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EMC 10-Q 2009 Documents found in this filing:Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2009 OR
For transition period from to Commission File Number 1-9853 EMC CORPORATION (Exact name of registrant as specified in its charter)
(508) 435-1000 (Registrant’s telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x The number of shares of common stock, par value $.01 per share, of the registrant outstanding as of September 30, 2009 was 2,039,821,792.
Table of Contents
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Table of ContentsFINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEETS (in thousands, except per share amounts) (unaudited)
The accompanying notes are an integral part of the consolidated financial statements.
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Table of ContentsCONSOLIDATED INCOME STATEMENTS (in thousands, except per share amounts) (unaudited)
The accompanying notes are an integral part of the consolidated financial statements.
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Table of ContentsCONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)
The accompanying notes are an integral part of the consolidated financial statements.
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Table of ContentsCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in thousands) (unaudited)
The accompanying notes are an integral part of the consolidated financial statements.
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Table of ContentsCONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (in thousands) (unaudited) For the nine months ended September 30, 2009:
For the nine months ended September 30, 2008: (As Adjusted)
The accompanying notes are an integral part of the consolidated financial statements.
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Table of ContentsNOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation Company EMC Corporation (“EMC”) and its subsidiaries develop, deliver and support the Information Technology (“IT”) industry’s broadest range of information infrastructure technologies and solutions. EMC’s Information Infrastructure business supports customers’ information lifecycle management (ILM) strategies and helps them build information infrastructures that store, protect, optimize and leverage their vast and growing quantities of information. EMC’s Information Infrastructure business consists of three segments – Information Storage, Content Management and Archiving and RSA Information Security. EMC’s VMware Virtual Infrastructure business, which is comprised of a majority equity stake in VMware, Inc. (“VMware”), is the leading provider of virtualization infrastructure solutions from the desktop to the data center. VMware’s virtual infrastructure software solutions run on industry-standard desktops and servers and support a wide range of operating system and application environments, as well as networking and storage infrastructures. General The accompanying interim consolidated financial statements are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. These consolidated financial statements include the accounts of EMC, its wholly owned subsidiaries and VMware, a company majority-owned by EMC. All intercompany transactions have been eliminated. Certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted. Accordingly, these interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2008 which are contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 27, 2009. Effective January 1, 2009, we adopted new authoritative guidance relating to the accounting for convertible debt instruments. The guidance changed the accounting treatment for certain convertible securities including our convertible debt. Under the guidance, issuers are required to allocate the bond proceeds into a debt portion and a conversion option. The allocation of the bond portion is based upon the fair value of the debt without the equity conversion option. The residual value is allocated to the conversion option which is accounted for as additional paid-in capital. As a result of this change, the bonds are recorded at a discount which is amortized over the instrument’s expected life using the effective interest method, resulting in additional non-cash interest expense. We revised prior period financial statements by reclassifying $669.1 million of our convertible debt associated with our $1.725 billion 1.75% convertible senior notes due 2011 (the “2011 Notes”) and our $1.725 billion 1.75% convertible senior notes due 2013 (the “2013 Notes” and, together with the 2011 Notes, the “Notes”) to additional paid-in capital and increased interest expense by $26.0 million and $76.3 million for the three and nine months ended September 30, 2008, respectively. See Note 3. The revision reduced net income attributable to EMC Corporation by $17.9 million and $52.4 million for the three and nine months ended September 30, 2008, respectively, and reduced both basic and diluted net income attributable to EMC Corporation common shareholders by $0.01 and $0.02 for the three and nine months ended September 30, 2008, respectively. Retained earnings as of January 1, 2008 were reduced by $74.2 million. Effective January 1, 2009, we adopted new authoritative guidance for non-controlling interests in Consolidated Financial Statements. The guidance requires that (a) the ownership interest in subsidiaries be clearly identified, labeled and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity, (b) the amount of consolidated net income attributable to the parent and to the non-controlling interest be clearly identified and presented on the face of the consolidated income statement, and (c) changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently within equity. A parent’s ownership interest in a subsidiary changes if the parent purchases additional ownership interest in its subsidiary, the parent sells some of its ownership interest or the subsidiary issues additional ownership interests. Upon adoption of the guidance, previously reported financial statements were revised and we
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reclassified the previously reported Minority interest in VMware to a component of shareholders’ equity as non-controlling interest in VMware, Inc. Previously reported Minority interest was renamed Net income attributable to the non-controlling interest in VMware, Inc. See Note 4. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for any future period or the entire fiscal year. The interim consolidated financial statements, in the opinion of management, reflect all adjustments necessary to fairly state the results as of and for the three and nine-month periods ended September 30, 2009 and 2008. Net Income Per Share Basic net income per weighted average share has been computed using the weighted average number of shares of common stock outstanding during the period. Diluted net income per weighted average share is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the period. Common equivalent shares consist of stock options, restricted stock and restricted stock units, our Notes and associated warrants (“Sold Warrants”). Additionally, for purposes of calculating diluted net income per weighted average share, net income is adjusted for the difference between VMware’s reported diluted and basic net income per weighted average share, if any, multiplied by the number of shares of VMware held by EMC. New Accounting Pronouncements In December 2007, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance on business combinations which establishes principles and requirements for how the acquirer in a business combination (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, (ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase, and (iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This guidance was implemented on January 1, 2009. In June 2009, the FASB issued the FASB Accounting Standards Codification (“Codification”). The Codification is the single source for all authoritative GAAP recognized by the FASB to be applied for financial statements issued for periods ending after September 15, 2009. The Codification does not change GAAP and will not have an effect on our financial position, results of operations or liquidity. In June 2009, the FASB issued authoritative guidance for the transfer of assets, which clarifies whether a transferor and all of the entities included in the transferor’s financial statements being presented have surrendered control over transferred financial assets. The pronouncement is effective for us beginning in 2010. Early adoption is prohibited. We do not expect the guidance to have a material impact on our financial position or results of operations. In June 2009, the FASB issued authoritative guidance to replace the quantitative-based risks and rewards calculation for determining which enterprise, if any, has a controlling financial interest in a variable interest entity with an approach focused on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance. The pronouncement is effective for us beginning in 2010. Early adoption is prohibited. We are currently evaluating the potential impact of the guidance on our financial position and results of operations. In September 2009, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables. This guidance provides another alternative for establishing fair value for a deliverable. When vendor specific objective evidence or third-party evidence for deliverables in an arrangement cannot be determined, companies will be required to develop a best estimate of the selling price for separate deliverables and allocate arrangement consideration using the relative selling price method. This guidance is effective January 1, 2011, and early adoption is permitted. We are currently evaluating the impact of this guidance on our financial position and results of operations. In September 2009, the FASB issued authoritative guidance on software-enabled products. Under this guidance, tangible products that have software components that are essential to the functionality of the tangible product will be excluded from the software revenue recognition guidance. The new guidance will include factors to help companies determine what is essential to the functionality. Software-enabled products will now be subject to other revenue guidance and will follow the above new guidance for
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multiple deliverable arrangements. This guidance is effective in 2011, and early adoption is permitted. We are currently evaluating the impact of this guidance on our financial position and results of operations. 2. Acquisitions In the second quarter of 2009, we acquired all of the outstanding capital stock of Configuresoft, Inc. (“Configuresoft”), a provider of server configuration, change and compliance management software. The acquisition complements and extends our server configuration management solutions within the Information Storage segment. In the third quarter of 2009, we acquired all of the outstanding capital stock of Data Domain, Inc. (“Data Domain”), a provider of storage solutions for backup and archive applications based on deduplication technology. Data Domain deduplication storage systems are designed to deliver reliable, efficient and cost-effective solutions that enable enterprises of all sizes to manage, retain and protect their data. This acquisition further complements and expands our Information Storage business. The purchase price for Data Domain, net of cash and investments, was approximately $2,017.3 million, which consisted of $1,933.9 million of cash consideration, including $65.0 million paid in the second quarter of 2009, and $83.4 million for the fair value of our stock options granted in exchange for existing Data Domain options. We incurred $12.0 million of transaction costs for financial advisory, legal and accounting services, which costs are included in restructuring and acquisition-related charges in our Consolidated Income Statements. The fair value of our stock options issued to employees of Data Domain was estimated using a Black-Scholes option pricing model. The fair value of the stock options was estimated assuming no expected dividends and the following weighted average assumptions:
The consolidated financial statements include the results of Data Domain from the date of acquisition. The purchase price has been allocated to the assets acquired and the liabilities assumed based on estimated fair values as of the acquisition date. The following represents the allocation of the Data Domain purchase price (table in thousands):
The total weighted-average amortization period for intangible assets is 4.3 years. The intangible assets are being amortized over the pattern in which the economic benefits of the intangible assets are being utilized, which in general reflects the cash flows generated from such assets. We acquired three in-process research and development (“IPR&D”) projects. The value assigned to the IPR&D projects was determined utilizing the income approach by determining cash flow projections relating to the projects. We
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applied discount rates ranging from 19% to 21% to determine the value of the IPR&D projects. Each IPR&D project will be assessed for impairment until completed. Upon completion, the project will be amortized over its estimated useful life over the pattern in which the economic benefits of the intangible assets are being utilized. The goodwill associated with this acquisition is reported within our Information Storage segment. None of the goodwill is deductible for tax purposes. The goodwill results from expected synergies from the transaction, including complementary products that will enhance our overall product portfolio, which we believe will result in incremental revenue and profitability. In the third quarter of 2009, we acquired all of the capital stock of FastScale Technology, Inc., a provider of software platforms and solutions that optimizes deployments for physical, virtual and cloud infrastructures. This acquisition complements and extends our Information Storage segment. In the third quarter of 2009, we acquired all of the capital stock of Kazeon Systems, Inc., a provider of eDiscovery products and solutions which allow corporations, legal service providers and law firms to efficiently search, classify and analyze the growing volumes of information dispersed through their networks. This acquisition complements and extends our Content Management and Archiving segment. In the third quarter of 2009, VMware acquired the remaining outstanding capital stock of SpringSource Global, Inc. (“SpringSource”), a leader in enterprise and web application development and management. Through the acquisition of SpringSource, VMware plans to deliver new solutions that enable companies to more efficiently build, run and manage applications within both internal and external cloud architectures that can host both existing and new applications. These solutions will extend VMware’s strategy to deliver Platform-as-a-Service solutions that can be hosted at customer datacenters or at service providers. This acquisition will also support VMware’s mission to simplify enterprise information technology and make customer environments more efficient, scalable and easier to manage. The purchase price for SpringSource, net of cash acquired, was approximately $372.5 million, which consisted of $356.3 million of cash consideration and $16.2 million for the fair value of VMware stock options granted in exchange for existing SpringSource options. Intangible assets, excluding goodwill, as of September 30, 2009 and December 31, 2008 consist of (tables in thousands):
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Changes in the carrying amount of goodwill, net, on a consolidated basis and by segment for the period ended September 30, 2009 consist of the following (table in thousands):
The fair value adjustment for investments in Data Domain and SpringSource represent gains on their respective common stock. As part of the acquisition of these entities, our previously held investments were re-measured to fair value, resulting in $25.8 million of gains. The results of the acquired companies have been included in our consolidated results of operations from their respective dates of acquisition. The following pro forma information gives effect to all the business combinations that were completed in the three and nine months ended September 30, 2009 as if the business combinations occurred at the beginning of the periods presented. The pro forma results are not necessarily indicative of what actually would have occurred had the business combinations been in effect for the periods presented (table in thousands, except per share data):
3. Convertible Debt In November 2006, we issued our Notes for total gross proceeds of $3.45 billion. The Notes are senior unsecured obligations and rank equally with all other existing and future senior unsecured debt. Holders may convert their Notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding (i) September 1, 2011, with respect to the 2011 Notes, and (ii) September 1, 2013, with respect to the 2013 Notes, in each case only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the “measurement period”) in which the price per Note of the applicable series for each day of that measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such day; (2) during any calendar quarter, if the last reported sale price of our common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or (3) upon the occurrence of certain events specified in the Notes. Additionally, the Notes will become convertible during the last three months prior to the respective maturities of the 2011 Notes and the 2013 Notes. Upon conversion, we will pay cash up to the principal amount of the debt converted. With respect to any conversion value in excess of the principal amount of the Notes converted, we have the option to settle the excess with cash, shares of our common stock, or a combination of cash and shares of our common stock based on a daily conversion value, determined in accordance with the indenture, calculated on a proportionate basis for each day of the relevant 20-day observation period. The initial conversion rate
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for the Notes will be 62.1978 shares of our common stock per one thousand dollars of principal amount of Notes, which represents a 27.5% conversion premium from the date the Notes were issued and is equivalent to a conversion price of approximately $16.08 per share of our common stock. The conversion price is subject to adjustment in some events as set forth in the indenture. In addition, if a “fundamental change” (as defined in the indenture) occurs prior to the maturity date, we will in some cases increase the conversion rate for a holder of Notes that elects to convert its Notes in connection with such fundamental change. The Notes pay interest in cash at a rate of 1.75% semi-annually in arrears on December 1 and June 1 of each year. In connection with the sale of the Notes, we entered into separate convertible note hedge transactions with respect to our common stock (the “Purchased Options”). The Purchased Options allow us to receive shares of our common stock and/or cash related to the excess conversion value that we would pay to the holders of the Notes upon conversion. The Purchased Options will cover, subject to customary anti-dilution adjustments, approximately 215 million shares of our common stock. Half of the Purchased Options expire on December 1, 2011 and the remaining half of the Purchased Options expire on December 1, 2013. We paid an aggregate amount of $669.1 million of the proceeds from the sale of the Notes for the Purchased Options. We also entered into separate transactions in which we sold warrants to acquire, subject to customary anti-dilution adjustments, approximately 215 million shares of our common stock at an exercise price of approximately $19.55 per share of our common stock. Half of the Sold Warrants have expiration dates between February 15, 2012 and March 15, 2012 and the remaining half of the Sold Warrants have expiration dates between February 18, 2014 and March 18, 2014. We received aggregate proceeds of $391.1 million from the sale of the Sold Warrants. The Purchased Options and Sold Warrants will generally have the effect of increasing the conversion price of the Notes to approximately $19.55 per share of our common stock, representing an approximate 55% conversion premium based on the closing price of $12.61 per share of our common stock on November 13, 2006. The carrying amount reported in the consolidated balance sheet as of September 30, 2009 for our long-term convertible debt was $3,072.5 million. The fair value of the long-term convertible debt as of September 30, 2009 was $4,162.7 million based on active market prices for the debt. The following tables represent the key components of our convertible debt (tables in thousands):
As of September 30, 2009, the unamortized discount consists of $133.1 million which will be amortized over 2.3 years and an unamortized discount of $244.4 million which will be amortized over 4.3 years. The effective interest rate on the Notes was 5.6% for the quarters ended September 30, 2009 and 2008. The carrying amount of the equity component was $669.1 million at both September 30, 2009 and December 31, 2008.
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4. Non-controlling Interest in VMware, Inc. The effects of changes in our ownership interest in VMware on our equity were as follows (table in thousands):
5. Derivatives We hedge our exposure in foreign currency-denominated monetary assets and liabilities with foreign currency forward and option contracts. Since these derivatives hedge existing exposures that are denominated in foreign currencies, the contracts do not qualify for hedge accounting. Accordingly, these outstanding non-designated derivatives are recognized on the consolidated balance sheet at fair value, and the changes in fair value from these contracts are recorded in other income (expense), net, in the consolidated income statement. These derivative contracts mature in less than one year. We also use foreign currency forward and option contracts to hedge our exposure on a portion of our forecasted revenue and expense transactions and commodity option contracts to hedge our exposure on a portion of our forecasted energy expense transactions. These derivatives are designated as cash flow hedges and we did not have any derivatives designated as fair value hedges as of September 30, 2009 and December 31, 2008. All outstanding derivatives are recognized on the balance sheet at fair value and changes in their fair value are recorded in accumulated other comprehensive loss until the underlying forecasted transactions occur. To achieve hedge accounting, the criteria specified in authoritative guidance must be met. These criteria include (i) ensuring at the inception of the hedge that formal documentation exists for both the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge and (ii) at the inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value attributed to the hedged risk during the period that the hedge is designated. Further, an assessment of effectiveness is required at a minimum on a quarterly basis. Absent meeting these criteria, changes in fair value are recognized currently in other expense, net, in the consolidated income statement. Once the underlying forecasted transaction is realized, the gain or loss from the derivative designated as a hedge of the transaction is reclassified from accumulated other comprehensive loss to the consolidated income statement, in the related revenue or expense caption, as appropriate. In the event the underlying forecasted transaction does not occur, the amount recorded in accumulated other comprehensive loss will be reclassified to other income (expense), net, in the consolidated income statement in the then-current period. Any ineffective portion of the derivatives designated as cash flow hedges is recognized in current earnings. The ineffective portion of the derivatives includes gains or losses associated with differences between actual and forecasted amounts.
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The following table provides the major types of derivative instruments outstanding as of September 30, 2009 and December 31, 2008 (table in thousands):
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Table of ContentsEMC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The following tables provide the effect derivative instruments had on other comprehensive loss (“OCI”) and results of operations (tables in thousands):
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6. Investments and Fair Value In 2008, we adopted new authoritative guidance for fair value measurements that defines fair value, establishes a framework for measuring fair value and enhances disclosures about fair value measurements. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last is considered unobservable, that may be used to measure fair value:
In the second quarter of 2009, we adopted new authoritative literature that requires the credit component of an other-than-temporary impairment of investments in debt securities to be recognized in earnings and the non-credit component to be recognized in other comprehensive loss when the securities are not intended to be sold and it is more likely than not that we will not be required to sell the security prior to the recovery. The adoption of the pronouncement required the recording of a cumulative effect adjustment to retained earnings with a corresponding adjustment to other comprehensive loss equal to the present value of the cash flows expected to be collected less the amortized cost basis of the debt securities held at March 31, 2009 for which an other-than-temporary impairment was previously recognized for securities that we do not intend to sell nor is it more likely than not that we will be required to sell before recovery of its amortized cost basis. We elected not to record the cumulative effect adjustment, as the amount was de minimis to our financial condition. Our investments are comprised primarily of debt securities that are classified as available for sale and recorded at their fair market values. At September 30, 2009, with the exception of our auction rate securities, the vast majority of our investments were priced by pricing vendors. These pricing vendors utilize the most recent observable market information in pricing these securities or, if specific prices are not available for these securities, use other observable inputs. In the event observable inputs are not available, we assess other factors to determine the security’s market value, including broker quotes or model valuations. Each month, we perform independent price verifications of all of our holdings. In the event a price fails a pre-established tolerance check, it is researched so that we can assess the cause of the variance to determine what we believe is the appropriate fair market value. In general, investments with remaining effective maturities of 12 months or less from the balance sheet date are classified as short-term investments. Investments with remaining effective maturities of more than 12 months from the balance sheet date are classified as long-term investments. As a result of the lack of liquidity for auction rate securities, we have classified these as long-term investments as of September 30, 2009. At September 30, 2009, all of our available for sale, short- and long-term investments, excluding auction rate securities, were recognized at fair value, which was determined based upon observable inputs from our pricing service vendors for identical or similar assets. At September 30, 2009 and December 31, 2008, auction rate securities were valued using a discounted cash flow model.
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The following tables summarize the composition of our investments at September 30, 2009 and December 31, 2008 (tables in thousands):
The following table represents our fair value hierarchy for our financial assets and liabilities measured at fair value as of September 30, 2009 (table in thousands):
To determine the estimated fair value of our investment in auction rate securities, we used a discounted cash flow model. The assumptions used in preparing the discounted cash flow model include an incremental discount rate for the lack of liquidity in the market (“liquidity discount margin”) for an estimated period of time. The discount rate we selected was based on AA-rated banks as the majority of our portfolio is invested in student loans where EMC acts as a financier to these lenders. The liquidity discount margin represents an estimate of the additional return an investor would require for the lack of liquidity of these securities over an estimated five-year holding period. The rate used for the discount margin was 2% at September 30, 2009 versus 5% at December 31, 2008 as credit spreads on AA-rated banks have improved.
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The following table provides a summary of changes in fair value of our Level 3 financial assets for the three and nine months ended September 30, 2009 (table in thousands):
Unrealized losses on investments at September 30, 2009 by investment category and length of time the investment has been in a continuous unrealized loss position are as follows (table in thousands):
Investment Losses For the three months ended September 30, 2009, we recognized other-than-temporary impairment losses of $0.8 million, of which $0.2 million was recognized in other comprehensive loss and $0.6 million was recognized in earnings. We did not present these amounts on the Consolidated Income Statements because they are immaterial. For all of our securities where the amortized cost basis was greater than the fair value at September 30, 2009, we have concluded that currently we neither plan to sell the security nor is it more likely than not that we would be required to sell the security before its anticipated recovery. In making the determination as to whether the unrealized loss is other-than-temporary, we considered the length of time and extent the investment has been in an unrealized loss position, the financial condition and near-term prospects of the issuers, the issuers’ credit rating, the underlying value and performance of the collateral, third party guarantees and the time to maturity. The following table provides a summary of changes in credit losses on investments with other-than-temporary impairments (table in thousands):
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The significant components of the temporary impairments and credit loss are as follows: Auction Rate Securities Our auction rate securities are predominantly rated AAA and are primarily collateralized by student loans. The underlying loans of all but two of our auction rate securities, with a market value of $17.9 million, have partial guarantees by the U.S. government as part of the Federal Family Education Loan Program (“FFELP”) through the U.S. Department of Education. FFELP guarantees at least 95.0% of the loans which collateralize the auction rate securities. The two securities whose underlying loans are not guaranteed by the U.S. government have credit enhancements and are insured by third party agencies. We believe the quality of the collateral underlying all of our auction rate securities will enable us to recover our principal balance in full. Beginning in mid-February 2008, liquidity issues in the global credit markets resulted in the complete failure of auctions associated with our auction rate securities as the amount of securities submitted for sale in those auctions exceeded the amount of bids. For each unsuccessful auction, the interest rate moves to a maximum rate defined for each security, generally reset periodically at a level higher than defined short-term interest benchmarks. To date, we have collected all interest payable on all of our auction rate securities when due and expect to continue to do so in the future. The principal associated with failed auctions will not be accessible until successful auctions occur, a buyer is found outside of the auction process, the issuers establish a different form of financing to replace these securities, issuers repay principal over time from cash flows prior to final maturity, or final payments come due according to contractual maturities which range from 2024 to 2047. We understand that issuers and financial markets are in the process of developing alternatives that may improve liquidity, although it is not yet clear when or to what extent such efforts will be successful. We expect that we will receive the entire principal associated with these auction rate securities through one of the means described above, and accordingly, we did not experience credit losses within our Auction Rate Security portfolio. None of the auction rate securities in our portfolio are mortgage-backed or collateralized debt obligations. Asset- and Mortgage-Backed Securities Our asset- and mortgage-backed securities are predominantly rated AAA. The assets underlying these securities are generally residential or commercial obligations, automobile loans, credit card loans, equipment loans and home equity loans. The average maturity is 0.61 and 3.96 years for the asset-backed and mortgage-backed securities, respectively. For these securities, 59% are mortgage-backed. The mortgage loans may have fixed rate or adjustable rate terms. The remainder of the portfolio consists of asset-backed securities. To date, we have collected all interest payable on all these securities when due. For each security, regardless if it has a temporary decline in value, we analyzed the collateral value, collateral statistics, including the borrowers’ payment history and cash flows expected to be collected, and our position in the capital structure. We estimated the losses in the underlying loans for these securities and compared these losses to the amortized cost basis in the security. In estimating these losses, we included the remaining payment terms of the security, prepayment speeds, expected defaults and whether subordinated interests are capable of absorbing estimated losses on the loans underlying the security. For those securities where the underlying collateral is not sufficient or the expected cash flows to be collected is less than the amortized cost basis, we have recognized the credit component of the other-than-temporary losses on these securities. For the securities where the collateral and expected cash flows are deemed to be adequate, we believe we will realize the current cost basis of these securities based on our position in the credit structure and the aforementioned items previously mentioned. The contractual maturities of investments held at September 30, 2009 are as follows (table in thousands):
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The following table summarizes our strategic investments at September 30, 2009 and December 31, 2008 (table in thousands). The investments are classified within other assets, net, in the balance sheet and are stated at the lower of cost or fair value. Fair value for strategic investments in privately-held companies is primarily based on Level 2 and Level 3 inputs. Fair value for publicly-traded investments is determined based upon quoted prices representing a Level 1 input.
Gross unrealized gains on strategic investments were $5.0 million at September 30, 2009. Gross realized gains on strategic investments were $31.1 million for the quarter ended September 30, 2009. The realized gains primarily consist of adjustments to the fair value of previously held interests in Data Domain and SpringSource of $25.8 million (see Note 2). Gross realized losses on strategic investments were $2.0 million for the quarter ended September 30, 2009. 7. Inventories Inventories consist of (table in thousands):
8. Property, Plant and Equipment Property, plant and equipment consist of (table in thousands):
Building construction in progress at September 30, 2009 includes $62.7 million for facilities not yet placed in service that we are holding for future use. 9. Notes Receivable In June 2009, we entered into a term loan agreement with Quantum Corporation (“Quantum”), pursuant to which Quantum borrowed a principal amount equal to $75.4 million from us. The agreement requires quarterly interest payments at a rate of 12% per annum. The scheduled maturity date of this loan is September 30, 2014. In June 2009, we entered into a second term loan agreement with Quantum pursuant to which Quantum borrowed an aggregate principal amount equal to $46.3 million from us. This second loan agreement has terms similar to the first loan agreement with quarterly interest payments at a rate of 12% per annum and provides for two tranches of borrowings. Quantum
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borrowed an amount equal to $24.6 million under the first tranche, with a scheduled maturity date of September 30, 2014 and an amount equal to $21.7 million under the second tranche, with a scheduled maturity date of December 31, 2011. As of September 30, 2009, the aggregate outstanding principal amount under all loans was $121.7 million. These loans are junior to Quantum’s current senior debt and senior to all other indebtedness. These notes are included in “other assets, net” in the consolidated balance sheet. 10. Accrued Expenses Accrued expenses consist of (table in thousands):
Product Warranties Systems sales include a standard product warranty. At the time of the sale, we accrue for the systems’ warranty costs. The initial systems’ warranty accrual is based upon our historical experience, expected future costs and specific identification of the systems’ requirements. Upon expiration of the initial warranty, we may sell additional maintenance contracts to our customers. Revenue from these additional maintenance contracts is deferred and recognized ratably over the service period. The following represents the activity in our warranty accrual for our standard product warranty (table in thousands):
The provision includes amounts accrued for systems at the time of shipment, adjustments for changes in estimated costs for warranties on systems shipped in the period and changes in estimated costs for warranties on systems shipped in prior periods. It is not practicable to determine the amounts applicable to each of the components. Additionally, the accrual for the nine months ended September 30, 2008 includes $6.3 million assumed in the acquisition of Iomega Corporation.
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11. Shareholders’ Equity Net Income Per Share The reconciliation from basic to diluted earnings per share for both the numerators and denominators is as follows (table in thousands):
Options to acquire 114.5 million and 172.4 million shares of our common stock for the three and nine months ended September 30, 2009, respectively, and options to acquire 154.1 million and 116.6 million shares of our common stock for the three and nine months ended September 30, 2008, respectively, were excluded from the calculation of diluted earnings per share attributable to EMC Corporation shareholders because of their antidilutive effect. For the three and nine months ended September 30, 2009, there were no shares potentially issuable under our Notes and the Sold Warrants because these instruments were not “in-the-money.” For the three and nine months ended September 30, 2008, there were no shares and 0.1 million shares, respectively, potentially issuable under our Notes. For the three and nine months ended September 30, 2008, there were no shares potentially issuable under the Sold Warrants because these instruments were not “in-the-money”. The incremental dilution from VMware represents the impact of VMware’s dilutive securities on EMC’s diluted net income per share and is calculated by multiplying the difference between VMware’s basic and diluted earnings per share by the number of VMware shares owned by EMC. Accumulated Other Comprehensive Loss, Net Accumulated other comprehensive loss, net, which is presented net of tax, consists of the following (table in thousands):
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12. Restructuring and Acquisition-Related Charges For the three and nine months ended September 30, 2009, we incurred restructuring and acquisition-related charges of $34.8 million and $83.6 million, respectively. For the three months ended September 30, 2009, we incurred $20.3 million of restructuring charges, primarily related to our 2008 restructuring program and $14.5 million of costs were incurred in connection with acquisitions for financial advisory, legal and accounting services. For the nine months ended September 30, 2009, we incurred $66.6 million of restructuring charges, primarily related to our 2008 restructuring program and $17.0 million of costs were incurred in connection with acquisitions for financial advisory, legal and accounting services. For the third quarter of 2009, we also recognized a $12.5 million charge to write-off a prepaid royalty associated with a contractual obligation that included a minimum purchase commitment. We do not anticipate achieving the minimum purchase level. The charge is classified within cost of product sales on the accompanying Consolidated Income Statements. During the three months ended September 30, 2008, we recognized restructuring charges of $4.4 million. For the nine months ended September 30, 2008, we recognized restructuring net charges of $2.7 million. For purposes of presentation, $4.0 million is presented as a restructuring charge and $1.3 million is presented as a reduction to SG&A. In the fourth quarter of 2008, we implemented a restructuring program to further streamline the costs related to our Information Infrastructure business. The plan includes the following components:
In addition to this plan, we also recognized an asset impairment charge of $28.0 million for certain assets for which the forecasted cash flows from the assets were less than the assets’ net book value. The total charge resulting from these actions is expected to be between $362.0 million and $387.0 million, with $247.9 million recognized in 2008, $100.0 million to $125.0 million to be recognized in 2009 and 2010 and the remainder to be recognized through 2015. Total cash expenditures associated with the plan are expected to be in the range of $310.7 million to $335.7 million. Additionally, in the third quarter of 2008 we implemented a restructuring program resulting in a reduction in force of approximately 75 employees and the consolidation of excess facilities. The charges for the three and nine months ended September 30, 2009 were primarily attributable to recognizing additional expense related to the restructuring program implemented in the fourth quarter of 2008. The activity for each charge is explained in the following sections. 2008 Restructuring Programs The activity for the 2008 restructuring programs for the three and nine months ended September 30, 2009 and 2008 is presented below (tables in thousands): Three Months Ended September 30, 2009
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Nine Months Ended September 30, 2009
Three and Nine Months Ended September 30, 2008
For the three and nine months ended September 30, 2009, the adjustment to the workforce reductions provision is primarily attributable to individuals whose severance expense is being recognized ratably from the date of notification through their last day of work. These employees are required to render services beyond a minimum retention period in order to receive their severance. As of September 30, 2009, we had completed approximately 80% of the headcount reductions. The adjustment to the provision for the consolidation of excess facilities and other contractual obligations represents lease termination costs for facilities vacated in the quarter in accordance with our plan as part of our 2008 restructuring programs. The adjustment for abandoned assets represents additional identified infrastructure determined to no longer have benefit and abandoned in 2009. The remaining cash portion owed for the 2008 restructuring programs is $100.6 million. The cash expenditures relating to workforce reductions are expected to be substantially paid out by the end of 2010. The cash expenditures relating to the consolidation of excess facilities and other contractual obligations are expected to be paid out by the end of 2015. Prior Restructuring Programs Prior to 2008, we had instituted several restructuring programs. The activity for these programs for the three and nine months ended September 30, 2009 and 2008, respectively, is presented below (tables in thousands): Three Months Ended September 30, 2009
Nine Months Ended September 30, 2009
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Three Months Ended September 30, 2008
Nine Months Ended September 30, 2008
The remaining cash portion owed for these programs is $18.6 million. The cash expenditures relating to workforce reductions are expected to be substantially paid out by the end of 2010. The cash expenditures relating to the excess facilities are expected to be paid out by the end of 2015. The cash expenditures relating to the contractual obligations are expected to be paid out by the end of 2009. 13. Commitments and Contingencies Line of Credit We have available for use a credit line of $50.0 million in the United States. As of September 30, 2009, we had no borrowings outstanding on the line of credit. The credit line bears interest at the bank’s base rate and requires us, upon utilization of the credit line, to meet certain financial covenants with respect to limitations on losses. In the event the covenants are not met, the lender may require us to provide collateral to secure the outstanding balance, if any. At September 30, 2009, we were in compliance with the covenants. Litigation We are involved in a variety of claims, demands, suits, investigations, and proceedings, including those identified below, that arise from time to time relating to matters incidental to the ordinary course of our business, including actions with respect to contracts, intellectual property, product liability, employment, benefits and securities matters. As required by authoritative guidance, we have estimated the amount of probable losses that may result from any such pending matters, and such amounts are reflected in our consolidated financial statements. These recorded amounts are not material to our consolidated financial position or results of operations. While it is not possible to predict the outcome of these matters with certainty, we do not expect the results of any of these actions to have a material adverse effect on our business, results of operations or financial condition. Because litigation is inherently unpredictable, however, the actual amounts of loss may prove to be larger or smaller than the amounts reflected in our consolidated financial statements, and we could incur judgments or enter into settlements of claims that could adversely affect our operating results or cash flows in a particular period. United States ex rel. Rille and Roberts v. EMC Corporation. On February 27, 2009, the U.S. District Court for the Eastern District of Arkansas entered an order unsealing a civil False Claims Act “qui tam” action by two individuals (the “relators”) that named EMC as a defendant in December 2006. This action relates to the previously disclosed investigation being conducted by the Civil Division of the United States Department of Justice (the “DoJ”) regarding (i) EMC’s fee arrangements with systems integrators and other partners in federal government transactions, and (ii) EMC’s compliance with the terms and conditions of
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certain agreements pursuant to which we sold products and services to the federal government. By the same order of February 27, 2009, the U.S. District Court for the Eastern District of Arkansas also unsealed a complaint in intervention filed by the DoJ in June 2008 in this matter and directed that EMC be served with both complaints. The DoJ complaint, which adopts the claims advanced by the relators, asserts claims under the Anti-Kickback Act and False Claims Act in addition to breach of contract and other claims. The DoJ and the relators seek various remedies, including treble damages and statutory penalties. By order dated June 3, 2009, the Arkansas Court granted a motion by EMC to transfer the action to the U.S. District Court for the Eastern District of Virginia, where it is now pending. This action could lead to other related proceedings by various agencies of the federal government, which could result in suspension or debarment from sales to the federal government. We are defending this matter vigorously. Derivative Demand Letters. In April 2009, we received two derivative demand letters sent on behalf of individuals purporting to be EMC shareholders. Both letters contain allegations to the effect that the existence of the matter captioned United States ex rel. Rille and Roberts v. EMC Corporation serves as evidence that certain Company officers and directors failed to exercise due care and/or failed to oversee compliance with the laws identified in the Roberts complaints. The matters relating to the demand letters were referred to a Special Committee of independent directors of the Board of Directors, which investigated and made a determination regarding such allegations. At the conclusion of their investigation, the Special Committee determined in good faith that commencing or maintaining derivative proceedings based on the allegations would not be in the best interests of EMC. In October 2009, one of the individuals filed a complaint in the Superior Court for Middlesex County in Massachusetts alleging claims for breach of fiduciary duty against EMC directors and certain officers based on the same allegations set forth in the demand letter. We intend to defend this matter vigorously. 14. Segment Information We manage our business in two broad categories: EMC Information Infrastructure and VMware Virtual Infrastructure. EMC Information Infrastructure operates in three segments: Information Storage, Content Management and Archiving and RSA Information Security, while VMware Virtual Infrastructure operates in a single segment. Our management measures are designed to assess performance of these operating segments excluding certain items. As a result, corporate reconciling items are used to capture the items excluded from segment operating performance measures, including stock-based compensation expense and intangible asset amortization expense. Additionally, in certain instances, IPR&D charges, restructuring and acquisition-related charges and infrequently occurring gains or losses are also excluded from the measures used by management in assessing segment performance. The VMware Virtual Infrastructure amounts represent the revenues and expenses of VMware as reflected within EMC’s consolidated financial statements. Research and development expenses, SG&A and other income associated with the EMC Information Infrastructure business are not allocated to the segments within the EMC Information Infrastructure business, as they are managed centrally at the business unit level. For the three segments within the EMC Information Infrastructure business, gross profit is the segment operating performance measure.
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Our segment information for the three and nine months ended September 30, 2009 and 2008 is as follows (tables in thousands, except percentages):
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