings depends on numerous factors,
including its ability to:
Various factors impacting market acceptance are outside of
Brocade’s control, including the availability and price of
competing products, and alternative technologies; product
qualification requirements by Brocade’s OEM partners, which
can cause delays in the market acceptance; and the ability of
its OEM partners to successfully distribute, support and provide
training for its products. If Brocade is not able to
successfully develop and market new and enhanced products and
services, its business and results of operations will be harmed.
Brocade has made a series of investments, and plans to continue
to invest, in offerings focused on new markets that are adjacent
or parallel to Brocade’s traditional market, including new
and emerging markets. For instance, Brocade has recently made a
series of introductions in the emerging File Area Network (FAN)
market with several enhancements to existing products in its
family of file management software solutions which includes
Brocade StorageX, Brocade Wide Area File Services, or WAFS, and
Brocade File Lifecycle Manager, or FLM. In addition, Brocade has
added ten new professional service offerings to its solution
portfolio.
Brocade’s strategy is to derive competitive advantage and
drive incremental revenue growth through such investments. As a
result, Brocade believes these new markets could substantially
increase its total available market opportunities. However,
Brocade cannot be certain that it has accurately identified and
estimated these market opportunities. Moreover, Brocade cannot
assure you that its new strategic offerings will achieve market
acceptance, or that Brocade will benefit fully from the
substantial investments it has made and plans to continue to
make in them. Brocade may also have only limited experience in
these new markets given that such markets are adjacent or
parallel to Brocade’s core market. As a result, Brocade may
not be able to successfully penetrate or realize anticipated
revenue from these new potential market opportunities. Brocade
also faces greater challenges in accurately predicting its
revenue and margins with respect to these other markets.
Developing new offerings also requires significant, upfront,
incremental investments that may not result in revenue for an
extended period of time, if at all. Particularly as Brocade
seeks to diversify its product and service offerings, Brocade
expects to incur significant costs and expenses for product
development, sales, marketing and customer services, most of
which are fixed in the short-term or incurred in advance of
receipt of corresponding revenue. In addition, these investments
have caused, and will likely continue to result in, higher
operating expenses and if they are not successful,
Brocade’s operating income and operating margin will
deteriorate. These new offerings may also involve cost and
revenue structures that are different from those used in
Brocade’s historical business, which would impact
Brocade’s operating results.
Table of Contents
Because these new offerings may address different market needs
than those it has historically addressed, Brocade may face a
number of additional challenges, such as:
Brocade’s new product and service offerings also may
contain some features that are currently offered by
Brocade’s OEM partners, which could cause conflicts with
partners on whom Brocade relies to bring its current products to
customers and thus negatively impact Brocade’s relationship
with such partners.
Brocade’s business and operations are also experiencing
rapid change as it diversifies its product and service
offerings. For instance, Brocade has hired a number of
additional employees, and plans to continue to add additional
personnel and resources, to further develop and market these new
offerings. If Brocade fails to effectively manage these changes
and implement necessary changes, Brocade’s business and
operating results could be harmed and Brocade may have to incur
significant expenditures to address the additional operational
and control requirements from these changes.
The storage network and data management markets are becoming
increasingly more competitive as new products, services and
technologies are introduced by existing competitors and as new
competitors enter the market. Increased competition in the past
has resulted in greater pricing pressure, and reduced sales,
margins, profits and market share. For example, Brocade expects
to experience increased competition in future periods as other
companies gain market traction with recently released 4 Gbit
products that are intended to compete with Brocade’s 4 Gbit
products. Moreover, new competitive products could be based on
existing technologies or new technologies that may or may not be
compatible with Brocade’s storage network technology.
Competitive products include, but are not limited to, non-Fibre
Channel based emerging products utilizing Gigabit Ethernet, 10
Gigabit Ethernet, InfiniBand, and Internet Small Computer System
Interface (“iSCSI”).
Currently, Brocade believes that it principally faces
competition from providers of Fibre Channel switching products
for interconnecting servers and storage. These competitors
include Cisco Systems, McDATA (with which Brocade will continue
to be a competitor until Brocade’s pending acquisition of
McDATA closes) and QLogic Corporation. In addition,
Brocade’s OEM partners, who also have relationships with
some of Brocade’s current competitors, could become new
competitors by developing and introducing products that compete
with Brocade’s product offerings, by choosing to sell
Brocade’s competitors’ products instead of
Brocade’s products, or by offering preferred pricing or
promotions on Brocade’s competitors’ products.
Competitive pressure will likely intensify as Brocade’s
industry experiences further consolidation in connection with
mergers by Brocade, its competitors and its OEM partners.
Some of Brocade’s competitors have longer operating
histories and significantly greater human, financial and capital
resources than Brocade does. Brocade’s competitors could
adopt more aggressive pricing policies than Brocade. Brocade
believes that competition based on price may become more
aggressive than it has traditionally experienced. Brocade’s
competitors could also devote greater resources to the
development, promotion, and sale of their products than Brocade
may be able to support and, as a result, be able to respond more
quickly to changes in customer or market requirements.
Brocade’s failure to successfully compete in the market
would harm Brocade’s business and financial results.
Table of Contents
Brocade’s competitors may also put pressure on
Brocade’s distribution model of selling products to
customers through OEM solution providers by focusing a large
number of sales personnel on end-user customers or by entering
into strategic partnerships. For example, one of Brocade’s
competitors has formed a strategic partnership with a provider
of network storage systems, which includes an agreement whereby
Brocade’s competitor resells the storage systems of its
partner in exchange for sales by the partner of Brocade’s
competitor’s products. Such strategic partnerships, if
successful, may influence Brocade to change Brocade’s
traditional distribution model.
Brocade depends on recurring purchases from a limited number of
large OEM partners for the majority of its revenue. As a result,
these large OEM partners have a significant influence on
Brocade’s quarterly and annual financial results.
Brocade’s agreements with its OEM partners are typically
cancelable, non-exclusive, have no minimum purchase requirements
and have no specific timing requirements for purchases. For
fiscal year 2006, three customers each represented ten percent
or more of Brocade’s total revenues for a combined total of
73 percent. Brocade anticipates that its revenues and
operating results will continue to depend on sales to a
relatively small number of OEM partners. The loss of any one
significant OEM partner, or a decrease in the level of sales to
any one significant OEM partner, or unsuccessful quarterly
negotiation on key terms, conditions or timing of purchase
orders placed during a quarter, would likely cause serious harm
to Brocade’s business and financial results.
In addition, some of Brocade’s OEM partners purchase
Brocade’s products for their inventories in anticipation of
customer demand. These OEM partners make decisions to purchase
inventory based on a variety of factors, including their product
qualification cycles and their expectations of end customer
demand, which may be affected by seasonality and their internal
supply management objectives. Others require that Brocade
maintain inventories of Brocade’s products in hubs adjacent
to their manufacturing facilities and purchase Brocade’s
products only as necessary to fulfill immediate customer demand.
If more of Brocade’s OEM partners transition to a hub
model, form partnerships, alliances or agreements with other
companies that divert business away from Brocade; or otherwise
change their business practices, their ordering patterns may
become less predictable. Consequently, changes in ordering
patterns may affect both the timing and volatility of
Brocade’s reported revenues. The timing of sales to
Brocade’s OEM partners, and consequently the timing and
volatility of Brocade’s reported revenues, may be further
affected by the product introduction schedules of Brocade’s
OEM partners.
Brocade’s OEM partners evaluate and qualify Brocade’s
products for a limited time period before they begin to market
and sell them. Assisting Brocade’s OEM partners through the
evaluation process requires significant sales, marketing and
engineering management efforts on Brocade’s part,
particularly if Brocade’s products are being qualified with
multiple distribution partners at the same time. In addition,
once Brocade’s products have been qualified, its customer
agreements have no minimum purchase commitments. Brocade may not
be able to effectively maintain or expand its distribution
channels, manage distribution relationships successfully, or
market its products through distribution partners. Brocade must
continually assess, anticipate and respond to the needs of its
distribution partners and their customers, and ensure that its
products integrate with their solutions. Brocade’s failure
to successfully manage its distribution relationships or the
failure of its distribution partners to sell Brocade’s
products could reduce Brocade’s revenues significantly. In
addition, Brocade’s ability to respond to the needs of its
distribution partners in the future may depend on third parties
producing complementary products and applications for
Brocade’s products. If Brocade fails to respond
successfully to the needs of these groups, its business and
financial results could be harmed.
The average selling price for Brocade’s products has
declined in the past, and Brocade expects it to continue to
decline in the future as a result of changes in product mix,
competitive pricing pressure, increased sales discounts, new
product introductions by Brocade or Brocade’s competitors,
the entrance of new competitors or other factors. For example,
in 2005, Brocade introduced and began shipping a number of new
products that expand and extend the breadth of Brocade’s
product offerings. Several of these new products have lower
revenue per port and lower gross
Table of Contents
margin than Brocade’s traditional products. If Brocade is
unable to offset any negative impact that changes in product
mix, competitive pricing pressures, increased sales discounts,
enhanced marketing programs, new product introductions by
Brocade or Brocade’s competitors, or other factors may have
on it by increasing the volume of products shipped or reducing
product manufacturing cost, Brocade’s total revenues and
gross margins will be negatively impacted.
In addition, to maintain Brocade’s gross margins Brocade
must maintain or increase the number of products shipped,
develop and introduce new products and product enhancements, and
continue to reduce the manufacturing cost of Brocade’s
products. While Brocade has successfully reduced the cost of
manufacturing Brocade’s products in the past, Brocade may
not be able to continue to reduce cost of production at
historical rates. Moreover, most of Brocade’s expenses are
fixed in the short-term or incurred in advance of receipt of
corresponding revenue. As a result, Brocade may not be able to
decrease its spending quickly enough or in sufficient amounts to
offset any unexpected shortfall in revenues. If this occurs,
Brocade could incur losses, Brocade’s operating results and
gross margins could be below its expectations and the
expectations of investors and stock market analysts, and its
stock price could be negatively affected.
The loss of Brocade’s third-party contract manufacturer
could significantly impact Brocade’s ability to produce its
products for an indefinite period of time. Qualifying a new
contract manufacturer and commencing volume production is a
lengthy and expensive process. If Brocade is required to change
its contract manufacturer or if its contract manufacturer
experiences delays, disruptions, capacity constraints, component
parts shortages or quality control problems in its manufacturing
operations, shipment of Brocade’s products to
Brocade’s customers could be delayed resulting in loss of
revenues and Brocade’s competitive position and
relationship with customers could be harmed.
Brocade purchases certain key components used in the manufacture
of its products from single or limited sources. Brocade
purchases specific ASICs from a single source, and Brocade
purchases microprocessors, certain connectors, small form-factor
pluggable transceivers, or SFP’s, logic chips, power
supplies and programmable logic devices from limited sources.
Brocade also licenses certain third-party software that is
incorporated into Brocade’s operating system software and
other software products. If Brocade is unable to obtain these
and other components when required or Brocade experiences
significant component defects, Brocade may not be able to
deliver Brocade’s products to Brocade’s customers in a
timely manner. As a result, Brocade’s business and
financial results could be harmed.
Brocade uses rolling forecasts based on anticipated product
orders to determine component requirements. If Brocade
overestimates component requirements, Brocade may have excess
inventory, which would increase Brocade’s costs. If Brocade
underestimates component requirements, Brocade may have
inadequate inventory, which could interrupt the manufacturing
process and result in lost or delayed revenue. In addition, lead
times for components vary significantly and depend on factors
such as the specific supplier, contract terms, and demand for a
component at a given time. Brocade also may experience shortages
of certain components from time to time, which also could delay
the manufacturing and sales processes. If Brocade overestimates
or underestimates Brocade’s component requirements, or if
Brocade experiences shortages, Brocade’s business and
financial results could be harmed.
Many of Brocade’s OEM partners experience uneven sales
patterns in their businesses due to the cyclical nature of
information technology spending. For example, some of
Brocade’s partners close a disproportionate percentage of
their sales transactions in the last month, weeks and days of
each fiscal quarter, and other partners experience spikes in
sales during the fourth calendar quarter of each year. Because
the majority of Brocade’s sales are derived from a small
number of OEM partners, when they experience seasonality,
Brocade typically experiences
Table of Contents
similar seasonality. Historically, Brocade’s first and
fourth fiscal quarters are seasonally stronger quarters than its
second and third fiscal quarters. In addition, Brocade has
experienced quarters where uneven sales patterns of
Brocade’s OEM partners have resulted in a significant
portion of Brocade’s revenue occurring in the last month of
Brocade’s fiscal quarter. This exposes Brocade to
additional inventory risk as it has to order products in
anticipation of expected future orders and additional sales risk
if Brocade is unable to fulfill unanticipated demand. Brocade is
not able to predict the degree to which the seasonality and
uneven sales patterns of Brocade’s OEM partners or other
customers will affect Brocade’s business in the future
particularly as Brocade release new products.
Brocade
has been named as a party to several class action and derivative
action lawsuits arising from Brocade’s internal reviews and
related restatements of Brocade’s financial statements
during 2005, and Brocade may be named in additional litigation,
all of which could require significant management time and
attention and result in significant legal expenses as well as
result in an unfavorable outcome which could have a material
adverse effect on Brocade’s business, financial condition,
results of operations and cash flows.
Brocade is subject to a number of lawsuits arising from
Brocade’s internal reviews and the related restatements of
Brocade’s financial statements in 2005, some purportedly
filed on behalf of a class of Brocade’s stockholders,
against Brocade and certain of its executive officers claiming
violations of securities laws and others purportedly filed on
behalf of Brocade against certain of Brocade’s executive
officers and board members, and Brocade may become the subject
of additional private or government actions. The expense of
defending such litigation may be significant. The amount of time
to resolve these lawsuits is unpredictable and defending Brocade
may divert management’s attention from the
day-to-day
operations of Brocade’s business, which could adversely
affect Brocade’s business, results of operations and cash
flows. In addition, an unfavorable outcome in such litigation,
such as a court judgment against the Company resulting in
monetary damages or penalties, could have a material adverse
effect on Brocade’s business, results of operations and
cash flows.
As a
result of Brocade’s internal reviews and related
restatements, Brocade is subject to investigations by the SEC
and Department of Justice, or DOJ, which may not be resolved
favorably and have required, and will continue to require, a
significant amount of management time and attention and
accounting resources and legal expense, which could adversely
affect Brocade’s business, results of operations and cash
flows.
The SEC and the DOJ are currently conducting investigations of
Brocade. The period of time necessary to resolve the SEC and DOJ
investigations is uncertain, and these matters could require
significant management and financial resources which could
otherwise be devoted to the operation of Brocade’s
business. If Brocade is subject to an adverse finding resulting
from the SEC and DOJ investigation, Brocade could be required to
pay damages or penalties or have other remedies imposed upon
Brocade. During the three months ended January 28, 2006
Brocade began active settlement discussions with the Staff of
the SEC’s Division of Enforcement, or the Staff. As a
result of these discussions, for the three months ended
January 28, 2006 Brocade recorded $7.0 million
provision for an estimated settlement expense. The
$7.0 million estimated settlement expense is based on an
offer of settlement that Brocade made to the Staff and for which
the Staff has stated it intends to recommend to the SEC’s
Commissioners. The offer of settlement is contingent upon final
approval by the SEC’s Commissioners. The restatements of
Brocade’s financial results in 2005, the ongoing SEC and
DOJ investigations and any negative outcome that may occur from
these investigations could impact Brocade’s relationships
with customers and Brocade’s ability to generate revenue.
In addition, considerable legal and accounting expenses related
to these matters have been incurred to date and significant
expenditures are expected to continue to be incurred in the
future. The SEC and DOJ investigations could adversely affect
Brocade’s business, results of operations, financial
position and cash flows.
In July 2006, the United States Attorney’s Office for the
Northern District of California, the SEC, and the Federal Bureau
of Investigation announced the filing of civil and, in some
cases criminal, charges against certain former executive
officers of Brocade. While those actions are targeted against
former executive officers and not Brocade, those actions may
nevertheless have an adverse impact on Brocade. In addition to
the risks noted above, Brocade has certain indemnification
obligations to such former officers in connection with such
actions, which may result in significant expense to Brocade.
Table of Contents
Brocade’s quarterly and annual revenues and operating
results may vary significantly in the future due to a number of
factors, any of which may cause Brocade’s stock price to
fluctuate. Factors that may affect the predictability of
Brocade’s annual and quarterly results include, but are not
limited to, the following:
Accordingly, the results of any prior periods should not be
relied upon as an indication of future performance. Brocade
cannot assure you that in some future quarter Brocade’s
revenues or operating results will not be below Brocade’s
projections or the expectations of stock market analysts or
investors, which could cause Brocade’s stock price to
decline.
The
failure to accurately forecast demand for Brocade’s
products or the failure to successfully manage the production of
Brocade’s products could negatively affect the supply of
key components for Brocade’s products and Brocade’s
ability to manufacture and sell Brocade’s
products.
Brocade provides product forecasts to its contract manufacturer
and places purchase orders with it in advance of the scheduled
delivery of products to Brocade’s customers. Moreover, in
preparing sales and demand forecasts, Brocade relies largely on
input from its OEM partners. Therefore, if Brocade or its OEM
partners are unable to accurately forecast demand, or if Brocade
fails to effectively communicate with its distribution partners
about end-user demand or other time-sensitive information, sales
and demand forecasts may not reflect the most accurate,
up-to-date
information. If these forecasts are inaccurate, Brocade may be
unable to obtain adequate manufacturing
Table of Contents
capacity from its contract manufacturer to meet customers’
delivery requirements, or Brocade may accumulate excess
inventories. Furthermore, Brocade may not be able to identify
forecast discrepancies until late in its fiscal quarter.
Consequently, Brocade may not be able to make adjustments to its
business model. If Brocade is unable to obtain adequate
manufacturing capacity from its contract manufacturer, if
Brocade accumulates excess inventories, or if Brocade is unable
to make necessary adjustments to Brocade’s business model,
revenue may be delayed or even lost to Brocade’s
competitors, and Brocade’s business and financial results
may be harmed.
In addition, although the purchase orders placed with
Brocade’s contract manufacturer are cancelable, in certain
circumstances Brocade could be required to purchase certain
unused material not returnable, usable by, or sold to other
customers if Brocade cancels any of Brocade’s orders. This
purchase commitment exposure is particularly high in periods of
new product introductions and product transitions. If Brocade is
required to purchase unused material from Brocade’s
contract manufacturer, Brocade would incur unanticipated
expenses and Brocade’s business and financial results could
be negatively affected.
Brocade has in the past, and may in the future, acquire or make
strategic investments in additional companies, products or
technologies. Most recently, Brocade announced that Brocade
entered into an agreement to acquire McDATA in August 2006.
Other examples include the acquisition of NuView, Inc. in March
2006 and Therion Software Corporation in May 2005, and a
strategic investment in Tacit Networks in May 2005 (acquired by
Packeteer, Inc. in May 2006). Brocade may not realize the
anticipated benefits of these or any other mergers or strategic
investments, which involve numerous risks, including:
If Brocade is not able to successfully integrate businesses,
products, technologies or personnel that Brocade acquires, or to
realize expected benefits of Brocade’s mergers or strategic
investments, Brocade’s business and financial results may
be adversely affected.
Table of Contents
Brocade’s success depends to a significant degree upon the
continued contributions of key management, engineering, sales
and other personnel, many of whom would be difficult to replace.
Brocade believes its future success will also depend, in large
part, upon Brocade’s ability to attract and retain highly
skilled managerial, engineering, sales and other personnel, and
on the ability of management to operate effectively, both
individually and as a group, in geographically disparate
locations. Brocade has experienced difficulty in hiring
qualified personnel in areas such as application specific
integrated circuits, software, system and test, sales,
marketing, service, key management and customer support. In
addition, Brocade’s past reductions in force could
potentially make attracting and retaining qualified employees
more difficult in the future. Brocade’s ability to hire
qualified personnel may also be negatively impacted by
Brocade’s internal reviews and financial statement
restatements in 2005, related investigations by the SEC and DOJ,
and Brocade’s stock price. The loss of the services of any
of Brocade’s key employees, the inability to attract or
retain qualified personnel in the future, or delays in hiring
required personnel, particularly engineers and sales personnel,
could delay the development and introduction of, and negatively
affect Brocade’s ability to sell its products.
In addition, companies in the computer storage and server
industry whose employees accept positions with competitors may
claim that their competitors have engaged in unfair hiring
practices or that there will be inappropriate disclosure of
confidential or proprietary information. Brocade may be subject
to such claims in the future as Brocade seeks to hire additional
qualified personnel. Such claims could result in material
litigation. As a result, Brocade could incur substantial costs
in defending against these claims, regardless of their merits,
and be subject to additional restrictions if any such litigation
is resolved against Brocade.
Brocade is subject to various environmental and other
regulations governing product safety, materials usage, packaging
and other environmental impacts in the various countries where
Brocade’s products are sold. For example, many of
Brocade’s products are subject to laws and regulations that
restrict the use of mercury, hexavalent chromium, cadmium and
other substances, and require producers of electrical and
electronic equipment to assume responsibility for collecting,
treating, recycling and disposing of Brocade’s products
when they have reached the end of their useful life. For
example, in Europe substance restrictions apply to products
sold, and certain of Brocade’s OEM partners require
compliance with these or more stringent requirements. In some
cases Brocade redesigned Brocade’s products to comply with
these substance restrictions as well as related requirements
imposed by Brocade’s OEM customers. In addition, recycling,
labeling, financing and related requirements apply to products
Brocade sells in Europe. Brocade is also coordinating with
Brocade’s suppliers to provide Brocade with compliant
materials, parts and components. Despite Brocade’s efforts
to ensure that Brocade’s products comply with new and
emerging requirements, Brocade cannot provide absolute assurance
that its products will, in all cases comply with such
requirements. If Brocade’s products do not comply with the
European substance restrictions or other applicable
environmental laws, Brocade could become subject to fines, civil
or criminal sanctions, and contract damage claims. In addition,
Brocade could be prohibited from shipping non-compliant products
into one or more jurisdictions, and required to recall and
replace any non-compliant products already shipped, which would
disrupt Brocade’s ability to ship products and result in
reduced revenue, increased obsolete or excess inventories and
harm to Brocade’s business and customer relationships.
Brocade’s suppliers may also fail to provide it with
compliant materials, parts and components despite Brocade’s
requirement to them to provide compliant materials, parts and
components, which could impact Brocade’s ability to timely
produce compliant products and, accordingly could disrupt
Brocade’s business. In addition, various other countries
and states in the United States have issued, or are in the
process of issuing, other environmental regulations that may
impose additional restrictions or obligations and require
further changes to Brocade’s products.
Table of Contents
In the past, unfavorable or uncertain economic conditions and
reduced global information technology spending rates have
adversely affected Brocade’s operating results. Brocade is
unable to predict changes in general economic conditions and
when information technology spending rates will be affected. If
there are future reductions in either domestic or international
information technology spending rates, or if information
technology spending rates do not improve, Brocade’s
revenues, operating results and financial condition may be
adversely affected.
Even if information technology spending rates increase, Brocade
cannot be certain that the market for storage network and data
management solutions will be positively impacted. Brocade’s
storage networking products are sold as part of storage systems
and subsystems. As a result, the demand for Brocade’s
storage networking products has historically been affected by
changes in storage requirements associated with growth related
to new applications and an increase in transaction levels.
Although in the past Brocade has experienced historical growth
in Brocade’s business as enterprise-class customers have
adopted storage area network technology, demand for storage
network products in the enterprise-class sector could be
adversely affected if the overall economy weakens or experiences
greater uncertainty, or if larger businesses were to decide to
limit new equipment purchases. If information technology
spending levels are restricted, and new products improve
Brocade’s customers’ ability to utilize their existing
storage infrastructure, the demand for storage network products
may decline. If this occurs, Brocade’s business and
financial results will be harmed.
As Brocade introduces new or enhanced products, Brocade must
successfully manage the transition from older products to
minimize disruption in customers’ ordering patterns, avoid
excessive levels of older product inventories and provide
sufficient supplies of new products to meet customer demands.
For example, Brocade’s introduction of 4 Gigabit per
second, or Gbit, technology solutions that replaced many of
Brocade’s 2 Gbit products contributed to a quarterly drop
in revenue in the third quarter of fiscal year 2005 and
write-downs of $3.4 million and $1.8 million for
excess and obsolete inventory during the third and fourth
quarters of fiscal year 2005, respectively. When Brocade
introduces new or enhanced products, Brocade faces numerous
risks relating to product transitions, including the inability
to accurately forecast demand, and manage different sales and
support requirements due to the type or complexity of the new
products.
Brocade is subject to rules and regulations of federal and state
government as well as the stock exchange on which Brocade’s
common stock is listed. These entities, including the Public
Company Accounting Oversight Board, or PCAOB, the SEC, the
Internal Revenue Service and Nasdaq, have issued a significant
number of new and increasingly complex requirements and
regulations over the course of the last several years and
continue to develop additional regulations and requirements in
response to laws enacted by Congress, most notably the
Sarbanes-Oxley Act of 2002. Brocade’s efforts to comply
with these requirements have resulted in, and are likely to
continue to result in, increased expenses and a diversion of
management time and attention from revenue-generating activities
to compliance activities.
Brocade is subject to periodic audits or other reviews by such
governmental agencies. For example, in November 2005, Brocade
was notified by the Internal Revenue Service that Brocade’s
domestic federal income tax return for the year ended
October 25, 2003 was subject to audit. Additionally, in May
2006, the Franchise Tax Board notified Brocade that its
California income tax returns for the years ended
October 25, 2003 and October 30, 2004 are subject to
audit. The SEC also periodically reviews Brocade’s public
company filings. Any such examination or review frequently
requires management’s time and diversion of internal
resources and, in the event of an unfavorable outcome, may
result in additional liabilities or adjustments to
Brocade’s historical financial results.
Table of Contents
A portion of Brocade’s outstanding stock options are
subject to variable accounting. Under variable accounting,
Brocade is required to remeasure the value of the options, and
the corresponding compensation expense, at the end of each
reporting period until the option is exercised, cancelled or
expires unexercised. As a result, the stock-based compensation
expense Brocade recognizes in any given period can vary
substantially due to changes in the market value of
Brocade’s common stock. Volatility associated with stock
price movements has resulted in compensation benefits when
Brocade’s stock price has declined and compensation expense
when Brocade’s stock price has increased. For example, the
market value of Brocade’s common stock at the end of the
third and fourth quarters of fiscal year 2005 and the first
quarter of 2006 was $4.48, $3.60 and $4.62 per share,
respectively. Accordingly, Brocade recorded compensation expense
(benefit) in the fourth quarter of fiscal year 2005 and the
first quarter of fiscal year 2006 of approximately
$(0.2) million and $0.3 million, respectively. Brocade
is unable to predict the future market value of Brocade’s
common stock and therefore is unable to predict the compensation
expense or benefit that Brocade will record in future periods.
The U.S. generally accepted accounting principles are
subject to interpretation by the Financial Accounting Standards
Board, or FASB, the American Institute of Certified Public
Accountants, the PCAOB, the SEC, and various bodies formed to
promulgate and interpret appropriate accounting principles. A
change in these principles or interpretations could have a
significant effect on Brocade’s reported financial results.
On December 15, 2004, the FASB issued SFAS 123R,
Share-Based Payment, which requires Brocade to measure
compensation expense for employee stock options using the fair
value method beginning the first quarter of fiscal year 2006,
which is the quarter ended January 28, 2006. SFAS 123R
applies to all outstanding stock options that are not vested at
the effective date and grants of new stock options made
subsequent to the effective date. As a result of SFAS 123R,
Brocade recorded higher levels of stock based compensation due
to differences between the valuation methods of SFAS 123R
and APB 25. In prior periods, Brocade recorded any
compensation expense associated with stock option grants to
employees using the intrinsic value method in accordance with
Accounting Principles Board Opinion No. 25.
A significant portion of Brocade’s sales occur in
international jurisdictions and Brocade’s contract
manufacturer has significant operations in China. Brocade also
plans to continue to expand its international operations and
sales activities. Expansion of international operations will
involve inherent risks that Brocade may not be able to control,
including:
Table of Contents
In addition, international political instability may halt or
hinder Brocade’s ability to do business and may increase
Brocade’s costs. Various events, including the occurrence
or threat of terrorist attacks, increased national security
measures in the United States and other countries, and military
action and armed conflicts, can suddenly increase international
tensions. In addition, concerns about other international
crises, such as the spread of severe acute respiratory syndrome,
avian influenza, or bird flu, and West Nile viruses, may have an
adverse effect on the world economy and could adversely affect
Brocade’s business operations or the operations of
Brocade’s OEM partners, contract manufacturer and suppliers.
To date, no material amount of Brocade’s international
revenues and costs of revenues have been denominated in foreign
currencies. As a result, an increase in the value of the United
States dollar relative to foreign currencies could make
Brocade’s products more expensive and, thus, not
competitively priced in foreign markets. Additionally, a
decrease in the value of the United States dollar relative to
foreign currencies could increase Brocade’s operating costs
in foreign locations. In the future, a larger portion of
Brocade’s international revenues may be denominated in
foreign currencies, which will subject Brocade to additional
risks associated with fluctuations in those foreign currencies.
Brocade currently does not have hedging program in place to
offset its foreign currency risk.
Networking products frequently contain undetected software or
hardware errors, or bugs, when first introduced or as new
versions are released. Brocade’s products are becoming
increasingly complex and, particularly as Brocade continues to
expand Brocade’s product portfolio to include
software-centric products, including software licensed from
third parties, errors may be found from time to time in
Brocade’s products. Some types of errors also may not be
detected until the product is installed in a heavy production or
user environment. In addition, Brocade’s products are often
combined with other products, including software, from other
vendors. As a result, when problems occur, it may be difficult
to identify the source of the problem. These problems may cause
Brocade to incur significant warranty and repair costs, divert
the attention of engineering personnel from product development
efforts and cause significant customer relations problems.
Moreover, the occurrence of hardware and software errors,
whether caused by another vendor’s storage network and data
management products or Brocade’s, could delay market
acceptance of Brocade’s new products.
Many of Brocade’s products are designed to include software
or other intellectual property licensed from third parties.
While it may be necessary in the future to seek or renew
licenses relating to various aspects of Brocade’s products,
Brocade believes that, based upon past experience and standard
industry practice, such licenses generally could be obtained on
commercially reasonable terms. Nonetheless, there can be no
assurance that the necessary licenses would be available on
acceptable terms, if at all. Brocade’s inability to obtain
certain licenses or other rights on favorable terms could have a
material adverse effect on Brocade’s business, operating
results and financial condition. In addition, if Brocade fails
to carefully manage the use of “open source” software
in Brocade’s products, Brocade may be required to license
key portions of Brocade’s products on a royalty free basis
or expose key parts of source code.
In recent years, there has been significant litigation in the
United States involving patents and other intellectual property
rights. Brocade has in the past been involved in intellectual
property-related disputes, including lawsuits with Vixel
Corporation, Raytheon Company and McDATA, and Brocade may be
involved in such disputes in the future, to protect
Brocade’s intellectual property or as a result of an
alleged infringement of the intellectual property
Table of Contents
of others. Brocade also may be subject to indemnification
obligations with respect to infringement of third party
intellectual property rights pursuant to Brocade’s
agreements with OEM partners or customers. These claims and any
resulting lawsuit could subject Brocade to significant liability
for damages and invalidation of proprietary rights. Any such
lawsuits, even if ultimately resolved in Brocade’s favor,
would likely be time-consuming and expensive to resolve and
would divert management’s time and attention. Any potential
intellectual property dispute also could force Brocade to do one
or more of the following:
If Brocade is forced to take any of the foregoing actions,
Brocade’s business and results of operations could be
materially harmed.
Brocade’s operations and the operations of its suppliers,
contract manufacturer and customers are vulnerable to
interruption by fire, earthquake, hurricanes, power loss,
telecommunications failure and other events beyond
Brocade’s control. For example, a substantial portion of
Brocade’s facilities, including its corporate headquarters,
is located near major earthquake faults. In the event of a major
earthquake, Brocade could experience business interruptions,
destruction of facilities and loss of life. Brocade does not
carry earthquake insurance and has not set aside funds or
reserves to cover such potential earthquake-related losses. In
addition, Brocade’s contract manufacturer has a major
facility located in an area that is subject to hurricanes. In
the event that a material business interruption occurs that
affects Brocade or its suppliers, contract manufacturer or
customers, shipments could be delayed and Brocade’s
business and financial results could be harmed.
Provisions of Brocade’s certificate of incorporation and
bylaws may discourage, delay or prevent a merger or merger that
a stockholder may consider favorable. These provisions include:
Certain provisions of Delaware law also may discourage, delay,
or prevent someone from acquiring or merging with Brocade, and
Brocade’s agreements with certain of Brocade’s
customers require that Brocade give prior notice of a change of
control and grant certain manufacturing rights following a
change of control. Brocade’s various anti-takeover
provisions could prevent or delay a change in control of
Brocade, which could hinder stockholders’ ability to
receive a premium for Brocade’s stock.
In addition, Brocade currently has in place a stockholder rights
plan; however, in November 2006, Brocade’s board of
directors determined to terminate the rights plan, which is
expected to be done in the near future.
Table of Contents
None.
Brocade’s principal administrative, sales and marketing,
education, customer support, and research and development
facilities are located in approximately 405,000 square feet
of office space in San Jose, California. Approximately
211,000 square feet of such office space is leased, and the
remaining 194,000 square feet is owned by Brocade. The
leases on Brocade’s leased office space will expire in
August 2010. In addition to the San Jose facilities,
Brocade also leases sales, marketing, and administrative office
space in various locations throughout the world.
From time to time, claims are made against Brocade in the
ordinary course of its business, which could result in
litigation. Claims and associated litigation are subject to
inherent uncertainties and unfavorable outcomes could occur,
such as monetary damages, fines, penalties or injunctions
prohibiting Brocade from selling one or more products or
engaging in other activities. The occurrence of an unfavorable
outcome in any specific period could have a material adverse
affect on Brocade’s results of operations for that period
or future periods.
On July 20, 2001, the first of a number of putative class
actions for violations of the federal securities laws was filed
in the United States District Court for the Southern District of
New York against Brocade, certain of its officers and directors,
and certain of the underwriters for Brocade’s initial
public offering of securities. A consolidated amended class
action captioned In Re Brocade Communications Systems, Inc.
Initial Public Offering Securities Litigation was filed on
April 19, 2002. The complaint generally alleges that
various underwriters engaged in improper and undisclosed
activities related to the allocation of shares in Brocade’s
initial public offering and seeks unspecified damages on behalf
of a purported class of purchasers of common stock from
May 24, 1999 to December 6, 2000. The lawsuit against
Brocade is being coordinated for pretrial proceedings with a
number of other pending litigations challenging underwriter
practices in over 300 cases as In Re Initial Public Offering
Securities Litigation, 21 MC 92(SAS). In October 2002, the
individual defendants were dismissed without prejudice from the
action, pursuant to a tolling agreement. On February 19,
2003, the Court issued an Opinion and Order dismissing all of
the plaintiffs’ claims against Brocade. In June 2004, a
stipulation of settlement for the claims against the issuer
defendants, including Brocade, was submitted to the Court for
approval. On August 31, 2005, the Court granted preliminary
approval of the settlement. On April 24, 2006 the Court
held a fairness hearing in connection with the motion for final
approval of the settlement. The Court has yet to issue a ruling
on the motion for final approval. The settlement remains subject
to a number of conditions, including final approval by the
Court. On December 5, 2006, the Court of Appeals for the
Second Circuit reversed the court’s October 2004 order
certifying a class in six test cases that were selected by the
underwriter defendants and plaintiffs in the coordinated
proceeding. Brocade is not one of the test cases and it is
unclear what impact this will have on the class certified in
Brocade’s case.
On May 16, 2005, Brocade announced that the SEC and the
Department of Justice, or the DOJ, are conducting an
investigation regarding Brocade’s historical stock option
granting processes. Brocade has been cooperating with the SEC
and DOJ. During the first quarter of fiscal year 2006, Brocade
began active settlement discussions with the Staff of the
SEC’s Division of Enforcement, or the Staff, regarding its
financial restatements related to stock option accounting. As a
result of these discussions, for the three months ended
January 28, 2006, Brocade recorded $7.0 million
provision for an estimated settlement expense. The
$7.0 million estimated settlement expense is based on an
offer of settlement that Brocade made to the Staff and for which
the Staff has noted it intends on recommending to the SEC’s
Commissioners. The offer of settlement is contingent upon final
approval by the SEC’s Commissioners.
Beginning on or about May 19, 2005, several securities
class action complaints were filed against Brocade and certain
of its current and former officers. These actions were filed in
the United States District Court for the Northern District of
California on behalf of purchasers of Brocade’s stock from
February 2001 to May 2005. These lawsuits followed
Brocade’s restatement of certain financial results due to
stock-based compensation accounting issues. On January 12,
2006, the Court appointed a lead plaintiff and lead counsel. On
April 14, 2006, the lead
Table of Contents
plaintiff filed a consolidated complaint on behalf of purchasers
of Brocade’s stock from May 2000 to May 2005. The
consolidated complaint alleges, among other things, violations
of sections 10(b) and 20(a) of the Securities Exchange Act
of 1934 and
Rule 10b-5
promulgated thereunder. The consolidated complaint generally
alleges that Brocade and the individual defendants made false or
misleading public statements regarding Brocade’s business
and operations and seeks unspecified monetary damages and other
relief against the defendants. These lawsuits followed
Brocade’s restatement of certain financial results due to
stock-based compensation accounting issues.
Beginning on or about May 24, 2005, several derivative
actions were also filed against certain of Brocade’s
current and former directors and officers. These actions were
filed in the United States District Court for the Northern
District of California and in the California Superior Court in
Santa Clara County. The complaints allege that certain of
Brocade’s officers and directors breached their fiduciary
duties to Brocade by engaging in alleged wrongful conduct
including conduct complained of in the securities litigation
described above. Brocade is named solely as a nominal defendant
against whom the plaintiffs seek no recovery. The derivative
actions pending in the District Court for the Northern District
of California were consolidated and the Court created a Lead
Counsel structure. The derivative plaintiffs filed a
consolidated complaint in the District Court for the Northern
District of California on October 7, 2005, and Brocade
filed a motion to dismiss that action on October 27, 2005.
On January 6, 2006, Brocade’s motion was granted and
the consolidated complaint in the District Court for the
Northern District of California was dismissed with leave to
amend. The parties to this action subsequently reached a
preliminary settlement, which remains subject to approval by the
Court.
The derivative actions pending in the Superior Court in
Santa Clara County were consolidated. The derivative
plaintiffs filed a consolidated complaint in the Superior Court
in Santa Clara County on September 19, 2005. Brocade
filed a motion to stay that action in deference to the
substantially identical consolidated derivative action pending
in the District Court for the Northern District of California,
and on November 15, 2005, the Court stayed the action. In
October 2006, the Court partially lifted the stay and granted
plaintiffs leave to file an amended complaint. On
November 13, 2006, plaintiffs filed an amended complaint.
No amounts have been recorded in Brocade’s Consolidated
Financial Statements associated with these matters as the
amounts are not probable or estimable other than the
$7.0 million provision for an estimated settlement expense
with the SEC as noted above.
None.
Our common stock has been quoted on the Nasdaq Global Select
Market under the symbol “BRCD” since our initial
public offering on May 24, 1999. Prior to this time, there
was no public market for the stock. See
“Item 6 — Selected Financial Data” for
the high and low sales prices per share of our common stock as
reported on the Nasdaq Global Select Market, for the periods
indicated.
According to records of our transfer agent, we had 621
stockholders of record at December 12, 2006 and we believe
there are a substantially greater number of beneficial holders.
We did not pay dividends in fiscal year 2005 or fiscal year
2006. We currently expect to retain future earnings, if any, for
use in the operation and expansion of our business and do not
anticipate paying any cash dividends in the foreseeable future.
See Note 11, “Stockholders’ Equity,” of the
Notes to Consolidated Financial Statements for equity
compensation plan information.
Table of Contents
The following table summarizes stock repurchase activity for the
three months ended October 28, 2006 (in thousands,
except per share amounts):
Table of Contents
The following selected financial data should be read in
conjunction with our consolidated financial statements and
related notes, “Management’s Discussion and Analysis
of Financial Condition and Results of Operations,” and
other financial information appearing elsewhere in this Annual
Report on
Form 10-K.
The consolidated statement of operations data set forth below
for each of the years in the three-year period ended
October 28, 2006, the consolidated balance sheet data as of
October 28, 2006 and October 29, 2005, are derived
from, and qualified by reference to, the audited financial
statements appearing elsewhere in this Annual Report on
Form 10-K.
The consolidated balance sheet data as of October 30, 2004
is derived from audited financial statements not included
herein. The consolidated statement of operations data for the
years ended October 25, 2003, and October 26, 2002,
and the balance sheet data as of October 25, 2003 and
October 26, 2002, are derived from unaudited financial
statements not included herein.
Table of Contents
Note: We report our fiscal year on a
52/53-week
period ending on the last Saturday in October of each year.
Accordingly, the fiscal year ends for fiscal years 2006, 2005,
and 2004, were October 28, 29, and 30,
respectively. As is customary for companies that use the
52/53-week
convention, every 5th year contains a
53-week
fiscal year. As a result, our fiscal year 2004 was a
53-week
fiscal year. Also as a result, our second quarter of fiscal year
2004 included one extra week and was 14 weeks in length.
Fiscal years 2006, 2005, 2003 and 2002 were
52-week
fiscal years.
Table of Contents
Table of Contents
31
Table of Contents
Results
of Operations
We report our fiscal year on a
52/53-week
period ending on the last Saturday in October of each year.
Accordingly, the fiscal year ends for fiscal years 2006, 2005,
and 2004 were October 28, 29, and 30,
respectively. As is customary for companies that use the
52/53-week
convention, every 5th year contains a
53-week
fiscal year. As a result, our fiscal year 2004 was a
53-week
fiscal year. Also as a result, our second quarter of fiscal year
2004 included one extra week and was 14 weeks in length.
Fiscal years 2006 and 2005, were
52-week
fiscal years. The following table sets forth certain financial
data for the periods indicated as a percentage of total net
revenues:
Revenues. Our revenues are derived primarily
from sales of our family of SAN products. Our fabric switches
and directors, which range in size from 8 ports to 384 ports,
connect servers and storage devices creating a SAN.
From a geographical perspective, our total net revenues for the
year ended October 28, 2006 and October 29, 2005 were
as follows (in thousands):
Table of Contents
In addition, from a geographical perspective, net revenues for
the year ended October 29, 2005 and October 30, 2004
were as follows (in thousands):
For the year ended October 28, 2006, the increase in net
revenues reflected a 47 percent increase in the number of
ports shipped partially offset by a 12 percent decline in
average selling price per port. For the year ended
October 29, 2005, the decrease in net revenues reflected a
21 percent decline in average selling price per port,
partially offset by an 11 percent increase in the number of
ports shipped. For the year ended October 30, 2004, the
increase in net revenues reflected a 42 percent increase in
the number of ports shipped, partially offset by a
22 percent decline in average selling price per port. The
declines in average selling prices for the year ended
October 30, 2004 are the result of a more competitive
pricing environment. We believe the increase in the number of
ports shipped reflects higher demand for our products as
end-users continue to consolidate storage and servers
infrastructures using SANs, expand SANs to support more
applications, and deploy SANs in new environments.
We expect the number of ports shipped to fluctuate depending on
the demand for our existing and recently introduced products as
well as the timing of product transitions by our OEM customers.
We also expect that average selling price per port will likely
decline at rates higher than we experienced in the year ended
October 28, 2006, primarily due to accelerated pricing
pressures, or new product introductions by us or our competitors.
Historically, domestic revenues have been between
60 percent and 75 percent of total revenues. Revenues
are attributed to geographic areas based on the location of the
customer to which our products are shipped. International
revenues primarily consist of sales to customers in Western
Europe and the greater Asia Pacific region. For the year ended
October 28, 2006, international revenues have increased
primarily as a result of faster growth in Europe relative to
North America and Asia Pacific region. For the years ended
October 29, 2005 and October 30, 2004, international
revenues decreased as a result of faster growth in the North
America region. However, certain OEM customers take possession
of our products domestically and then distribute these products
to their international customers. Because we account for all of
those OEM revenues as domestic revenues, we cannot be certain of
the extent to which our domestic and international revenue mix
is impacted by the practices of our OEM customers.
A significant portion of our revenue is concentrated among a
small number of OEM customers. For the year ended
October 28, 2006, three customers, EMC, HP and IBM, each
represented greater than ten percent or more of our total
revenues and together represented a total of 73 percent of
our total revenues. For the years ended October 29, 2005
and October 30, 2004, the same three customers each
represented greater than ten percent of our total revenues for
combined totals of 71 percent and 70 percent of our
total revenues, respectively. We expect that a significant
portion of our future revenues will continue to come from sales
of products to a small number of OEM customers. Therefore, the
loss of, or a decrease in the level of sales to, or a change in
the ordering pattern of, any one of these customers could
seriously harm our financial condition and results of operations.
Cost of Goods Sold Cost of goods sold consists of product
costs, which are variable, and manufacturing operations costs,
which are generally fixed.
Costs of goods sold for the years ended October 28, 2006
and October 29, 2005 was as follows (in thousands):
In addition, cost of goods sold for the years ended
October 29, 2005 and October 30, 2004 was as follows
(in thousands):
Table of Contents
For the year ended October 28, 2006, product costs relative
to revenue decreased by 4.0 percent as compared to the year
ended October 29, 2005, due to the transition from 2 Gbit
products to new 4 Gbit products and relatively stable pricing,
more efficient production with higher volumes, and a favorable
mix of products shipped. Manufacturing operation costs and
service operation costs decreased by 0.4 percent relative
to net revenues primarily due to the increase in revenue
partially offset by an increase in headcount and higher
sustaining engineering charges, as products transitioned into
sustaining engineering from development. In addition,
stock-based compensation expense for the year ended
October 28, 2006 increased by 1.2 percent relative to
net revenues primarily as a result of our adoption of
SFAS 123R. For the year ended October 29, 2005,
product costs relative to net revenues decreased by
0.7 percent as compared to the year ended October 30,
2004 due to decreases in component and manufacturing operations
costs. Manufacturing operations costs relative to net revenues
decreased by 0.5 percent principally due to increases in
number of ports shipped. In addition, gross margin relative to
net revenues for the year ended October 29, 2005, increased by
0.2 percent due to higher stock compensation expense in the
year ended October 30, 2004 primarily as a result of
changes in the market value of our common stock.
Gross margin is primarily affected by average selling price per
port, number of ports shipped, and cost of goods sold. Over the
last fiscal year, declines in average selling price per port
have been lower than in the immediately preceding fiscal year,
primarily due to our 4 Gbit product cycle and a more favorable
market environment than is typically the case. Going forward, we
expect that the decline in average selling price per port for
our products to decline at the rates we experienced in fiscal
year 2005, unless they are further affected by a stronger or
weaker than anticipated competitive environment, new product
introductions by us or our competitors, or other factors that
may be beyond our control. We believe that we have the ability
to partially mitigate the effect of declines in average selling
price per port on gross margins through our product and
manufacturing operations cost reductions. However, the average
selling price per port could decline at a faster pace than we
anticipate. In addition, manufacturing operation costs could be
negatively affected by variable stock-based compensation. If
this dynamic occurs, we may not be able to reduce our costs fast
enough to prevent a decline in our gross margins. In addition,
we must also maintain or increase current volume of ports
shipped to maintain our current gross margins. If we are unable
to offset future reductions of average selling price per port
with reductions in product and manufacturing operations costs,
or if as a result of future reductions in average selling price
per port our revenues do not grow, our gross margins would be
negatively affected.
We recently introduced several new products and expect to
introduce additional new products in the future. As new or
enhanced products are introduced, we must successfully manage
the transition from older products in order to minimize
disruption in customers’ ordering patterns, avoid excessive
levels of older product inventories, and provide sufficient
supplies of new products to meet customer demands. Our gross
margins may be adversely affected if we fail to successfully
manage the introductions of these new products.
Research and development expenses. Research
and development (“R&D”) expenses consist primarily
of salaries and related expenses for personnel engaged in
engineering and R&D activities; fees paid to consultants and
outside service providers; nonrecurring engineering charges;
prototyping expenses related to the design, development, testing
and enhancement of our products; depreciation related to
engineering and test equipment, amortization of deferred stock
compensation; and IT and facilities expenses.
Research and development expenses for the years ended
October 28, 2006 and October 29, 2005 were as follows
(in thousands):
In addition, research and development expenses for the years
ended October 29, 2005 and October 30, 2004 were as
follows (in thousands):
Table of Contents
For the year ended October 28, 2006, R&D expenses
increased by $32.4 million, or twenty four percent, to
$164.8 million, compared with $132.4 million for the
year ended October 29, 2005. This increase is primarily due
to a $23.1 million increase in salaries and
headcount-related expenses resulting from continuing investment
in our line of File Services products and from the acquisitions
of NuView, as well as $12.2 million increase in stock-based
compensation expense primarily attributable to our adoption of
SFAS 123R.
For the year ended October 29, 2005, R&D expenses
decreased by $10.1 million, or seven percent, to
$132.4 million, compared with $142.5 million for the
year ended October 30, 2004. This decrease is primarily due
to a $14.0 million decrease in salaries and head count
related expenses as a result of the restructuring programs we
implemented in the second quarter of fiscal year 2004, partially
offset by a $6.4 million increase in outside service
providers due to continued investment in offshore research and
development. In addition, R&D expenses decreased by
$2.6 million due to lower stock compensation expense in the
year ended October 29, 2005 primarily as a result of
changes in the market value of our common stock. Further, the
decrease in R&D expenses reflects the effect of the extra
week in the second quarter of fiscal year 2004.
Excluding any stock-based compensation expenses related to stock
awards remeasured at their intrinsic value, which will vary
depending on the changes in the market value of our common
stock, we currently anticipate that R&D expenses in fiscal
year 2007 will increase in absolute dollars as a result of
increased headcount.
Sales and marketing expenses. Sales and
marketing expenses consist primarily of salaries, commissions
and related expenses for personnel engaged in marketing and
sales; costs associated with promotional and travel expenses;
and IT and facilities expenses.
Sales and marketing expenses for the years ended
October 28, 2006 and October 29, 2005 were as follows
(in thousands):
In addition, sales and marketing expenses for the years ended
October 29, 2005 and October 30, 2004 were as follows
(in thousands):
For the year ended October 28, 2006, sales and marketing
expenses increased by $38.2 million, or thirty eight
percent, to $139.4 million, compared with
$101.2 million for the year ended October 29, 2005.
This increase is primarily due to a $18.8 million increase
in salaries and headcount-related expenses, including higher
commission expenses due to higher revenues, a $7.7 million
increase in sales and marketing program expenses primarily
related to our line of File Services products, and a
$7.2 million increase in stock based compensation expense
primarily attributable to our adoption of SFAS 123R.
For the year ended October 29, 2005, sales and marketing
expenses decreased by $1.2 million, or one percent, to
$101.2 million, compared with $102.4 million for the
year ended October 30, 2004. This decrease is primarily due
to a $3.5 million decrease in salaries and head count
related expenses, including lower commissions expenses due to
lower revenues, and a $1.7 million decrease in stock
compensation expense primarily due to compensation for certain
employees on leaves of absences and in transition or advisory
roles in the year ended October 30, 2004, partially offset
by a $3.1 million increase in sales and marketing program
expenses. In addition, the decrease in sales and marketing
expenses reflects the effect of the extra week in the second
quarter of fiscal year 2004.
Excluding any stock-based compensation expenses related to stock
awards remeasured at their intrinsic value, which will vary
depending on the changes in the market value of our common
stock, we currently anticipate that sales and marketing expenses
in fiscal year 2007 will increase in absolute dollars as a
result of increased headcount.
General and administrative expenses. General
and administrative (“G&A”) expenses consist
primarily of salaries and related expenses for corporate
executives, finance, human resources and investor relations, as
well as
Table of Contents
recruiting expenses, professional fees, corporate legal
expenses, other corporate expenses, and IT and facilities
expenses.
General and administrative expenses for the years ended
October 28, 2006 and October 29, 2005 were as follows
(in thousands):
In addition, general and administrative expenses for the years
ended October 29, 2005 and October 30, 2004 were as
follows (in thousands):
G&A expenses for the year ended October 28, 2006
increased by $5.9 million, or twenty three percent, to
$31.1 million compared with $25.2 million for the year
ended October 29, 2005. The increase in G&A for fiscal
year 2006 is primarily due to a $3.6 million increase in
stock-based compensation primarily attributable to our adoption
of SFAS 123R and $3.2 million increase in salaries and
headcount-related expenses to support ongoing initiatives.
For the year ended October 29, 2005, G&A expenses
increased by $0.6 million, or two percent, to
$25.2 million, compared with $24.6 million for the
year ended October 30, 2004. The increase in G&A for
fiscal year 2005 is primarily due to a $1.5 million
increase in professional service fees, partially offset by a
$0.6 million decrease in stock compensation expense
primarily as a result of changes in the market value of our
common stock.
Excluding any stock-based compensation expenses related to stock
awards remeasured at their intrinsic value, which will vary
depending on the changes in the market value of our common
stock, we currently anticipate that G&A expenses in fiscal
year 2007 to increase in absolute dollars.
Legal fees associated with indemnification obligations, SEC
investigation and other related costs. These
expenses consist of professional legal and accounting service
fees for various matters, including applicable indemnification
obligations, the completed internal reviews and the ongoing SEC
and Department of Justice (“DOJ”) joint investigations.
Legal fees associated with applicable indemnification
obligations, SEC investigation and other related costs for the
years ended October 28, 2006 and October 29, 2005 were
as follows (in thousands):
In addition, legal fees associated with indemnification
obligations, SEC investigation and other related costs for the
years ended October 29, 2005 and October 30, 2004 were
as follows (in thousands):
On January 24, 2005, we announced that our Audit Committee
completed an internal review regarding historical stock option
granting practices. Following the January 2005 Audit Committee
internal review, on May 16, 2005, we announced that
additional information had come to our attention that indicated
that certain guidelines regarding stock option granting
practices were not followed and our Audit Committee had
commenced an internal review of our stock option accounting
focusing on leaves of absence and transition and advisory roles.
This Audit Committee review was completed in November 2005. We
are currently undergoing an SEC and DOJ joint investigation
regarding our historical stock option granting practices.
We did not incur any internal review or SEC investigation costs
during the year ended October 30, 2004.
Table of Contents
Provision for SEC settlement for the years ended
October 28, 2006 and October 29, 2005 was as follows
(in thousands):
During the first quarter of fiscal year 2006, we began active
settlement discussions with the Staff of the SEC’s Division
of Enforcement (the “Staff”) regarding our financial
restatements related to stock option accounting. As a result of
these discussions, for the fiscal years ended October 28,
2006 and October 29, 2005, we recorded a $7.0 million
and $0.0 million provision, respectively, for an estimated
settlement expense. The $7.0 million estimated settlement
expense is based on an offer of settlement that the Company made
to the Staff and for which the Staff has stated that it intends
to recommend to the SEC’s Commissioners. The offer of
settlement is contingent upon final approval by the SEC’s
Commissioners. No other provision amounts have been recorded in
the Consolidated Financial Statements for the periods presented
as the amounts are not estimable.
Stock compensation expense for the years ended October 28,
2006 and October 29, 2005 was as follows
(in thousands):
In addition, stock compensation expense for the years ended
October 29, 2005 and October 30, 2004 was as follows
(in thousands):
Total stock-based compensation expense for the year ended
October 28, 2006 was $31.4 million. Of this amount,
$8.6 million was included in cost of sales,
$11.9 million in research and development,
$7.4 million in sales and marketing, and $3.5 million
in general and administrative expenses. Total stock-based
compensation expense (benefit), net of tax, for the year ended
October 29, 2005 was $(0.6) million. Of this amount,
$(0.4) million was included in cost of sales,
$(0.3) million in research and development,
$0.2 million in sales and marketing and $(0.1) million
in general and administrative. Total stock-based compensation
expense (benefit) for the year ended October 29, 2005
excludes certain stock-based awards which were previously
reported as pro forma compensation expense under APB 25
(see Note 2, “Summary of Significant Accounting
Policies,” of the Notes to Consolidated Financial
Statements).
Effective October 30, 2005, we began recording compensation
expense associated with stock-based awards and other forms of
equity compensation in accordance with SFAS 123R. Under the
fair value recognition provisions of SFAS 123R, stock-based
compensation expense is measured at the grant date based on the
fair value of the award and is recognized as expense over the
vesting period. Determining the fair value of stock-based awards
and other forms of equity compensation at the grant date
requires judgment, including estimating our stock price
volatility and employee stock option exercise behaviors. If
actual results differ significantly from these estimates,
stock-based compensation expense and our results of operations
could be materially impacted. For the year ended
October 28, 2006, stock-based compensation expense for
stock options and employee stock purchases of $15.4 million
and $4.4 million, respectively, is included in cost of
sales, research and development, sales and marketing, or general
and administrative expenses, by employee.
We also have stock-based compensation arising from stock option
grants that are remeasured at their intrinsic value and subject
to changes in measurement date and restricted stock awards. For
the year ended October 28, 2006, total compensation expense
of $3.9 million resulting from stock option grants
remeasured at their intrinsic value was included in cost of
sales, research and development, sales and marketing, or general
and administrative
Table of Contents
expenses and $3.9 million resulting from restricted stock
awards issued during the fiscal year. For the year ended
October 29, 2005, there was no compensation expense
resulting from stock option grants remeasured at their intrinsic
value and subject to change in measurement date. Accordingly,
amortization of stock-based compensation does not include the
compensation expense arising from these awards. The stock-based
compensation expense associated with remeasuring awards at their
intrinsic value each reporting period will vary significantly as
a result of future changes in the market value of our common
stock. The change in stock-based compensation related to awards
remeasured at their intrinsic value during the year ended
October 28, 2006, as compared to the year ended
October 29, 2005, is due to a change in market values of
our common stock during the reported periods.
In addition to the stock-based compensation expense recorded for
stock-based awards, for the year ended October 28, 2006 and
October 29, 2005, we recorded $1.8 million and
$0.5 million, respectively, in acquisition-related
amortization of stock compensation. The amortized stock-based
compensation expense represents the fair value of unvested
restricted common stock and assumed stock options, and is being
amortized over the respective remaining service periods on a
straight-line basis. As of October 28, 2006, the remaining
unamortized balance of acquisition-related stock compensation
was approximately $0.7 million.
Further, on June 12, 2006, the Company completed a tender
offer that allowed employees to amend or cancel certain options
to remedy potential adverse personal tax consequences. As a
result, the Company amended certain options granted after
August 14, 2003 that were or may have been granted at a
discount and were tendered by employees to increase the option
grant price to the fair market value on the date of grant, and
to give the employee a cash payment for the difference in option
grant price between the amended option and the original
discounted price. In addition, the Company cancelled certain
options granted prior to August 14, 2003 that were or may
have been granted at a discount, and were tendered by employees
in exchange for a cash payment based on the Black-Scholes value
of the option. The Company has accounted for these modifications
and settlements in accordance with SFAS 123R and as a
result recorded incremental compensation expense of
$2.1 million during the three months ended July 29,
2006. No tender offer was completed in prior fiscal years.
Amortization of intangible assets for the years ended
October 28, 2006 and October 29, 2005 was as follows
(in thousands):
During the year ended October 28, 2006, we recorded
amortization of intangible assets of $2.3 million related
to the acquisition of NuView. We account for intangible assets
in accordance with Statement of Financial Accounting Standards
No. 142, Goodwill and Other Intangible Assets
(“SFAS 142”). Intangible assets are recorded
based on estimates of fair value at the time of the acquisition
and identifiable intangible assets are amortized on a straight
line basis over their estimated useful lives (see Note 4:
“Goodwill and Identifiable Intangible Assets,” of the
Notes to Consolidated Financial Statements).
No other intangible amounts have been recorded in the
Consolidated Financial Statements for the periods presented.
Restructuring and facilities lease losses, net, for the years
ended October 28, 2006 and October 29, 2005 was as
follows (in thousands):
Table of Contents
In addition, restructuring and facilities lease losses, net, for
the years ended October 29, 2005 and October 30, 2004
were as follows (in thousands):
During the year ended October 28, 2006, we recorded a
charge of $3.8 million related to estimated facilities
lease losses, net of expected sublease income. This charge
represents an estimate based on current market data. No other
facilities lease loss expenses have been recorded in the
Consolidated Financial Statements for the periods presented. For
the year ended October 29, 2005, we recorded a reduction of
$0.7 million to restructuring costs related to recovery of
previously recorded restructuring costs. For the year ended
October 30, 2004, restructuring costs consist of
$10.5 million related to a restructuring plan implemented
during the three months ended May 1, 2004, and a reduction
of $1.5 million to restructuring costs related to our
previously recorded restructuring liabilities, primarily due to
lower than expected costs related to outplacement costs and
severance (see Note 5, “Restructuring Costs,” of
the Notes to Consolidated Financial Statements).
During the year ended October 30, 2004, we recorded a lease
termination charge of $75.6 million. During the three
months ended January 24, 2004, we purchased a previously
leased building located near our San Jose headquarters for
$106.8 million. Of the $106.8 million,
$30.0 million was allocated to the purchase of land and
building and $76.8 million was considered a lease
termination fee (see Note 6, “Liabilities Associated
with Facilities Lease Losses and Asset Impairment Charges,”
of the Notes to Consolidated Financial Statements). No lease
termination charge was recorded in any of the other periods
presented.
Settlement of an acquisition related claim for the years ended
October 29, 2005 and October 30, 2004 was as follows
(in thousands):
During the second quarter of fiscal year 2004, the Company
recorded a $6.9 million charge in settlement of a claim
relating to its acquisition of Rhapsody. Under the terms of the
settlement, in the third quarter of fiscal year 2004, the
Company issued 1.3 million shares of its common stock to
the former Rhapsody shareholders in exchange for a release of
claims.
We did not record any settlement of an acquisition related claim
for the years ended October 28, 2006 and October 29,
2005.
In-process research and development for the years ended
October 28, 2006 and October 29, 2005 was as follows
(in thousands):
On May 3, 2005, we completed our acquisition of Therion, a
privately held company based in Redmond, Washington that
developed software management solutions for the automated
provisioning of servers over a storage network. As of the
acquisition date, Therion was a development stage company with
no recognized revenue and a core technology that had not yet
reached technological feasibility. Accordingly, the acquisition
of Therion was accounted for as an asset purchase. In connection
with this acquisition, we recorded a $7.8 million
in-process research and development charge, and allocated the
remaining purchase price to net assets of $2.9 million,
deferred stock compensation of $1.5 million, and net
liabilities of $0.1 million, based on fair values (see
Note 3, “Acquisitions,” of the Notes to
Consolidated Financial Statements).
Table of Contents
We did not record any acquired in-process R&D for the years
ended October 28, 2006 and October 30, 2004.
Acquisition and integration costs for the years ended
October 28, 2006 and October 29, 2005 were as follows
(in thousands):
On August 8, 2006, the Company announced that it had
entered into a definitive agreement to acquire McDATA in an all
stock transaction valued at approximately $634 million as
of such date. Under the terms of the agreement, McDATA
stockholders will receive 0.75 shares of Brocade common
stock for each share of McDATA class A common stock and
each share of McDATA class B common stock they hold. The
acquisition is subject to obtaining approval from both Brocade
and McDATA stockholders, regulatory approvals and certain other
closing conditions.
In connection with our proposed acquisition of McDATA (see
Note 10 “Commitments and Contingencies”, of the
Notes to Consolidated Financial Statements), we recorded
acquisition and integration costs of $9.6 million in fiscal
2006, which consisted primarily of costs incurred for consulting
services and other professional fees.
No other integration or acquisition-related compensation amounts
have been recorded in the Consolidated Financial Statements for
the periods years ended October 29, 2005 and
October 30, 2004.
Interest and other income, net, for the years ended
October 28, 2006 and October 29, 2005 was as follows
(in thousands):
In addition, interest and other income, net, for the years ended
October 29, 2005 and October 30, 2004 was as follows
(in thousands):
Interest and other income, net increased to $29.1 for the year
ended October 28, 2006, compared to $22.7 million for
the year ended October 29, 2005 and $18.8 million for
the year ended October 30, 2004. For the year ended
October 28, 2006, the increase was primarily due to higher
average rates of return due to investment mix and an increase in
interest rates, as well as increase in cash invested. For the
year ended October 29, 2005, the increase was primarily due
to higher average rates of return due to investment mix and
increase in interest rates, as well as increased average cash,
cash equivalent, restricted short-term investments and
short-term and long-term investment balances. On August 22,
2006, as contemplated by the irrevocable letter of instruction
to the Trustee, the short-term investments deposited with the
Trustee, which fully collateralized the outstanding convertible
debt were liquidated and $280.8 million, which included
debt principal, accrued interest and the call premium, was paid
to redeem all outstanding convertible debt.
Interest expense for the years ended October 28, 2006 and
October 29, 2005 was as follows (in thousands):
Table of Contents
In addition, interest expense for the years ended
October 29, 2005 and October 30, 2004 was as follows
(in thousands):
Interest expense primarily represents the interest cost
associated with our convertible subordinated debt, which we
liquidated during the last quarter of the 2006 fiscal year. The
decrease in interest expense for both the years ended
October 28, 2006 and October 29, 2005, compared with
the year ended October 30, 2004 was primarily the result of
the repurchases of our convertible subordinated debt, resulting
in a lower debt outstanding. As of October 28, 2006 and
October 29, 2005, the outstanding balance of our
convertible subordinated debt was $0.0 million and
$278.9 million, respectively (see Note 9,
“Convertible Subordinated Debt,” of the Notes to
Consolidated Financial Statements).
Gain on repurchases of convertible subordinated debt for the
years ended October 28, 2006 and October 29, 2005 was
as follows (in thousands):
In addition, gain on repurchase of convertible subordinated debt
for the years ended October 29, 2005 and October 30,
2004 was as follows (in thousands):
During the years ended October 28, 2006 and
October 29, 2005, and October 30, 2004, we repurchased
$0.0 million, $73.4 million, and $90.7 million in
face value of our convertible subordinated debt, respectively,
on the open market. For the year ended October 29, 2005, we
paid an average of $0.96 for each dollar of face value for an
aggregate purchase price of $70.5 million, which resulted
in a pre-tax gain of $2.3 million. For the year ended
October 30, 2004, we paid an average of $0.93 for each
dollar of face value for an aggregate purchase price of
$84.4 million, which resulted in a pre-tax gain of
$5.6 million.
Gain (loss) on investments, net, for the years ended
October 28, 2006 and October 29, 2005 was as follows
(in thousands):
In addition, gain (loss) on investments, net, for the years
ended October 29, 2005 and October 30, 2004 was as
follows (in thousands):
For the year ended October 28, 2006, gain on sale of
investment was $2.7 million due to the disposition of
non-marketable private strategic investments at amounts above
the carrying value. The carrying value of our equity investments
in non-publicly traded companies at October 28, 2006 was
$0.8 million. For the year ended October 29, 2005, net
loss on investments was $5.1 million, consisting of
$5.2 million losses on the disposition of portfolio
investments primarily associated with the defeasance of the
indenture agreement relating to our 2% Convertible Notes,
offset by $0.1 million gains on the disposition of
non-marketable private strategic investments. For the year
Table of Contents
ended October 30, 2004, net gain on investments was
$0.4 million consisting of gains on the disposition of
previously written down non-marketable private strategic
investments. As of October 28, 2006 and October 29,
2005, we had net unrealized holding gains (losses) of
$(1.1) million and $(4.2) million, respectively,
associated with our remaining investment portfolio. The carrying
value of our equity investments in non-publicly traded companies
at October 28, 2006 and October 29, 2005 was
$0.8 million and $3.8 million, respectively.
Provision for income taxes for the years ended October 28,
2006 and October 29, 2005 was as follows
(in thousands):
Provision for income taxes for the years ended October 29,
2005 and October 30, 2004 was as follows
(in thousands):
Estimates and judgments are required in the calculation of
certain tax liabilities and in the determination of the
recoverability of certain of the deferred tax assets, which
arise from variable stock option expenses, net operating losses,
tax carryforwards and temporary differences between the tax and
financial statement recognition of revenue and expense.
SFAS No. 109, “Accounting for Income
Taxes” (“SFAS 109”), also requires that
the deferred tax assets be reduced by a valuation allowance, if
based on the weight of available evidence, it is more likely
than not that some portion or all of the recorded deferred tax
assets will not be realized in future periods.
In evaluating our ability to recover our deferred tax assets, in
full or in part, we consider all available positive and negative
evidence including our past operating results, the existence of
cumulative losses in the most recent fiscal years and our
forecast of future taxable income on a jurisdiction by
jurisdiction basis. In determining future taxable income, we are
responsible for assumptions utilized including the amount of
state and federal pre-tax operating income, the reversal of
temporary differences and the implementation of feasible and
prudent tax planning strategies. These assumptions require
significant judgments about the forecasts of future taxable
income and are consistent with the plans and estimates we are
using to manage the underlying businesses. Cumulative losses
incurred in four of the last seven fiscal years represented
sufficient negative evidence to require a full valuation
allowance. As of October 28, 2006, we had a valuation
allowance against the deferred tax assets, which we intend to
maintain until sufficient positive evidence exists to support
reversal of the valuation allowance. Future reversals or
increases to our valuation allowance could have a significant
impact on our future earnings.
In addition, the calculation of our tax liabilities involves
dealing with uncertainties in the application of complex tax
regulations in a multitude of jurisdictions. We recognize
potential liabilities for anticipated tax audit issues in the
U.S. and other tax jurisdictions based on our estimate of
whether, and the extent to which, additional taxes will be due.
If events occur and the payment of these amounts ultimately
proves to be unnecessary, the reversal of the liabilities would
result in tax benefits being recognized in the period when we
determine the liabilities are no longer necessary. If our
estimate of tax liabilities proves to be less than the ultimate
assessment, a further charge to expense would result.
For the year ended October 28, 2006, we have recorded an
income tax provision of $30.7 million, compared to income
tax provisions of $12.1 million and $14.1 million in
the years ended October 29, 2005 and October 30, 2004,
respectively. For the year ended October 28, 2006, the
Company had a change in valuation allowance of
$16.2 million. The cumulative valuation allowance has been
placed against the gross deferred tax assets with the exception
of future benefits of
non-U.S. stock
options. The valuation allowance will be reduced in the period
in which the Company is able to utilize the deferred tax assets
on its tax return, resulting in a reduction in income tax
payable. In the year ended October 28, 2006, our income tax
provision is primarily for international and domestic
operations. In the year ended October 29, 2005, our income
tax provision is primarily for our international
Table of Contents
operations, a one-time U.S. tax liability associated with
the earnings repatriated pursuant to the American Jobs Creation
Act of 2004 (the “AJCA”), and domestic operations. We
expect to continue to record an income tax provision for our
international and domestic operations in the future. Since we
have a full valuation allowance against deferred tax assets
which result from U.S. operations, U.S. income tax
expense or benefits are offset by releasing or increasing,
respectively, the valuation allowance. Our U.S. federal
income tax liability is reduced by the utilization of net
operating loss and credit carry forwards from prior years such
that only alternative minimum tax results. To the extent these
carryforwards are fully utilized against future earnings, our US
federal effective tax rate is expected to increase. To the
extent that international revenues and earnings differ from
those historically achieved, a factor largely influenced by the
buying behavior of our OEM partners, or unfavorable changes in
tax laws and regulations occur, our income tax provision could
change.
The AJCA was enacted on October 22, 2004. One provision of
the AJCA effectively reduces the tax rate on qualifying
repatriation of earnings held by foreign-based subsidiaries to
approximately 5.25 percent. Normally, such repatriations
would be taxed at a rate of up to 35 percent. In the fourth
quarter of fiscal year 2005, we made the decision that we would
repatriate approximately $78.2 million under the AJCA. This
repatriation of earnings triggered a U.S. federal tax
payment of approximately $3.4 million and a state tax
payment of approximately $0.6 million. Prior to the AJCA,
we did not provide deferred taxes on undistributed earnings of
foreign subsidiaries as we intended to utilize these earnings
through expansion of our business operations outside the United
States for an indefinite period of time. Going forward, we
intend to indefinitely reinvest prospective foreign earnings.
In November 2005, we were notified by the Internal Revenue
Service that our domestic federal income tax return for the year
ended October 25, 2003 was subject to audit. We believe we
have adequate reserves to cover any potential assessments that
may result from the examination.
In April 2006, we were notified by the Franchise Tax Board
(“FTB”) that our California income tax returns for the
years ended October 25, 2003 and October 30, 2004 were
subject to audit. The FTB Audit is ongoing and we believe our
reserves are adequate to cover any potential assessments that
may result from the examination.
Cash, cash equivalents, restricted short-term investments, and
short-term and long-term investments were $582.6 million as
of October 28, 2006, a decrease of $181.8 million over
prior year total of $764.4 million. For the year ended
October 28, 2006, we generated $166.9 million in cash
from operating activities. Cash from operations significantly
exceeded net income for the year ended October 28, 2006 due
to non-cash expense items, primarily related to depreciation and
amortization, an increase in non-cash compensation expense and
an increase in accounts payable and accrued compensation. Days
sales outstanding in receivables for the year ended
October 28, 2006 was 43 days, compared with
44 days for the year ended October 29, 2005.
Net cash provided by investing activities for the year ended
October 28, 2006 totaled $194.4 million and was
primarily the result of $650.9 million in net proceeds from
sales and maturities of short, restricted short and long-term
investments and other non-marketable investments, partially
offset by $366.2 million cash used for purchases of
restricted short and long-term investments $30.4 million
invested in capital equipment, and $59.9 million cash used
in connection with an acquisition.
Table of Contents
Net cash used in financing activities for the year ended
October 28, 2006 totaled $269.0 million. Net cash used
in financing activities was primarily the result of
$278.9 million cash used for the redemption of outstanding
convertible debt and $40.2 million cash used to repurchase
our common stock under the stock repurchase program approved in
August 2004 by our Board of Directors, partially offset by
$34.3 million in net proceeds from employee participation
in employee stock programs and exercises of stock options and
$15.8 excess tax benefit related employee stock plans.
Net proceeds from the issuance of common stock related to
employee participation in employee stock programs have
historically been a significant component of our liquidity. The
extent to which our employees participate in these programs
generally increases or decreases based upon changes in the
market price of our common stock. As a result, our cash flow
resulting from the issuance of common stock related to employee
participation in employee stock programs will vary.
Manufacturing and Purchase Commitments We have a
manufacturing agreement with Foxconn under which we provide
twelve-month product forecasts and place purchase orders in
advance of the scheduled delivery of products to our customers.
The required lead-time for placing orders with Foxconn depends
on the specific product. As of October 28, 2006, our
aggregate commitment to Foxconn for inventory components used in
the manufacture of Brocade products was $87.9 million, net
of purchase commitment reserves of $6.1 million, which we
expect to utilize during future normal ongoing operations.
Although the purchase orders we place with Foxconn are
cancelable, the terms of the agreement requires us to purchase
from Foxconn all inventory components not returnable or usable
by, or sold to, other customers of Foxconn. Our purchase
commitments reserve reflects our estimate of purchase
commitments we do not expect to consume in normal operations.
Convertible Subordinated Debt On December 21, 2001,
and January 10, 2002, we sold an aggregate of
$550 million in principal amount of two percent convertible
subordinated notes due January 2007 (the “Notes” or
“Convertible Subordinated Debt”) (see Note 9,
“Convertible Subordinated Debt,” of the Notes to
Consolidated Financial Statements). Holders of the Notes may, in
whole or in part, have converted the Notes into shares of our
common stock at a conversion rate of 22.8571 shares per
$1,000 principal amount of notes at any time prior to maturity
on January 1, 2007, subject to earlier redemption.
On August 23, 2005, in accordance with the terms of the
indenture agreement dated December 21, 2001 with respect to
the Convertible Subordinated Debt, the Company elected to
deposit securities with the trustee of the Notes (the
“Trustee”), which fully collateralized the outstanding
notes, and to discharge the indenture agreement. Pursuant to
this election, the Company provided an irrevocable letter of
instruction to the Trustee to issue a notice of redemption on
June 26, 2006 and to redeem the Notes on August 22,
2006 (the “Redemption Date”). Following
August 23, 2005, the Trustee, using the securities
deposited with them, paid to the noteholders (1) all the
interest scheduled to become due per the original note prior to
the Redemption Date, and (2) all the principal and
remaining interest, plus a call premium of 0.4% of the face
value of the Notes, on the Redemption Date. As of
October 29, 2005, the Company had an aggregate of
$277.2 million in interest-bearing U.S. securities
with the Trustee. The securities remained on the Company’s
balance sheet as restricted short-term investments until the
Redemption Date. The Company recorded a loss on investments
of $4.7 million in the three months ended October 29,
2005 with respect to the disposition of certain short-term and
long-term investments that was necessary to deposit the
securities with the Trustee.
The notes were redeemed on August 22, 2006 as contemplated
by the irrevocable letter of instruction to the Trustee. As of
October 28, 2006, the remaining balance outstanding of the
convertible subordinated debt was $0.0 million.
Other Contractual Obligations On November 18, 2003,
we purchased a previously leased building located near our
San Jose headquarters, and issued a $1.0 million
guarantee as part of the purchase agreement.
Table of Contents
The following table summarizes our contractual obligations
(including interest expense) and commitments as of
October 28, 2006 (in thousands):
Share Repurchase Program. In August 2004, our
board of directors approved a share repurchase program for up to
$100.0 million of our common stock. The purchases may be
made, from time to time, in the open market and will be funded
from available working capital. The number of shares to be
purchased and the timing of purchases will be based on the level
of our cash balances, general business and market conditions,
and other factors, including alternative investment
opportunities. To date, we have repurchased 7.9 million
shares and $52.7 million remains available for future
repurchases under this program.
We believe that our existing cash, cash equivalents, short-term
and long-term investments, and cash expected to be generated
from future operations will be sufficient to meet our capital
requirements at least through the next 12 months, although
we may elect to seek additional funding prior to that time, if
available. Our future capital requirements will depend on many
factors, including our rate of revenue growth, the timing and
extent of spending to support our product development efforts
and the expansion of our sales and marketing programs, the
timing of introductions of new products and enhancements to our
existing products, and market acceptance of our products.
Our discussion and analysis of financial condition and results
of operations is based upon our Consolidated Financial
Statements, which have been prepared in accordance with
U.S. generally accepted accounting principles. The
preparation of these Consolidated Financial Statements requires
us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and
related disclosure of contingent assets and liabilities. We
evaluate, on an on-going basis, our estimates and judgments,
including those related to sales returns, bad debts, excess
inventory and purchase commitments, investments, warranty
obligations, restructuring costs, lease losses, income taxes,
and contingencies and litigation. We base our estimates on
historical experience and assumptions that we believe to be
reasonable under the circumstances, the results of which form
the basis for making judgments about the carrying values of
assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates.
The methods, estimates, and judgments we use in applying our
most critical accounting policies have a significant impact on
the results that we report in our Consolidated Financial
Statements. The SEC considers an entity’s most critical
accounting policies to be those policies that are both most
important to the portrayal of a company’s financial
condition and results of operations, and those that require
management’s most difficult, subjective or complex
judgments, often as a result of the need to make estimates about
matters that are inherently
Table of Contents
uncertain at the time of estimation. We believe the following
critical accounting policies, among others, require significant
judgments and estimates used in the preparation of our
Consolidated Financial Statements:
Revenue recognition, and allowances for sales returns, sales
programs, and doubtful accounts. Product revenue
is generally recognized when persuasive evidence of an
arrangement exists, delivery has occurred, the fee is fixed or
determinable, and collection is probable. However, for newly
introduced products, many of our large OEM customers require a
product qualification period during which our products are
tested and approved by the OEM customer for sale to their
customers. Revenue recognition, and related cost, is deferred
for shipments to new OEM customers and for shipments of newly
introduced products to existing OEM customers until satisfactory
evidence of completion of the product qualification has been
received from the OEM customer. In addition, revenue from sales
to our master reseller customers is recognized in the same
period in which the product is sold by the master reseller
(sell-through).
We reduce revenue for estimated sales returns, sales programs,
and other allowances at the time of shipment. Sales returns,
sales programs, and other allowances are estimated based on
historical experience, current trends, and our expectations
regarding future experience. Reductions to revenue associated
with sales returns, sales programs, and other allowances include
consideration of historical sales levels, the timing and
magnitude of historical sales returns, claims under sales
programs, and other allowances, and a projection of this
experience into the future. In addition, we maintain allowances
for doubtful accounts, which are also accounted for as a
reduction in revenue, for estimated losses resulting from the
inability of our customers to make required payments. We analyze
accounts receivable, historical collection patterns, customer
concentrations, customer creditworthiness, current economic
trends, changes in customer payment terms and practices, and
customer communication when evaluating the adequacy of the
allowance for doubtful accounts. If actual sales returns, sales
programs, and other allowances exceed our estimate, or if the
financial condition of our customers was to deteriorate,
resulting in an impairment of their ability to make payments,
additional allowances and charges may be required.
Service revenue consists of training, warranty, and maintenance
arrangements, including post-contract customer support
(“PCS”) and other professional services. PCS services
are offered under renewable, annual fee-based contracts or as
part of multiple element arrangements and typically include
upgrades and enhancements to our software operating system
software, and telephone support. Service revenue, including
revenue allocated to PCS elements, is deferred and recognized
ratably over the contractual period. Service contracts are
typically one to three years in length. Professional services
are offered under fee based contracts or as part of multiple
element arrangements. Professional service revenue is recognized
as delivery of the underlying service occurs. Training revenue
is recognized upon completion of the training.
Our multiple-element product offerings include computer hardware
and software products, and support services. We also sell
certain software products and support services separately. Our
software products, including those that are embedded in our
hardware products and are essential to the functionality of our
hardware products and are, therefore, accounted for in
accordance with Statement of Position
97-2,
“Software Revenue Recognition”
(“SOP 97-2”),
as amended. We allocate revenue to each element in a multiple
element arrangement based upon vendor-specific objective
evidence (“VSOE”) of the fair value of the element or,
if VSOE is not available for the delivered elements, by
application of the residual method. In the application of the
residual method, we allocate revenue to the undelivered elements
based on VSOE for those elements and allocate the residual
revenue to the
Table of Contents
delivered elements. VSOE of the fair value for an element is
based upon the price charged when the element is sold
separately. Revenue allocated to each element is then recognized
when the basic revenue recognition criteria are met for each
element. Changes in the allocation of revenue to each element in
a multiple element arrangement may affect the timing of revenue
recognition.
Stock-Based Compensation. Effective
October 30, 2005 we began recording compensation expense
associated with stock-based awards and other forms of equity
compensation in accordance with SFAS 123R. We adopted the
modified prospective transition method provided for under
SFAS 123R, and consequently have not retroactively adjusted
results from prior periods. Under this transition method,
compensation cost associated with stock-based awards recognized
for fiscal year 2006 now includes 1) quarterly amortization
related to the remaining unvested portion of stock-based awards
granted prior to October 30, 2005, based on the grant date
fair value estimated in accordance with the original provisions
of SFAS 123; and 2) quarterly amortization related to
stock-based awards granted subsequent to October 30, 2005,
based on the grant-date fair value estimated in accordance with
the provisions of SFAS 123R. In addition, we record expense
over the offering period and vesting term in connection with
1) shares issued under our employee stock purchase plan and
2) stock options and restricted stock awards. The
compensation expense for stock-based awards includes an estimate
for forfeitures and is recognized over the expected term of the
award under a graded vesting method.
Prior to October 30, 2005, we accounted for stock-based
awards using the intrinsic value method of accounting in
accordance with APB 25, whereby the difference between the
exercise price and the fair market value on the date of grant is
recognized as compensation expense. Under the intrinsic value
method of accounting, no compensation expense was recognized in
our Consolidated Statements of Operations when the exercise
price of our employee stock option grant equals the market price
of the underlying common stock on the date of grant, and the
measurement date of the option grant is certain. The measurement
date is certain when the date of grant is fixed and
determinable. Prior to October 30, 2005 when the
measurement date was not certain, we recorded stock-based
compensation expense using variable accounting under
APB 25. Effective October 30 2005, for awards where
the measurement date is not certain, we record stock-based
compensation expense under SFAS 123R. Under SFAS 123R,
we remeasure the intrinsic value of the options at the end of
each reporting period until the options are exercised, cancelled
or expire unexercised.
Warranty reserves. We provide warranties on
our products ranging from one to three years. Estimated future
warranty costs are accrued at the time of shipment and charged
to cost of revenues based upon historical experience, current
trends and our expectations regarding future experience. If
actual warranty costs exceed our estimate, additional charges
may be required.
Inventory and purchase commitment reserves. We
write down inventory and record purchase commitment reserves for
estimated excess and obsolete inventory equal to the difference
between the cost of inventory and the estimated fair value based
upon forecast of future product demand, product transition
cycles, and market conditions. Although we strive to ensure the
accuracy of our forecasts of future product demand, any
significant unanticipated changes in demand or technological
developments could have a significant impact on the value of our
inventory and commitments, and our reported results. If actual
market conditions are less favorable than those projected,
additional inventory write-downs, purchase commitment reserves,
and charges against earnings might be required.
Restructuring charges and lease loss
reserves. We monitor and regularly evaluate our
organizational structure and associated operating expenses.
Depending on events and circumstances, we may decide to take
additional actions to reduce future operating costs as our
business requirements evolve. In determining restructuring
charges, we analyze our future operating requirements, including
the required headcount by business functions and facility space
requirements. Our restructuring costs, and any resulting
accruals, involve significant estimates made by management using
the best information available at the time the estimates are
made, some of which may be provided by third parties. In
recording severance reserves, we accrue liability when all of
the following conditions have been met: employees’ rights
to receive compensation for future absences is attributable to
employees’ services already rendered; the obligation
relates to rights that vest or accumulate; payment of the
compensation is probable; and the amount can be reasonably
estimated. In recording facilities lease loss reserves, we make
various assumptions, including the time period over which the
facilities are expected to be vacant, expected sublease terms,
expected sublease rates, anticipated future operating expenses,
and expected future use of the facilities. Our
Table of Contents
estimates involve a number of risks and uncertainties, some of
which are beyond our control, including future real estate
market conditions and our ability to successfully enter into
subleases or lease termination agreements with terms as
favorable as those assumed when arriving at our estimates. We
regularly evaluate a number of factors to determine the
appropriateness and reasonableness of our restructuring and
lease loss accruals including the various assumptions noted
above. If actual results differ significantly from our
estimates, we may be required to adjust our restructuring and
lease loss accruals in the future.
Goodwill and intangible assets. We account for
goodwill in accordance with Statement of Financial Accounting
Standards No. 142, Goodwill and Other Intangible Assets
(“SFAS 142”). SFAS 142 requires that
goodwill be capitalized at cost and tested annually for
impairment. We evaluate goodwill on an annual basis during our
second fiscal quarter, or whenever events and changes in
circumstances indicate that the carrying amount of an asset may
not be recoverable. An impairment loss is recognized to the
extent that the carrying amount exceeds the assets implied fair
value. Events which might indicate impairment include, but are
not limited to, strategic decisions made in response to economic
and competitive conditions, the impact of economic environment
on our customer base, material negative changes in relationships
with significant customers,
and/or a
significant decline in our stock price for a sustained period.
No goodwill impairment was recorded for the periods presented.
Intangible assets other than goodwill are amortized over their
useful lives, unless these lives are determined to be
indefinite. Intangible assets are carried at cost less
accumulated amortization. Amortization is computed over the
estimated useful life of the respective asset. Intangible assets
are reviewed for impairment in accordance with Statement of
Financial Accounting Standards No. 144, Accounting for
the Impairment or Disposal of Long-Lived Assets
(“SFAS 144”). We perform an impairment tests
for long-lived assets on an annual basis or whenever events or
changes in circumstances indicate that the carrying value of
such assets may not be recoverable. Examples of such events or
circumstances include significant underperformance relative to
historical or projected future operating results, significant
changes in the manner of use of acquired assets or the strategy
for its business, significant negative industry or economic
trends,
and/or a
significant decline in the Company’s stock price for a
sustained period. Impairments are recognized based on the
difference between the fair value of the asset and its carrying
value, and fair value is generally measured based on discounted
cash flow analyses. No intangible asset impairment was recorded
for the periods presented.
Litigation costs. We are subject to the
possibility of legal actions arising in the ordinary course of
business. We regularly monitor the status of pending legal
actions to evaluate both the magnitude and likelihood of any
potential loss. We accrue for these potential losses when it is
probable that a liability has been incurred and the amount of
loss, or possible range of loss, can be reasonably estimated. If
actual results differ significantly from our estimates, we may
be required to adjust our accruals in the future.
Accounting for income taxes. We use the asset
and liability method of accounting for income taxes. Under this
method, income tax expense is recognized for the amount of taxes
payable or refundable for the current year. Deferred tax assets
and liabilities are recognized for the expected tax consequences
of temporary differences between the tax bases of assets and
liabilities and their reported amounts, along with net operating
loss carryforwards and credit carryforwards. A valuation
allowance is recognized to the extent that it is more likely
than not that the tax benefits will not be realized. Income tax
contingencies are accounted for in accordance with
SFAS No. 5, “Accounting for
Contingencies” (“SFAS 5”).
The determination of our tax provision is subject to judgments
and estimates due to operations in multiple tax jurisdictions
inside and outside the United States. Sales to our international
customers are principally taxed at rates that are lower than the
United States statutory rates. The ability to maintain our
current effective tax rate is contingent upon existing tax laws
in both the United States and in the respective countries in
which our international subsidiaries are located. Future changes
in domestic or international tax laws could affect the continued
realization of the tax benefits we are currently receiving and
expect to receive from international sales. In addition, an
increase in the percentage of our total revenue from
international customers or in the mix of international revenue
among particular tax jurisdictions could change our overall
effective tax rate. Also, our current effective tax rate assumes
that United States income taxes are not provided for
undistributed earnings of certain non-United States
subsidiaries. These earnings could become subject to United
States federal and state income taxes and foreign withholding
Table of Contents
taxes, as applicable, should they be either deemed or actually
remitted from our international subsidiaries to the United
States.
The carrying value of our net deferred tax assets is subject to
a full valuation allowance with the exception of non-US stock
option expense. At some point in the future, the Company may
have sufficient United States taxable income to release the
valuation allowance and accrue United States tax. We evaluate
the expected realization of our deferred tax assets and assess
the need for valuation allowances quarterly.
In July 2006, the FASB issued FASB Interpretation (FIN)
No. 48, Accounting for Uncertainty in Income
Taxes — An Interpretation of FASB Statement
No. 109 (“FIN 48”). FIN 48
prescribes detailed guidance for the financial statement
recognition, measurement and disclosure of uncertain tax
positions recognized in an enterprise’s financial
statements in accordance with SFAS No. 109,
“Accounting for Income Taxes.” Tax positions
must meet a more-likely-than-not recognition threshold at the
effective date to be recognized upon the adoption of FIN 48
and in subsequent periods. FIN 48 will be effective for
fiscal years beginning after December 15, 2006, and the
provisions of FIN 48 will be applied to all tax positions
upon initial adoption of the Interpretation. The cumulative
effect of applying the provisions of this Interpretation will be
reported as an adjustment to the opening balance of retained
earnings for that fiscal year. We are currently evaluating the
impact of FIN 48 on our financial statements and have not
yet determined the impact.
In September 2006, the FASB issued SFAS No. 157,
“Fair Value Measures”
(“SFAS 157”). SFAS 157 defines fair value,
establishes a framework for measuring fair value in generally
accepted accounting principles (GAAP), expands disclosures about
fair value measurements, and applies under other accounting
pronouncements that require or permit fair value measurements.
SFAS No. 157 does not require any new fair value
measurements. However, the FASB anticipates that for some
entities, the application of SFAS 157 will change current
practice. SFAS 157 is effective for financial statements
issued for fiscal years beginning after November 15, 2007.
We do not expect the adoption of SFAS 157 will have a material
impact on our financial position, results of operations, and
cash flows.
In September 2006, the Securities and Exchange Commission
(“SEC”) issued Staff Accounting
Bulletin No. 108 (Topic 1N), “Quantifying
Misstatements in Current Year Financial Statements,”
(“SAB 108”). SAB 108 addresses how the
effect of prior-year uncorrected misstatements should be
considered when quantifying misstatements in current-year
financial statements. SAB 108 requires SEC registrants
(i) to quantify misstatements using a combined approach
which considers both the balance-sheet and income-statement
approaches, (ii) to evaluate whether either approach
results in quantifying an error that is material in light of
relevant quantitative and qualitative factors, and (iii) to
adjust their financial statements if the new combined approach
results in a conclusion is that an error is material.
SAB 108 addresses the mechanics of correcting misstatements
that include effects from prior years. It indicates that the
current-year correction of a material error that includes
prior-year effects may result in the need to correct prior-year
financial statements even if the misstatement in the prior year
or years is considered immaterial. Any prior-year financial
statements found to be materially misstated in years subsequent
to the issuance of SAB 108 would be restated in accordance
with SFAS No. 154, “Accounting Changes and
Error Corrections.” Because the combined approach
represents a change in practice, the SEC staff will not require
registrants that followed an acceptable approach in the past to
restate prior years’ historical financials statements.
Rather, these registrants can report the cumulative effect of
adopting the new approach as an adjustment to the current
year’s beginning balance of retained earnings. If the new
approach is adopted in a quarter other than the first quarter,
financial statements for prior interim periods within the year
of adoption may need to be restated. SAB 108 is effective
for fiscal years ending after November 15, 2006. We do not
expect the adoption of SAB 108 will have a material impact
on our financial position, results of operations, and cash flows.
Our exposure to market risk due to changes in the general level
of United States interest rates relates primarily to our cash
equivalents, short-term and long-term investment portfolios, and
restricted short-term investments. Our cash, cash equivalents,
short-term and long-term investments are primarily maintained at
five major financial
Table of Contents
institutions in the United States. As of October 28, 2006,
we did not hold any derivative instruments. The primary
objective of our investment activities is the preservation of
principal while maximizing investment income and minimizing risk.
The following table presents the hypothetical changes in fair
values of our investments in debt securities issued by United
States government and its agencies as of October 28, 2006
that are sensitive to changes in interest rates
(in thousands):
These instruments are not leveraged and are classified as
available-for-sale.
The modeling technique used measures the change in fair values
arising from selected potential changes in interest rates.
Market changes reflect immediate hypothetical parallel shifts in
the yield curve of plus or minus 50 basis points (BPS), 100
BPS, and 150 BPS, which are representative of the historical
movements in the Federal Funds Rate.
The following table (in thousands) presents our cash and cash
equivalents, short-term and long-term investments subject to
interest rate risk and their related weighted average interest
rates at October 28, 2006. Carrying value approximates fair
value.
Our common stock is quoted on the Nasdaq National Market under
the symbol “BRCD.” On October 28, 2006, the last
reported sale price of our common stock on the Nasdaq National
Market was $8.43 per share.
Table of Contents
BROCADE
COMMUNICATIONS SYSTEMS, INC.
Table of Contents
THE BOARD OF DIRECTORS AND STOCKHOLDERS
BROCADE COMMUNICATIONS SYSTEMS, INC:
We have audited the accompanying consolidated balance sheets of
Brocade Communications Systems, Inc. and subsidiaries (the
Company) as of October 28, 2006 and October 29, 2005,
and the related consolidated statements of operations,
stockholders’ equity and comprehensive income (loss), and
cash flows for each of the years in the three-year period ended
October 28, 2006. In connection with our audits of the
consolidated financial statements, we also have audited the
financial statement schedule as listed in Item 15(2). These
consolidated financial statements and financial statement
schedule are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these
consolidated financial statements and financial statement
schedule based on our audits.
We conducted our audits in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by
management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred
to above present fairly, in all material respects, the financial
position of Brocade Communications Systems, Inc. and
subsidiaries as of October 28, 2006 and October 29,
2005, and the results of their operations and their cash flows
for each of the years in the three-year period ended
October 28, 2006, in conformity with U.S. generally
accepted accounting principles. Also, in our opinion, the
related financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as
a whole, presents fairly, in all material respects, the
information set forth therein.
As discussed in Note 2 to the consolidated financial
statements, the Company adopted the provisions of Statement of
Financial Accounting Standards No. 123(R),
Share-Based Payments, applying the modified prospective
method at the beginning of the year ended October 28, 2006.
We also have audited, in accordance with the standards of the
Public Company Accounting Oversight Board (United States), the
effectiveness of the Company’s internal control over
financial reporting as of October 28, 2006, based on the
criteria established in “Internal Control —
Integrated Framework” issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO), and
our report dated January 9, 2007 expressed an unqualified
opinion on management’s assessment of, and the effective
operation of, internal control over financial reporting.
/s/ KPMG
LLP
Mountain View, California
January 9, 2007
Table of Contents
BROCADE
COMMUNICATIONS SYSTEMS, INC.
CONSOLIDATED
STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
Table of Contents
BROCADE
COMMUNICATIONS SYSTEMS, INC.
CONSOLIDATED
BALANCE SHEETS
See accompanying notes to consolidated financial statements.
Table of Contents
BROCADE
COMMUNICATIONS SYSTEMS, INC.
CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME (LOSS)
See accompanying notes to consolidated financial statements
Table of Contents
BROCADE
COMMUNICATIONS SYSTEMS, INC.
CONSOLIDATED
STATEMENTS OF CASH FLOWS
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||