Riverbed Technology 10-Q 2012
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2012
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 001-33023
Riverbed Technology, Inc.
(Exact name of registrant as specified in its charter)
199 Fremont Street
San Francisco, California 94105
(Address of Principal Executive Offices including Zip Code)
(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 o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§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 o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act). Yes o No x
The number of shares of the registrant’s common stock, par value $0.0001, outstanding as of October 18, 2012 was: 153,893,507.
RIVERBED TECHNOLOGY, INC.
RIVERBED TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
As of September 30, 2012 and December 31, 2011
(in thousands, except par value)
See Notes to Condensed Consolidated Financial Statements.
RIVERBED TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
See Notes to Condensed Consolidated Financial Statements.
RIVERBED TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See Notes to Condensed Consolidated Financial Statements.
RIVERBED TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See Notes to Condensed Consolidated Financial Statements.
RIVERBED TECHNOLOGY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Riverbed Technology, Inc. was founded on May 23, 2002 and has developed innovative and comprehensive solutions to the fundamental problems associated with IT performance across wide area networks (WANs). Our portfolio of IT performance products enable our customers to simply and efficiently improve the performance of their applications and access to their data over WANs, and provide global application performance, reporting and analytics, application delivery control and cloud storage.
Significant Accounting Policies
Basis of Presentation
The condensed consolidated financial statements include our accounts and the accounts of our wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated. The accompanying condensed consolidated balance sheet as of September 30, 2012, the condensed consolidated statements of operations for the three and nine months ended September 30, 2012 and 2011, the condensed consolidated statements of comprehensive income for the three and nine months ended September 30, 2012 and 2011, and the condensed consolidated statements of cash flows for the nine months ended September 30, 2012 and 2011 are unaudited. The accompanying statements should be read in conjunction with the audited consolidated financial statements and related notes contained in our Annual Report on Form 10-K for the year ended December 31, 2011.
The accompanying condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (GAAP) pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). They do not include all of the financial information and footnotes required by GAAP for complete financial statements. We believe the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited financial statements and include all adjustments necessary for the fair presentation of our balance sheet as of September 30, 2012, our results of operations and comprehensive income for the three and nine months ended September 30, 2012 and 2011 and our cash flows for the nine months ended September 30, 2012 and 2011. All adjustments are of a normal recurring nature. The results for the nine months ended September 30, 2012 are not necessarily indicative of the results to be expected for any subsequent quarter or for the year ending December 31, 2012.
There have been no significant changes in our critical accounting policies during the three and nine months ended September 30, 2012, as compared to the critical accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2011.
Use of Estimates
Our condensed consolidated financial statements are prepared in accordance with GAAP. These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. Significant estimates and assumptions made by management include the determination of the fair value of stock awards issued, inventory valuation, the accounting for income taxes, including the determination of the timing of the establishment or release of our valuation allowance related to our deferred tax asset balances and reserves for uncertain tax positions, the accounting for business combinations and the accounting for acquisition-related contingent consideration. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments were made. To the extent there are material differences between these estimates and actual results, our condensed consolidated financial statements will be affected.
We have evaluated subsequent events through the date these condensed consolidated financial statements were issued.
We recognize revenue when all of the following have occurred: (1) we have entered into a legally binding arrangement with a customer; (2) delivery has occurred; (3) customer payment is deemed fixed or determinable and free of contingencies
and significant uncertainties; and (4) collection is reasonably assured.
The majority of our product revenue includes hardware appliances containing software components that function together to provide the essential functionality of the product. Therefore, our hardware appliances are considered non-software deliverables. Most non-software products and services qualify as separate units of accounting because they have value to the customer on a standalone basis and our revenue arrangements generally do not include a general right of return relative to delivered products. We account for non-software arrangements with multiple deliverables, which generally include support services sold with each of our hardware appliances, using the relative selling price method under the revenue recognition guidance for multiple deliverable arrangements.
Our product revenue also includes revenue from the sale of stand-alone software products. Stand-alone software may operate on our hardware appliance, but is not considered essential to the functionality of the hardware. Stand-alone software products generally include a perpetual license to our software. Stand-alone software sales are subject to the industry specific software revenue recognition guidance.
Certain arrangements with multiple deliverables may have stand-alone software deliverables that are subject to the software revenue recognition guidance along with non-software deliverables. The revenue for these multiple deliverable arrangements is allocated to the stand-alone software deliverables as a group and the non-software deliverables based on the relative selling prices of all of the deliverables in the arrangement.
The amount of product and services revenue recognized for arrangements with multiple deliverables is impacted by our valuation of relative selling prices. We apply the selling price hierarchy using vendor specific objective evidence (VSOE) when available, third-party evidence of selling price (TPE) if VSOE does not exist, and estimated selling price (ESP) if neither VSOE nor TPE is available.
VSOE of fair value for elements of an arrangement is based upon the normal pricing and discounting practices for a deliverable when sold separately, and VSOE for support services is further measured by the renewal rate offered to the customer. In determining VSOE, we require that a substantial majority of the selling prices fall within a reasonably narrow pricing range, generally evidenced by a substantial majority of such historical stand-alone transactions falling within a reasonably narrow range of the median rates. In addition, we consider major service groups, geographies, customer classifications, and other variables in determining VSOE.
We are typically not able to determine TPE for our products or services. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, our go-to-market strategy differs from that of our peers and our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, we are unable to reliably determine what similar competitor products’ selling prices are on a stand-alone basis.
When we are unable to establish the estimated stand-alone value of our non-software deliverables using VSOE or TPE, we use ESP in our allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine ESP for a product or service by considering multiple factors including, but not limited to, cost of products, gross margin objectives, pricing practices, geographies, customer classes and distribution channels.
For stand-alone software sales, we recognize revenue based on software revenue recognition guidance. Under the software revenue recognition guidance, we use the residual method to recognize revenue when an agreement includes one or more elements to be delivered at a future date and VSOE of the fair value of all undelivered elements exists. In the majority of our contracts, the only element that remains undelivered at the time of delivery of the product is support services. Under the residual method, the fair value of the undelivered stand-alone software which is typically support services is deferred and the remaining portion of the contract fee is recognized as product revenue. If evidence of the fair value of one or more undelivered stand-alone software elements does not exist, all revenue is generally deferred and recognized when delivery of those elements occurs or when fair value can be established. When the undelivered stand-alone software for which we do not have VSOE of fair value is support, revenue for the entire arrangement is bundled and recognized ratably over the support period.
For our non-software deliverables, we allocate the arrangement consideration based on the relative selling price of the deliverables. For our hardware appliances we use the ESP of the deliverable. For our support and services, we generally use VSOE as our relative selling price. When we are unable to establish VSOE for our support and services, we use ESP in our allocation of arrangement consideration. We regularly review VSOE and ESP. As our go-to-market strategies evolve, we may modify our pricing practices in the future, which could result in changes in selling prices, including both VSOE and ESP.
For sales to direct end-users and channel partners, including value-added resellers, value-added distributors, service
providers, and systems integrators, we recognize product revenue upon delivery, assuming all other revenue recognition criteria are met. For our hardware appliances, delivery occurs upon transfer of title and risk of loss, which is generally upon shipment. It is our practice to identify an end-user prior to shipment to a channel partner. For end-users and channel partners, we generally have no significant obligations for future performance such as rights of return or pricing credits. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue.
Support and services consist of support services, professional services, and training. Support services include repair and replacement of defective hardware appliances, software updates and access to technical support personnel. Software updates provide customers with rights to unspecified software product upgrades and to maintenance releases and patches released during the term of the support period. Revenue for support services is recognized on a straight-line basis over the service contract term, which is typically 1 to 3 years. Professional services are recognized upon delivery or completion of performance. Professional service arrangements are typically short term in nature and are largely completed within 90 days from the start of service. Training services are recognized upon delivery of the training.
Our fees are typically considered to be fixed or determinable at the inception of an arrangement, generally based on specific products and quantities to be delivered. Substantially all of our contracts do not include rights of return or acceptance provisions. To the extent that our agreements contain such terms, we recognize revenue once the acceptance provisions or right of return lapses. Payment terms to customers generally range from net 30 to 75 days. In the event payment terms are provided that differ from our standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.
We assess the ability to collect from our customers based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. If the customer is not deemed credit worthy, we defer revenue from the arrangement until payment is received and all other revenue recognition criteria have been met.
Inventory consists of hardware and related component parts and is stated at the lower of cost (on a first-in, first-out basis) or market. A portion of our inventory relates to evaluation units located at customer locations, as some of our customers test our equipment prior to purchasing. Inventory that is obsolete or in excess of our forecasted demand is written down to its estimated realizable value based on historical usage, expected demand, and with respect to evaluation units, the historical conversion rate, the age of the units, and the estimated loss of utility. Inherent in our estimates of market value in determining inventory valuation are estimates related to economic trends, future demand for our products, the timing of new product introductions and technological obsolescence of our products. Inventory write-downs are recognized as cost of product and amounted to $1.5 million and $1.6 million in the three months ended September 30, 2012 and 2011, respectively, and $4.7 million and $4.8 million in the nine months ended September 30, 2012 and 2011, respectively.
We hold service inventory that is used to repair or replace defective hardware reported by our customers who purchase support services. We classify service inventory as Prepaid expenses and other current assets. At September 30, 2012 and December 31, 2011, our service inventory balance was $13.1 million and $9.3 million, respectively.
Stock-based awards granted include stock options, restricted stock units (RSUs), and stock purchased under our Employee Stock Purchase Plan (the Purchase Plan). Stock-based compensation cost is measured at the grant date, based on the fair value of the awards, and is recognized as expense over the requisite service period only for those equity awards expected to vest.
The fair value of the RSUs is determined based on the stock price on the date of grant. The fair value of the RSUs is amortized on a straight-line basis over the requisite service period of the awards, which is generally three to four years. We estimated the fair value of stock options and stock purchased under our Purchase Plan using the Black-Scholes model. This model utilizes the estimated fair value of common stock and requires that, at the date of grant, we use the expected term of the grant, the expected volatility of the price of our common stock, risk-free interest rates and expected dividend yield of our common stock. The fair value is amortized on a straight-line basis over the requisite service periods of the awards, which is generally three to four years for stock options, and six months to two years for options to purchase stock under our Purchase Plan.
Accounting for Income Taxes
We use the asset and liability method of accounting for income taxes. Under this method, income tax expenses or benefits
are recognized for the amount of taxes payable or refundable for the current year and for deferred tax liabilities and assets for the expected tax consequences of temporary differences between the tax bases of assets and liabilities for financial reporting purposes and amounts recognized for income tax purposes. The measurement of current and deferred tax assets and liabilities are based on provisions of currently enacted tax laws. The effects of future changes in tax laws or rates are not contemplated.
As part of the process of preparing our condensed consolidated financial statements, we are required to estimate our income tax expense and tax contingencies in each of the tax jurisdictions in which we operate. This process involves estimating current income tax expense together with assessing temporary differences in the treatment of items for tax purposes versus financial accounting purposes that may create net deferred tax assets and liabilities. We rely on estimates and assumptions in preparing our income tax provision.
We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent earning experience by jurisdiction, expectations of future taxable income, and the carryforward periods available to us for tax reporting purposes, as well as other relevant factors. We may establish a valuation allowance to reduce deferred tax assets to the amount we believe is more likely than not to be realized. Due to inherent complexities arising from the nature of our businesses, future changes in income tax law, or variances between our actual and anticipated operating results, we make certain judgments and estimates. Therefore, actual income taxes could materially vary from these estimates.
We are subject to periodic audits by the Internal Revenue Service and other taxing authorities. These audits may challenge certain tax positions we have taken, such as the timing and amount of deductions and allocation of taxable income to the various tax jurisdictions. The accounting for income tax contingencies may require significant management judgment in estimating final outcomes. Actual results could differ materially from these estimates and could significantly affect the effective tax rate and cash flows in future years. We have elected to record interest and penalties in the financial statements as a component of income taxes.
Goodwill, Intangible Assets and Impairment Assessments
Goodwill represents the excess of the purchase price of an acquired business over the fair value of the underlying net tangible and intangible assets. Goodwill is tested for impairment at least annually (more frequently if certain indicators are present). In the event that we determine that the fair value of our single reporting unit is less than the reporting unit’s carrying value, we will incur an impairment charge for the amount of the difference during the quarter in which the determination is made.
Intangible assets that are not considered to have an indefinite life are amortized over their useful lives. On a periodic basis, we evaluate the estimated remaining useful life of purchased intangible assets and whether events or changes in circumstances warrant a revision to the remaining period of amortization. The carrying amounts of these assets are periodically reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable. Recoverability of these assets is measured by comparison of the carrying amount of each asset to the future undiscounted cash flows the asset is expected to generate. In the event that we determine certain assets are not fully recoverable, we will incur an impairment charge for those assets or portion thereof during the quarter in which the determination is made.
Recoverability of indefinite lived intangible assets is measured by comparison of the carrying amount of the asset to the future discounted cash flow the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired assets. No material impairments of intangible assets were identified during any of the periods presented.
In our business combinations, we are required to recognize all the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. Further, acquisition-related costs are recognized separately from the acquisition and expensed as incurred; restructuring costs are generally expensed in periods subsequent to the acquisition date; changes in the estimated fair value of contingent consideration after the initial measurement on the acquisition date are recognized in earnings in the period of the change in estimate; and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period are recognized as a component of provision for taxes. In addition, the fair value of in-process research and development is recorded as an indefinite-lived intangible asset until the underlying project is completed, at which time the intangible asset is amortized over its estimated useful life, or abandoned, at which time the intangible asset is expensed.
Accounting for business combinations requires management to make significant estimates and assumptions, especially at the acquisition date with respect to intangible assets, estimated contingent consideration payments and pre-acquisition
Although we believe the assumptions and estimates we have made have been reasonable and appropriate, they are based in part on historical experience and information obtained from management of the acquired company and are inherently uncertain. Examples of critical estimates in accounting for acquisitions include but are not limited to:
Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.
Derivative Financial Instruments
We use derivative instruments to manage our short-term exposures to fluctuations in foreign currency exchange rates, which exist as part of ongoing business operations. Our general practice is to hedge a majority of transaction exposures denominated in British pounds, euros, and Singapore dollars. These instruments have maturities between one to three months in the future. We do not enter into any derivative instruments for trading or speculative purposes.
We account for our derivative instruments as either assets or liabilities on the balance sheet and carry them at fair value. Gains and losses resulting from changes in fair value are accounted for depending on the use of the derivative and whether it is designated and qualifies for hedge accounting. Derivatives that qualify for hedge accounting are initially included in Accumulated other comprehensive income (loss) and subsequently reclassified into earnings upon the occurrence of the forecasted transactions to which they hedge. Derivatives that do not qualify for hedge accounting are adjusted to fair value each period through earnings.
Concentrations of Risk
Financial instruments that are potentially subject to concentrations of credit risk consist primarily of cash, cash equivalents, marketable securities, and trade receivables. Investment policies have been implemented that limit investments to investment grade securities. The average portfolio maturity is currently less than a year. The risk with respect to trade receivables is mitigated by credit evaluations we perform on our customers and by the diversification of our customer base. One value-added distributor, Arrow Enterprise Computing Solutions, Inc. (Arrow), accounted for 11% and 14% of our trade receivable balance as of September 30, 2012 and December 31, 2011, respectively. One value-added distributor, Arrow, represented 17% of our revenue for the three months ended September 30, 2012. Two value-added distributors, Arrow and Avnet, Inc., represented 17% and 10%, respectively, of our revenue for the nine months ended September 30, 2012. One value-added distributor, Arrow, represented 14% of our revenue for each of the three and nine months ended September 30, 2011.
We outsource the production of our inventory to third-party manufacturers. We rely on purchase orders or long-term contracts with our contract manufacturers. At September 30, 2012, we had no long-term contractual commitment with any manufacturer; however, we did have a P90D day commitment totaling $5.3 million.
Recent Accounting Pronouncements
In July 2012, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2012-02, Intangibles-Goodwill and Other (Topic 350)-Testing Indefinite-Lived Intangible Assets for Impairment (ASU 2012-02), to allow entities to use a qualitative approach to test indefinite-lived intangible assets for impairment. ASU 2012-02 permits an entity to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying value. If it is concluded that this is the case, it is necessary to perform the currently prescribed quantitative impairment test by comparing the fair value of the indefinite-lived intangible asset with its carrying value. Otherwise, the quantitative impairment test is not required. ASU 2012-02 is effective for us in fiscal 2014 and earlier adoption is permitted. We are currently evaluating the impact of our pending adoption of ASU 2012-02 on our consolidated financial statements.
In December 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities (ASU 2011-11), that requires an entity to disclose additional information about offsetting and related arrangements to enable users of the financial statements to understand the effect of those arrangements on the financial
position. ASU 2011-11 will be effective for us in fiscal 2013 and any related disclosures required will be applied retrospectively. We believe that the adoption of ASU 2011-11 may impact future disclosures but will not impact our consolidated financial statements.
Fiscal 2012 Acquisitions
On January 11, 2012, we entered into an agreement to purchase certain assets of Expand Networks Ltd. (Expand), including its intellectual property, for $6.5 million. We did not purchase the corporate entity of Expand and have not assumed any of Expand's liabilities or obligations. We did not consider this acquisition significant.
Fiscal 2011 Acquisitions
Zeus Technology Ltd.
In July 2011, we acquired the outstanding securities of Zeus Technology Ltd. (Zeus). The acquisition expanded our products and technology to compete in the virtual ADC market. Zeus pioneered the development of software-based highly scalable ADCs that deliver high-performance software-based load balancing and traffic management solutions for virtual and cloud environments. We have included the financial results of Zeus in our consolidated financial statements from the acquisition date.
Pursuant to the share purchase agreement with Zeus we made payments totaling $105.6 million in cash for all of the outstanding securities of Zeus on July 19, 2011. In addition, the share purchase agreement provided for certain additional potential payments (acquisition-related contingent consideration) totaling up to $27.0 million in cash, based on achievement of certain bookings targets related to Zeus products for the period from July 20, 2011 through July 31, 2012 (the Zeus Earn-Out period). The share purchase agreement also provided for a potential $3.0 million payment as an incentive bonus to former employees of Zeus, based on achievement of certain bookings targets related to Zeus products for the Zeus Earn-Out period.
Fair Value of Consideration Transferred
The total acquisition date fair value of the consideration transferred was estimated at $119.1 million, which included the initial payments totaling $105.6 million in cash and a liability of $13.5 million for the acquisition date fair value of the acquisition-related contingent consideration. The change in the fair value of the acquisition-related contingent consideration subsequent to the acquisition date, including changes from events after the acquisition date, such as changes in our estimate of the bookings targets, was recognized in earnings in the period the estimated fair value changed. The fair value estimate was based on the probability weighted bookings to be achieved over the Zeus Earn-Out period. Actual achievement of bookings below $25.0 million reduced the liability to zero and achievement of bookings of $40.0 million or more would have increased the liability to $27.0 million.
We estimated the fair value of the acquisition-related contingent consideration using a probability-weighted discounted cash flow model. This fair value measurement is based on significant inputs not observed in the market and thus represents a Level 3 measurement. Level 3 instruments are valued based on unobservable inputs that are supported by little or no market activity and reflect our own assumptions in measuring fair value. The estimated fair value of acquisition-related contingent consideration of $13.5 million included amounts to be distributed directly to shareholders, discounted at 17.5%, but excluded a fair value estimate of $1.7 million to be paid to former employees of Zeus. During the three and nine months ended September 30, 2012, we reduced the contingent consideration liability by $3.9 million and $14.1 million, respectively, which was recorded in Acquisition-related costs (credits), due to changes in the fair value of acquisition-related contingent consideration to be distributed directly to former Zeus shareholders. As of September 30, 2012, the acquisition-related contingent consideration liability to Zeus shareholders is zero. The amount of the acquisition-related contingent consideration liability to Zeus shareholders is based on our determination that the applicable bookings target related to Zeus products for the Zeus Earn-Out period was not achieved. The representative of the Zeus shareholders has exercised its contractual right to examine our determination of actual bookings related to Zeus products, and is currently disputing our determination and contending that the entire $27.0 million in contingent consideration is payable to Zeus shareholders. We believe that the contention of the representative of the Zeus shareholders is without merit and intend to vigorously defend our determination.
At the acquisition date, we estimated the fair value of an incentive bonus to be paid to the former employees of Zeus (Zeus incentive bonus) to be $1.7 million. This fair value was also estimated using a probability-weighted discounted cash flow model on the achievement of the bookings target. No liability for the Zeus incentive bonus was recorded as of the acquisition date, as this component is considered compensatory and was recognized as compensation cost in operating expense ratably over the service period from July 20, 2011 to July 31, 2012. As of September 30, 2012, we estimated the fair value of the
incentive bonus to be paid to the former employees of Zeus to be zero based on our determination that the applicable bookings target related to Zeus products for the Zeus Earn-Out period was not achieved. During the three and nine months ended September 30, 2012, we recorded credits to acquisition-related compensation cost of $0.3 million, and $0.7 million, respectively, for the incentive bonus to be paid to the former employees of Zeus.
In July 2011, we acquired the outstanding securities of Aptimize Ltd. (Aptimize) to expand our product offerings. We have included the financial results of Aptimize in our consolidated results from the acquisition date. This acquisition was not significant, and therefore the pro forma results of operations have not been presented.
Pursuant to the share purchase agreement with Aptimize we made payments totaling $17.3 million in cash for all of the outstanding securities of Aptimize. In addition, the share purchase agreement provided for certain additional potential payments (acquisition-related contingent consideration) totaling up to $17.0 million in cash to be paid to Aptimize shareholders, based on achievement of certain bookings targets related to Aptimize products for the period from September 1, 2011 through September 30, 2012. There was no change in the acquisition-related contingent consideration for Aptimize shareholders in the three months ended September 30, 2012. During the nine months ended September 30, 2012, we reduced the contingent consideration liability by $1.1 million, which was recorded in Acquisition-related costs (credits), due to a change in the fair value of acquisition-related contingent consideration to be distributed directly to former Aptimize shareholders. As of September 30, 2012, the acquisition-related contingent consideration liability to Aptimize shareholders is zero.
For a given acquisition, we may identify certain pre-acquisition contingencies that existed at the acquisition date and may extend our review and evaluation of these pre-acquisition contingencies throughout the measurement period in order to obtain sufficient information to assess whether we can reasonably determine the fair value of these contingencies by the end of the measurement period.
During the measurement period, we will recognize an asset or a liability with a corresponding adjustment to goodwill for such pre-acquisition contingency if: (i) it is probable that an asset existed or a liability had been incurred at the acquisition date and (ii) the amount of the asset or liability can be reasonably estimated. Subsequent to the measurement period, changes in our estimates of such contingencies will affect earnings and could have a material effect on our results of operations and financial position.
Acquisition-related Costs (Credits)
Acquisition-related costs (credits) include transaction costs, integration and other acquisition-related costs and changes in the fair value of the acquisition-related contingent consideration. During the three and nine months ended September 30, 2012, we recorded a credit of $3.9 million and $14.1 million, respectively, related to change in fair value of the acquisition-related contingent consideration to be paid directly to the Zeus shareholders for the three and nine months ended September 30, 2012. During the nine months ended September 30, 2012, we recorded a credit of $1.1 million related to change in fair value of the acquisition-related contingent consideration to be paid directly to the Aptimize shareholders. There was no change in the fair value of the acquisition-related contingent consideration to be paid directly to the Aptimize shareholders during the three months ended September 30, 2012.
Basic net income per common share is computed by dividing net income by the weighted average number of vested common shares outstanding during the period. Diluted net income per common share is computed by giving effect to all potential dilutive common shares, including stock awards. The following table sets forth the computation of net income per share:
Stock options outstanding with an exercise price higher than our average stock price for the periods presented, represent out-of-the-money awards and are excluded from the calculations of the diluted net income per share since the effect would have been anti-dilutive under the treasury stock method.
The following weighted average outstanding options were excluded from the computation of diluted net income per common share for the periods presented because including them would have had an anti-dilutive effect:
As of September 30, 2012, the fair value measurements of our cash, cash equivalents and investments, derivative assets and acquisition-related contingent consideration consisted of the following:
As of December 31, 2011, the fair value measurements of our cash, cash equivalents and investments and acquisition-related contingent consideration consisted of the following:
The following tables present the gross unrealized gains and gross unrealized losses as of September 30, 2012 and December 31, 2011:
We have evaluated our investments as of September 30, 2012 and have determined that no investments with unrealized losses are other-than-temporarily impaired. No investments have been in a continuous loss position greater than one year.
Cash, Cash Equivalents and Investments
Cash and cash equivalents consist primarily of highly liquid investments in money market mutual funds, government-sponsored enterprise obligations, treasury bills, commercial paper and other money market securities with remaining maturities at date of purchase of 90 days or less. The carrying value of cash and cash equivalents at September 30, 2012 and December 31, 2011 was $279.3 million and $215.5 million, respectively. The carrying value approximates fair value at September 30, 2012 and December 31, 2011.
Investments, which are classified as available for sale at September 30, 2012, are carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of stockholders’ equity. Investments consist of government-sponsored enterprise obligations, treasury bills, FDIC-backed certificates of deposit and corporate bonds and notes. The fair value of our investments is determined as the exit price in the principal market in which we would transact. Level 1 instruments are valued based on quoted market prices in active markets and include treasury bills and money market funds. Level 2 instruments are valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency and include corporate bonds and notes, municipal bonds, government-sponsored enterprise obligations and FDIC-backed certificates of deposit. Level 3 instruments are valued based on unobservable inputs that are supported by little or no market activity and reflect our own assumptions in measuring fair value. As of September 30, 2012 and December 31, 2011 we had no investments valued as Level 3 instruments. As of September 30, 2012 and December 31, 2011, the investments are recorded at amortized cost, which approximates fair market value. Generally, our investments have maturity dates up to two years from our date of purchase and active markets for these investments exist.
Restricted cash primarily represents collateralized letters of credit established in connection with lease agreements for our facilities. Current restricted cash totaled $1.3 million and $1.1 million as of September 30, 2012 and December 31, 2011, respectively. Current restricted cash is included in Prepaid expenses and other current assets in the consolidated balance sheet. Long-term restricted cash totaled $7.7 million and $6.0 million at September 30, 2012 and December 31, 2011, respectively. Long-term restricted cash is included in Other assets in the consolidated balance sheets and consists primarily of funds held as collateral for letters of credit for the security deposit on the leases of our corporate headquarters.
Fair Value of Derivative Instruments
We use derivative instruments to partially offset our market exposures to fluctuations in certain foreign currency exchange rates, which exist as part of ongoing business operations. These derivatives are considered Level 2 instruments. Derivative assets are included in Prepaid expenses and other current assets in the consolidated balance sheet. Derivative liabilities are included in Other accrued liabilities in the consolidated balance sheet. Refer to Note 10 for additional derivative financial instrument disclosure.
Acquisition-related Contingent Consideration
We estimated the fair value of the acquisition-related contingent consideration using a probability-weighted discounted cash flow model. This fair value measure was based on significant inputs not observed in the market and thus represented a Level 3 instrument. Level 3 instruments are valued based on unobservable inputs that are supported by little or no market activity and reflect our own assumptions in measuring fair value.
The change in the acquisition-related contingent consideration liability consisted of the following:
Inventories consist primarily of hardware and related component parts and evaluation units located at customer locations, and are stated at the lower of cost (on a first-in, first-out basis) or market. Inventory is comprised of the following:
Goodwill represents the excess of the purchase price of an acquired business over the fair value of the underlying net tangible and intangible assets. We consider the acquired businesses additions to our product portfolio and not additional reporting units or operating segments. We record goodwill adjustments pursuant to changes to net assets acquired during the measurement period, which is generally up to one year from the date of acquisition. A portion of the goodwill associated with the acquisitions of Global Protocols, LLC, Zeus and Aptimize, will be deductible for income tax purposes.
The change in goodwill consisted of the following:
Deferred revenue consisted of the following:
Deferred product revenue relates to arrangements where not all revenue recognition criteria have been met. During the third quarter of 2012, we recorded $65.0 million to deferred product revenue related to cash received from Juniper Networks, Inc. (Juniper).
Effective July 3, 2012, we entered into multiple agreements contemporaneously with Juniper pursuant to which we acquired certain rights and licenses to Juniper's WX WAN optimization product line, entered into a technology integration agreement to integrate our Steelhead® Mobile technology into the Juniper Networks® Junos® Pulse client to enable a mobile acceleration solution for mobile phones and tablets, and granted Juniper a source code license for our application delivery controller (ADC) technology and related tools with rights to modify, create and distribute their own ADC product.
Pursuant to these agreements, Juniper will pay us approximately $75.0 million, with the initial payment made in July 2012 of $65.0 million and $10.0 million due at the first anniversary of the effective date, and transfer to us certain assets of the Juniper WX WAN optimization business primarily related to customer lists, which was valued at $0.7 million. The consideration transferred to Juniper was a source code license to our ADC technology for distribution on their appliances and four years of nonstandard product support valued at $75.7 million. The transaction was accounted for as a business combination, and there was no goodwill recorded as part of the transaction. We will recognize the initial payment of $65.0 million as revenue ratably over the four-year support term, because we do not have VSOE of fair value for the undelivered nonstandard support services. As of September 30, 2012, based on cash received, $61.0 million of this transaction remained in deferred product revenue.
Deferred support revenue represents customer payments made in advance for support contracts. Support contracts are typically billed on a per annum basis in advance and revenue is recognized ratably over the support period.
Deferred revenue, non-current consists primarily of deferred revenue related to the Juniper transaction and customer payments made in advance for support contracts with terms of more than 12 months.
Our agreements with customers, as well as our reseller agreements, generally include certain provisions for indemnifying customers and resellers and their affiliated parties against liabilities if our products infringe a third party’s intellectual property rights. To date, we have not incurred any material costs as a result of such indemnifications and have not accrued any liabilities related to such obligations in our condensed consolidated financial statements.
As permitted or required under Delaware law and to the maximum extent allowable under that law, we have certain obligations to indemnify our officers, directors and certain key employees for certain events or occurrences while the officer, director or employee is or was serving at our request in such capacity. These indemnification obligations are valid as long as the director, officer or employee acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal proceeding, had no reasonable cause to believe his or her conduct was unlawful. The maximum potential amount of future payments we could be required to make under these indemnification obligations is unlimited; however, we have a director and officer insurance policy that mitigates our exposure and enables us to recover a portion of any future amounts paid.
We lease our facilities under non-cancelable operating lease agreements. Future minimum commitments for these operating leases in place as of September 30, 2012 with a remaining non-cancelable lease term in excess of one year are as follows:
The terms of certain lease agreements provide for rental payments on a graduated basis. We recognize rent expense on a straight-line basis over the lease period and have accrued for rent expense incurred but not paid. Rent expense under operating leases was $3.6 million and $2.9 million for the three months ended September 30, 2012 and 2011, respectively, and $9.8 million and $8.1 million for the nine months ended September 30, 2012 and 2011, respectively.
On February 2, 2012, we entered into a lease agreement, pursuant to which we will lease office space for an initial term of ten years, located at 680 Folsom Street, San Francisco, California. On April 13, 2012, we signed the first amendment to the lease agreement for additional space. Following the completion of certain construction, which we anticipate to be completed by August 2014, we intend to use the leased space as our new worldwide corporate headquarters. The base annual rent for the leased space will range from approximately $8.1 million to $11.0 million, none of which is expected to be due until construction has been completed and we have occupied the leased space. In addition to the base rent, we will be responsible for payment of certain operating expenses, including utilities and real estate taxes.
We use derivative instruments to partially offset our market exposures to fluctuations in certain foreign currency exchange rates, which exist as part of ongoing business operations. Our general practice is to hedge a majority of transaction exposures denominated in British pounds, Euros, Australian dollars and Singapore dollars. These instruments have maturities between one to six months in the future. We do not enter into derivative instrument transactions for trading or speculative purposes.
Foreign currency contracts designated as cash flow hedges
We utilize foreign currency forward contracts to hedge certain forecasted foreign currency transactions relating to cost of service and operating expense. These contracts are designated and documented as cash flow hedges at their inception. All changes in time value are excluded from the cash flow hedge and recorded to Other income (expense), net in the period incurred. The effective portion of derivative's gains or losses on these hedges is initially included in Accumulated other comprehensive income (loss) and is subsequently reclassified into the cost of service or operating expense, to which the hedged transaction relates, upon the occurrence of the forecasted transaction. We record any ineffectiveness of the hedging instruments in Other income (expense), net in our condensed consolidated financial statements in the period incurred. No ineffectiveness was recorded during the three and nine months ended September 30, 2012.
The notional amount of these contracts was $25.8 million at September 30, 2012 and zero at December 31, 2011. Outstanding contracts are recognized as either assets or liabilities on the balance sheet at fair value. The amount remaining in Accumulated other comprehensive loss as of September 30, 2012 was not significant and is expected to be recognized into earnings within the next three months.
Derivatives not designated as hedging instruments
We use foreign currency forward contracts to reduce the variability in gains and losses generated from the re-measurement of certain monetary assets and liabilities denominated in foreign currencies. These hedges do not qualify for hedge accounting treatment. These derivatives are carried at fair value with gains and losses recognized as Other income
(expense), net. Changes in the fair value of the derivatives are largely offset within the consolidated statement of operations by re-measurement of the underlying assets and liabilities. We had a notional value of $5.1 million in derivative instruments that were non-designated hedges at September 30, 2012 and zero at December 31, 2011.
Fair Value of Derivative Instruments
The fair value of derivative instruments in our condensed consolidated balance sheet was as follows as of September 30, 2012:
The effects of derivatives designated as hedging instruments on our condensed consolidated statements of operations were as follows for the three and nine months ended September 30, 2012:
The effects of derivatives not designated as hedging instruments on our condensed consolidated statements of operations were as follows for the three and nine months ended September 30, 2012:
Stock-Based Compensation Expense
The following table summarizes stock-based compensation expense for stock options, RSUs and the Purchase Plan recorded in our condensed consolidated statement of operations for the three and nine months ended September 30, 2012 and 2011:
Share-Based Payments Valuation Assumptions
The fair value of options granted was estimated at the date of grant using the following assumptions:
The fair value of Purchase Plan shares granted was estimated at the date of grant using the following assumptions:
As of September 30, 2012, total compensation cost related to stock options granted to employees and directors but not yet recognized was $61.1 million. This cost will be recognized on a straight-line basis over the remaining weighted-average service period. Amortization in the three months ended September 30, 2012 and 2011 was $5.1 million and $7.3 million, respectively. Amortization in the nine months ended September 30, 2012 and 2011 was $17.7 million and $24.6 million, respectively.
As of September 30, 2012, 6,549,000 shares were available for grant under the 2006 Equity Incentive Plan. As of September 30, 2012, 2,652,000 shares were available for grant under the 2006 Director Option Plan. As of September 30, 2012, 1,080,000 shares were available for grant under the 2009 Inducement Equity Incentive Plan.
Stock Purchase Plan
As of September 30, 2012, there was $21.1 million of total compensation cost, net of estimated forfeitures, left to be amortized under our Purchase Plan, which will be amortized over the remaining Purchase Plan offering period. Amortization in the three months ended September 30, 2012 and 2011 was $3.4 million and $2.0 million, respectively. Amortization in the nine
months ended September 30, 2012 and 2011 was $9.5 million and $6.2 million, respectively.
As of September 30, 2012, 1,858,000 shares were available under the Purchase Plan.
Restricted Stock Units
As of September 30, 2012, total unrecognized compensation cost related to non-vested RSUs to employees and directors was $101.4 million. This cost will be recognized over the remaining weighted-average service period. Amortization in the three months ended September 30, 2012 and 2011 was $11.8 million and $13.2 million, respectively. Amortization in the nine months ended September 30, 2012 and 2011 was $39.0 million and $37.2 million, respectively.
Share Repurchase Program
On August 19, 2011, our Board of Directors authorized a Share Repurchase Program (the Program), which authorizes us to repurchase up to $150.0 million of our outstanding common stock. On May 17, 2012, the Board of Directors approved a $150.0 million increase to the Program. The Program does not require us to purchase a minimum number of shares, and may be suspended, modified or discontinued at any time without prior notice. For the three months ended September 30, 2012, we repurchased 1,360,700 shares of common stock under this Program on the open market for an aggregate purchase price of $25.7 million, or a weighted average of $18.91 per share. For the nine months ended September 30, 2012, we repurchased 7,376,859 shares of common stock under this Program on the open market for an aggregate purchase price of $127.1 million, or a weighted average of $17.24 per share. The timing and amounts of these purchases were based on market conditions and other factors, including price, regulatory requirements and capital availability. The share repurchases were financed by available cash balances and cash from operations. The maximum dollar value of shares of common stock that remain available for purchase under the Program is $137.8 million.
For the three and nine months ended September 30, 2011, we repurchased 874,321 shares of common stock under a share repurchase program for an aggregate purchase price of $20.0 million, or weighted-average of $22.89 per share.
Our effective tax rate was 37.3% and 23.8% for the three months ended September 30, 2012 and 2011, respectively, and 38.5% and 35.8% for the nine months ended September 30, 2012 and 2011, respectively. Our income tax provision consists of federal, foreign, and state income taxes. The provision for income taxes for the three months ended September 30, 2012 and 2011 was $14.7 million, and $6.0 million, respectively. The provision for income taxes for the nine months ended September 30, 2012 and 2011 was $31.2 million and $24.3 million, respectively.
Our effective tax rate differs from the federal statutory rate due to state taxes and significant permanent differences. Significant permanent differences arise primarily from taxes in foreign jurisdictions with a tax rate different than the U.S. federal statutory rate, nondeductible stock-based compensation expense, and the amortization of deferred tax charges related to our intercompany sale of intellectual property rights.
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. While our Chief Executive Officer evaluates the financial information for certain of our product lines, the information for all product lines is aggregated for analysis on a consolidated level as the primary basis for the allocation of resources and assessment of financial results. Accordingly, the consolidated business is considered to be one operating segment.
Revenue by geography is based on the billing address of the customer. The following table sets forth revenue by geographic area.
On June 1, 2011, we served Silver Peak Systems, Inc. with a lawsuit, filed in the United States District Court for the District of Delaware, alleging infringement of certain patents. The lawsuit seeks unspecified damages and injunctive relief. On July 22, 2011, Silver Peak Systems denied the allegations and requested declaratory judgments of invalidity and non-infringement.
On August 17, 2011, Silver Peak Systems amended its counterclaims against us, alleging infringement by Riverbed of three U.S. patents: 7,630,295, titled “Network Device Continuity”; 7,945,736, titled “Dynamic Load Management of Network Memory”; and 7,948,921, titled “Automatic Network Optimization.” The patents purport to cover certain features offered on the Riverbed Steelhead products. Silver Peak seeks unspecified damages and a permanent injunction prohibiting Riverbed from offering those features. On September 20, 2011, we denied Silver Peak Systems’ allegations and requested declaratory judgments of invalidity and non-infringement.
On December 21, 2011, we amended our lawsuit against Silver Peak Systems to allege infringement of an additional patent.
At this time we are unable to estimate any range of reasonably possible loss relating to these actions. Discovery is ongoing, and trial of our claims against Silver Peak Systems is currently scheduled to begin on September 30, 2013. Trial of Silver Peak Systems' claims against us is currently scheduled to begin on March 24, 2014. We believe that we have meritorious defenses to the counterclaims against us, and we intend to vigorously contest these counterclaims.
From time to time, we are involved in various legal proceedings, claims and litigation arising in the ordinary course of business. There are no currently pending legal proceedings at September 30, 2012 that, in the opinion of management, would have a material adverse effect on our financial position, results of operations or cash flows.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this Form 10-Q. The information in this Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Such forward-looking statements include statements related to: our business and strategy, trends affecting our business and financial results, international expansion plans, direct and indirect sales plans and strategies, growth of our revenue, costs and expenses (including sales and marketing expenses), gross margins, our share repurchase program, our acquisitions, the effect of fluctuations in exchange rates and our hedging activities on our financial results, our effective tax rate and our liquidity and capital requirements. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical facts may be deemed to be forward-looking statements. For example, words such as “may,” “will,” “could,” “should,” “estimates,” “predicts,” “potential,” “continue,” “strategy,” “believes,” “anticipates,” “plans,” “expects,” “intends” and similar expressions are intended to identify forward-looking statements. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those discussed elsewhere in this Form 10-Q in the section titled “Risk Factors” and the risks discussed in our other SEC filings. We disclaim any obligation to publicly release any revisions or updates to the forward-looking statements after the date of this Form 10-Q.
We were founded in May 2002 by experienced industry leaders with a vision to improve the performance of wide-area distributed computing. Having significant experience in caching technology, our executive management team understood that existing approaches failed to address adequately all of the root causes of this poor performance. We determined that these performance problems could be best solved by simultaneously addressing inefficiencies in software applications and wide-area networks (WANs) as well as insufficient or unavailable bandwidth. This innovative approach served as the foundation of the development of our products. We began commercial shipments of our products in May 2004 and have since sold our products to over 20,000 customers worldwide. We currently offer several product lines including Steelhead appliances directed at the WAN optimization market, Cascade products in the network performance management (NPM) market, our Stingray product line, which competes in the virtual application delivery controller (ADC) market, and our Whitewater cloud storage gateway directed at the cloud back-up and disaster recovery solution market.
We are headquartered in San Francisco, California. Our personnel are located throughout the U.S. and in more than thirty countries worldwide. We expect to continue to add personnel in the U.S. and internationally to provide additional geographic sales, research and development, general and administrative and technical support coverage.
The Riverbed Strategy
Our goal is to establish our solutions as the preeminent performance and efficiency standard for organizations relying on wide-area distributed computing. Key elements of our strategy include:
Build a unified performance platform - Riverbed is the performance company. Our vision is to give customers the tools to create the highest performing IT environment possible, enabling users everywhere to be more productive while giving IT teams greater control over their enterprises' technology resources. Our vision focuses on the intersection of applications, networks, and storage, and brings customers a single, unified view of performance in their distributed environment.
Maintain and extend our technological advantages - We believe that we offer the broadest ability to enable rapid, reliable access to applications and data for our customers. We intend to enhance our position as a leader and innovator in the WAN optimization market. We also intend to continue to sell new capabilities, such as our new cloud solutions, into our installed base. Continuing investments in research and development are critical to maintaining our technological advantage.
Enhance and extend our product lines - We plan to introduce enhancements to our product capabilities in order to address our customers’ size and application requirements. We also plan to introduce new products to extend our market and utilize our technology platform to extend our capabilities.
Extend our technology partner ecosystem - We plan to enhance our product capabilities via integration of partner technologies, in particular by increasing the selection of third-party applications on the Riverbed Services Platform and Virtual Services Platform.
Increase market awareness - To generate increased demand for our products, we will continue promoting our brand and the effectiveness of our comprehensive IT performance solutions.
Scale our sales force and distribution channels - Growth in revenue and increase in market share are key goals for us. We intend to expand our direct sales force and leverage our indirect channels to extend our geographic reach and market penetration. We sell our products directly through our sales force and indirectly through channel partners. We derived 95% of our revenue through indirect channels in the first nine months of 2012. We intend to expand our direct sales force and leverage our indirect channels to extend our geographic reach and market penetration.
Enhance and extend our support and services capabilities - On an ongoing basis, we plan to enhance and extend our support and services capabilities to continue to support our growing global customer base.
Major Trends Affecting Our Financial Results
We believe that our current value proposition, which enables customers to improve the performance of their applications and access to their data across WANs, while also offering the ability to simplify IT infrastructure and realize significant capital and operating cost savings, should allow us to continue to grow our business. Our product revenue growth rate will depend significantly on continued growth in the WAN optimization, NPM and the virtual ADC markets, and our ability to continue to attract new customers in those markets and generate additional sales from existing customers. Our growth in support and services revenue is dependent upon increasing the number of products under support contracts, which is dependent on both growing our installed base of customers and renewing existing support contracts. Our future profitability and rate of growth will be directly affected by the continued acceptance of our products in the marketplace, as well as the timing and size of orders, product mix, average selling prices and costs of our products and general economic conditions. Our ability to achieve profitability in the future will also be affected by the extent to which we must incur additional expenses to expand our sales, support, marketing, development, and general and administrative capabilities to grow our business. The largest component of our expenses is personnel costs. Personnel costs consist of salaries, benefits and incentive compensation for our employees, including commissions for sales personnel and stock-based compensation.
Our revenue has grown rapidly since we began shipping products in May 2004, increasing from $2.6 million in 2004 to $726.5 million in 2011. Revenue grew by 14% in the nine months ended September 30, 2012 to $599.5 million from $523.6 million in the nine months ended September 30, 2011. We believe that our revenue growth is a positive sign that our products have a significant value proposition to our customers and that the markets that we compete in are still expanding.
Costs and Expenses
Operating expenses consist of sales and marketing, research and development, general and administrative expenses, and acquisition-related costs. Personnel-related costs, including stock-based compensation, are the most significant component of each of these expense categories. As of September 30, 2012, we had 1,806 employees, an increase of 16% from 1,554 employees at September 30, 2011. The increase in employees is the most significant driver behind the increase in costs and operating expenses from the nine months ended September 30, 2011 to the nine months ended September 30, 2012. The increase in employees was required to support our increased revenue and is due, in part, to our acquisitions during the period. The timing and number of additional hires has and could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue, in any particular period.
Stock-based Compensation Expense
Stock-based compensation expense and related payroll taxes were $20.5 million and $22.7 million in the three months ended September 30, 2012 and 2011, respectively, and $67.8 million and $71.9 million in the nine months ended September 30, 2012 and 2011, respectively. We expect to continue to incur significant stock-based compensation expense and anticipate further growth in stock-based compensation expense as our employee base grows because we expect stock-based compensation to continue to play an important part in the overall compensation structure for our employees.
Stock-based compensation expense and related payroll tax was as follows:
During the first quarter of 2012, we entered into an agreement to purchase certain assets of Expand Networks Ltd. (Expand), including its intellectual property for $6.5 million.
During fiscal 2011, we acquired two companies to expand our product offerings. The results of operations of these companies are included in our condensed consolidated results for the period subsequent to the acquisition date. In the three and nine months ended September 30, 2012, we recognized $10.1 million and $22.9 million, respectively, in revenue, from the sale of these acquired companies’ products and services and we recognized $9.2 million and $28.8 million, respectively, of operating expenses, which included $2.7 million and $8.1 million, respectively, of acquisition-related intangible amortization, and $0.8 million and $2.6 million, respectively, of stock-based compensation costs.
Critical Accounting Policies and Estimates
Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP). These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our condensed consolidated financial statements could be adversely affected.
The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following: revenue recognition, accounting for business combinations, stock-based compensation, accounting for income taxes, inventory valuation and allowances for doubtful accounts. Please refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Annual Report on Form 10-K for our year ended December 31, 2011 for a more complete discussion of our critical accounting policies and estimates including revenue recognition, accounting for business combinations including the fair value measurement of contingent consideration, goodwill, intangible assets and impairment assessments, stock-based compensation, accounting for income taxes, inventory valuation and allowances for doubtful accounts. Our critical accounting policies have been discussed with the Audit Committee of the Board of Directors. We believe there have been no material changes to our critical accounting policies and estimates during the three and nine months ended September 30, 2012, compared to those discussed in our Form 10-K for the year ended December 31, 2011.
Results of Operations
We derive our revenue from sales of our appliances and software licenses and from support and services. Product revenue primarily consists of revenue from sales of our Steelhead, Cascade, Stingray and Whitewater products and is typically recognized upon delivery. Support and services revenue includes unspecified software license updates and product support. Support revenue is recognized ratably over the contractual period, which is typically one year. Service revenue includes professional services and training, which to date has not been significant, and is recognized as the services are performed.
Quarter Ended September 30, 2012 Compared to the Quarter Ended September 30, 2011: Product revenue increased by 9.5% in the three months ended September 30, 2012 as compared to the three months ended September 30, 2011, due to an increase in unit volume from increasing sales to existing customers and the addition of new customers through acquisitions. We believe the market for our products has grown due to increased market awareness of WAN optimization, NPM and ADC and an increase in distributed organizations, which increases dependence on timely access to data and applications. As of September 30, 2012, our products have been sold to over 20,000 customers, compared to 16,000 customers as of September 30, 2011. As a result of the Juniper agreements, we recognized $4.0 million of revenue in the third quarter of 2012 and expect to recognize similar amounts ratably over the next four years.
Substantially all of our customers purchase support when they purchase our products. Support and services revenue increased 28.2% in the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. As our customer base grows, we expect our revenue generated from support and services to increase.
In the three months ended September 30, 2012, we derived 95% of our revenue from indirect channels compared to 96% for the three months ended September 30, 2011. We expect indirect channel revenue to continue to be a substantial majority of our revenue.
We generated 43% of our revenue in the three months ended September 30, 2012 from international locations, compared to 44% in the three months ended September 30, 2011. We continue to expand into international locations and introduce our products in new markets and expect international revenue to increase in dollar amount over time.
Nine months ended September 30, 2012 Compared to the Nine months ended September 30, 2011: Product revenue increased by 8.3% in the nine months ended September 30, 2012 over the same period in the prior year due primarily to an increase in unit volume from sales to new customers and additional purchases by existing customers.
Support and services revenue increased by 28.2% in the nine months ended September 30, 2012 over the same period in the prior year due to higher first year support sales from higher product sales and the continued renewal of support contracts by our existing customers.
Cost of Revenue and Gross Margin
Cost of product revenue consists of the costs of the appliance hardware, manufacturing, shipping and logistics costs, expenses for inventory obsolescence, warranty obligations, transportation costs and amortization of acquisition-related intangibles. We utilize third parties to assist in the design of and to manufacture our appliance hardware, embed our proprietary software and perform shipping logistics. Cost of support and service revenue consists of personnel costs of technical support and professional services personnel, spare parts and logistics services. As we expand internationally and into other sectors, we may incur additional costs to conform our products to comply with local laws or local product specifications. In addition, as we expand internationally, we will continue to hire additional technical support personnel to support our growing international customer base.
Our gross margin has been and will continue to be affected by a variety of factors, including the mix and average selling prices of our products, new product introductions and enhancements, the cost of our appliance hardware, expenses for inventory obsolescence and warranty obligations, cost of support and service personnel, and the mix of distribution channels through which our products are sold.
Quarter Ended September 30, 2012 Compared to the Quarter Ended September 30, 2011: The total cost of product revenue increased $4.0 million, or 14.9%, in the three months ended September 30, 2012 compared to the three months ended September 30, 2011, due primarily to an increase in the cost of product sold due to greater volume of products shipped for higher revenue, which increased product costs by $2.8 million, or 16.4%, and an increase in the amortization of acquisition-related intangible assets of $0.7 million. We opened a new logistics center in the Asia Pacific region in the first quarter of 2012. The new logistics center accounted for $0.2 million of the increase in cost of product revenue for the three months ended September 30, 2012. We expect similar costs going forward as a result of opening this logistics center.
Cost of support and services revenue increased $1.1 million, or 6.0%, as we added more technical support headcount domestically and abroad coupled with increases in freight, duties and taxes, and repair costs to support our growing customer base. Technical support and services headcount was 211 employees, as of September 30, 2012 compared to 191 employees as of September 30, 2011.
Gross margins increased slightly to 77% in the three months ended September 30, 2012 as compared to 76% in the three months ended September 30, 2011. Product gross margins decreased to