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SonicWALL 10-Q 2008 UNITED
STATES SECURITIES AND EXCHANGE COMMISSION
Washington,
DC 20549
Form
10-Q
For the Quarterly period
ended September 30, 2008
OR
£ TRANSITION REPORT PURSUANT TO SECTION
13 OR 15(d) OR THE SECURITIES EXCHANGE ACT 1934>
For the transition period
from to
Commission
file number: 000-27723
SonicWALL,
Inc.
(Exact
name of registrant as specified in its charter)
1143
Borregas Avenue
Sunnyvale,
California 94089
(408)
745-9600
Fax:
(408) 745-9300
(Address
of registrant’s principal executive offices)
Not
Applicable
(Former
name, former address and former fiscal year, if changed since last
report)
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 is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company. See the definition of “large accelerated filer”,
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.
Large
accelerated filer ¨ Accelerated
filer x
Non-accelerated
filer ¨ (Do not check if a
smaller reporting
company) Smaller
reporting company ¨
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes ¨ No x
Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date:
Page 2 of
39
PART
I. FINANCIAL INFORMATION
ITEM
1. FINANCIAL
STATEMENTS
SONICWALL,
INC.
CONDENSED
CONSOLIDATED BALANCE SHEETS
The
accompanying notes are an integral part of these condensed consolidated
financial statements. SONICWALL,
INC.
CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS
The
accompanying notes are an integral part of these condensed consolidated
financial statements. SONICWALL,
INC.
CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS
The
accompanying notes are an integral part of these condensed consolidated
financial statements. SONICWALL,
INC.
CONDENSED
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(In
thousands, except for share data)
The
accompanying notes are an integral part of these condensed consolidated
financial statements.
Page 6 of
39
SONICWALL,
INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
The
accompanying condensed consolidated financial statements prepared by SonicWALL,
Inc. (the “Company”), are unaudited and reflect all adjustments which are
normal, recurring and, in the opinion of management, necessary for a fair
statement of the financial position and the results of operations of the Company
for the interim periods presented. The condensed consolidated
statements have been prepared in accordance with the regulations of the
Securities and Exchange Commission (“SEC”). Accordingly, these statements do not
include all information and footnotes required by generally accepted accounting
principles. The results of operations for the three and nine month periods ended
September 30, 2008 are not necessarily indicative of the operating results to be
expected for the full fiscal year or future operating periods. The
information included in this report should be read in conjunction with the
consolidated financial statements and notes thereto for the fiscal year ended
December 31, 2007, as set forth in the Company’s Annual Report on Form 10-K
filed with the SEC on March 10, 2008.
2. CONSOLIDATION
The
condensed consolidated financial statements have been prepared in accordance
with U.S. GAAP and include the Company and its wholly owned
subsidiaries. All intercompany accounts and transactions have been
eliminated.
3. CRITICAL
ACCOUNTING POLICIES
There
have been no material changes to any of the Company’s critical accounting
policies and critical accounting estimates as disclosed in its annual report on
Form 10-K for the year ended December 31, 2007.
4. GOODWILL
AND PURCHASED INTANGIBLES
SFAS No.
142, Goodwill and Other
Intangible Assets, requires that goodwill and certain intangible assets
with an indefinite useful life be reviewed for impairment on an annual
basis. In addition, SFAS 142 requires purchased intangible assets
other than goodwill to be amortized over their useful lives unless these lives
are determined to be indefinite. The Company periodically evaluates
if there are any events or indicators that would require an impairment
assessment of the carrying value of the goodwill between each annual impairment
assessment. For the three and nine month periods ended September 30,
2008, no indicators of goodwill impairment were identified. The
Company has elected to perform its annual impairment analysis during the fourth
quarter of each year.
Intangible
assets as of September 30, 2008 and December 31, 2007 consist of the following
(in thousands):
All of
the Company’s intangible assets excluding goodwill are subject to amortization.
Estimated future amortization expense to be included in cost of revenue and
operating expense is as follows (in thousands):
Page 7 of
39
SONICWALL,
INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
5. NET
INCOME (LOSS) PER SHARE
The
following is a reconciliation of the numerators and denominators of the basic
and diluted net income (loss) per share computations for the periods
presented (in thousands, except per share amounts):
For the
nine month period ended September 30, 2008, potentially dilutive securities of
approximately 11.4 million shares consisting of options with a weighted average
exercise price of $8.85, have not been considered in the computation of net
income per share as these options’ exercise prices were greater than the average
market price of common shares for the period.
For the
nine month period ended September 30, 2007, potentially dilutive securities of
approximately 5.5 million shares consisting of options with a weighted average
exercise price of $9.87, have not been considered in the computation of net
income per share as these options’ exercise prices were greater than the average
market price of common shares for the period. In addition, 2.8 million
potentially dilutive shares were excluded from the computation of net loss per
share for the three month period ended September 30, 2007 because of our net
loss position during this period.
6. INVENTORIES
Inventories
are stated at the lower of standard cost (which approximates cost determined on
a first-in, first-out basis) or market. The Company writes-down the
value of inventories for estimated excess and obsolete inventories based upon
assumptions about future demand and market conditions. Inventories
consist primarily of finished goods. Inventory reserves, once
established, are only reversed upon sale or disposition of related
inventory.
7. COMMITMENTS
AND CONTINGENCIES
Lease
Commitments
Page 8 of
39
The
Company leases office space in several U.S. locations includes California,
Washington and Arizona. Additional sales and support offices as well as research
and development facilities are leased worldwide under leases that expire at
various dates ranging from 2008 to 2015, including larger facilities in
Bangalore, India and Shanghai, China.
In
September 2008, the Company closed approximately half of its leased facility in
the State of Washington and has recorded a liability of approximately $0.9
million equivalent to the net present value of the expected future lease costs,
net of estimated future sublease income. The liability is recorded as a
component of “Other accrued liabilities”.
Future
annual minimum lease payments under all non-cancelable operating leases with an
initial or remaining term in excess of one year as of September 30, 2008 are as
follows (in thousands):
Purchase
Commitments
The
Company outsources its manufacturing function to third party contract
manufacturers, and at September 30, 2008, it had purchase obligations totaling
$12.3 million. Of this amount, $8.8 million cannot be canceled and is
payable within one year. The Company is contingently liable for any
inventory owned by a contract manufacturer that becomes excess and
obsolete. As of September 30, 2008, $166,000 had been accrued for
excess and obsolete inventory held by our contract manufacturers. In
addition to the obligation related to Inventory, as of September 30, 2008, in
the normal course of business, the Company had $2.1 million in non-cancelable
purchase commitments.
Product
Warranties
The
Company’s standard warranty period for its products is one to two years and
includes repair or replacement obligations for units with product
defects. The Company’s software products carry a 90-day warranty and
include technical assistance, insignificant bug fixes and feature updates. The
Company estimates the accrual for future warranty costs based upon its
historical cost experience and its current and anticipated product failure
rates. If actual product failure rates or replacement costs differ
from its estimates, revisions to the estimated warranty obligations would be
required. The Company concluded that no adjustment to pre-existing
warranty accruals were necessary in the nine month periods ended September 30,
2008 and 2007. A reconciliation of the changes to the Company’s
warranty accrual as of September 30, 2008 and 2007 is as follows (in
thousands):
Guarantees
and Indemnification Agreements
The
Company enters into standard indemnification agreements in its ordinary course
of business. As part of its standard distribution agreements, the
Company indemnifies, holds harmless, and agrees to reimburse the indemnified
parties for losses suffered or incurred by the indemnified party, in connection
with any U.S. patent or any copyright or other intellectual property
infringement claim by any third party with respect to the Company's products,
software, or services. The indemnification agreements commence upon
execution of the agreement and do not have specific terms.
The maximum potential
amount of future payments the Company could be required to make under these
agreements is not limited. The Company has never incurred costs to
defend lawsuits or settle claims related to these indemnification
agreements. As a result, the Company believes the estimated fair
value of these agreements is minimal.
The Company's articles of incorporation limit the liability of directors to the full extent permitted by California law. In addition, the Company's bylaws provide that the Company will indemnify its directors and officers to the fullest extent permitted by California law, including circumstances in which indemnification is otherwise discretionary under California law. The Company has entered into indemnification agreements with its directors and officers that may require the Company: to indemnify its directors and officers against liabilities that may arise by reason of their status or service as directors or officers, other than liabilities arising from willful misconduct of a culpable nature; to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified; and to obtain directors' and officers' insurance if available on reasonable terms. The Company currently has directors and officers insurance in place. The Company has not incurred costs related to these indemnification agreements. The
Company has entered into agreements with certain executives where the Company
may be required to pay severance benefits up to 24 months of salary, bonuses and
accelerate vesting of stock options in the event of termination of employment
under certain circumstances, including a change of control.
In
January 2008, Mr. John DiLullo, Vice President of Worldwide Sales and a named
executive officer, ceased to be employed by the Company. Under the
terms of Mr. DiLullo’s retention and severance agreement entered into at the
time of his employment in January 2006, the Company paid severance benefits and
bonuses, in compliance with Internal Revenue Code Section 409A, in the amount of
approximately $258,000.
Legal
Proceedings
On
December 5, 2001, a securities class action complaint was filed in the U.S.
District Court for the Southern District of New York against the Company, three
of its officers and directors, and certain of the underwriters in the Company’s
initial public offering in November 1999 and its follow-on offering in March
2000. Similar complaints were filed in the same court against
numerous public companies that conducted initial public offerings (“IPOs”) of
their common stock since the mid-1990s. All of these lawsuits were
consolidated for pretrial purposes before Judge Shira Scheindlin. On
April 19, 2002, plaintiffs filed an amended complaint. The amended
complaint alleges claims under the Securities Act of 1933 and the Securities
Exchange Act of 1934, and seeks damages or rescission for misrepresentations or
omissions in the prospectuses relating to, among other things, the alleged
receipt of excessive and undisclosed commissions by the underwriters in
connection with the allocation of shares of common stock in the Company’s public
offerings. On July 15, 2002, the issuers filed an omnibus motion to
dismiss for failure to comply with applicable pleading standards. On
October 8, 2002, the Court entered an Order of Dismissal as to all of the
individual defendants in the SonicWALL IPO litigation, without
prejudice. On February 19, 2003, the Court denied the motion to
dismiss the Company’s claims. A tentative agreement has been reached
with plaintiffs’ counsel and the insurers for the settlement and release of
claims against the issuer defendants, including SonicWALL, in exchange for a
guaranteed recovery to be paid by the issuer defendants’ insurance carriers and
an assignment of certain claims. Papers formalizing the settlement
among the plaintiffs, issuer defendants, including SonicWALL, and insurers were
presented to the Court on September 14, 2004. The settlement is
subject to a number of conditions, including approval of the proposed settling
parties and the Court. On July 14, 2004, underwriter defendants filed
with the Court a memorandum in opposition to plaintiffs’ motion for preliminary
approval of the settlement with defendant issuers and
individuals. Plaintiffs and issuers subsequently filed papers with
the Court in further support of the settlement and addressing issues raised in
the underwriter’s opposition. On February 15, 2005, the Court granted
preliminary approval of the settlement, subject to the parties fulfilling
certain conditions. To address the concerns raised by the Court, the
parties submitted revised settlement documents that contained a more limited
“bar order” that would not preclude claims by the underwriters for
indemnification for an issuer pursuant to the IPO underwriting
agreement. On August 31, 2005, the Court entered an order confirming
its preliminary approval of the settlement. In December 2006, the
Second Circuit Court of Appeals reversed the class certification decision of the
District Court in six (6) focus cases. The Second Circuit Court of
Appeals also denied rehearing. In June 2007, the District Court
signed a stipulation terminating the settlement approval
process. Counsel for plaintiffs are seeking certification of a
narrower class and counsel for underwriters and plaintiffs are briefing the
issue of whether the appeals court ruling that the original class should not
have been certified applies to non-focus cases, and whether the ruling
re-started the statute of limitations running on class claims in those
actions. In December 2007, plaintiffs filed an opposition to motions
to dismiss of the focus case issuers and underwriters. The focus case
issuers and underwriters in turn submitted briefs in opposition to plaintiffs’
motion for class certification. In March 2008, plaintiffs filed a
reply in support of their motion for class certification in the focus cases. The
Court has not set a hearing date for argument. Discussions among the various
parties are ongoing. If the litigation against the Company continues, the
Company believes it has a meritorious defense and intends to defend
Page 10
of 39
SONICWALL, INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
the case
vigorously. No estimate can be made of the possible loss or possible range
of loss, if any, associated with the resolution of this contingency. As a
result, no loss has been accrued in the Company’s financial statements as of
September 30, 2008.
On March
13, 2006, eSoft, Inc. (“eSoft”) filed a complaint captioned eSoft, Inc. v.
SonicWALL, Inc., No. 06-CV-00445, in the United States District Court for the
District of Colorado. The Complaint alleged that the Company has
willfully infringed, actively induced the infringement of and/or knowingly
contributorily infringed U.S. Patent No. 6,961,773 (the “773 Patent”) and
sought (1) a judgment that the Company has willfully infringed,
actively induced the infringement and/or knowingly contributorily infringed the
patent, (2) the award of an unspecified amount of trebled damages, together with
expenses, costs and attorneys’ fees and (3) permanent injunctive relief
restraining and enjoining the Company from infringing the patent. At essentially
the same time, eSoft filed complaints against five (5) other defendants alleging
infringement of the 773 Patent. In response to a motion to re-examine
filed with the patent office by defendants in two of the other cases, the
Company filed a motion to stay proceedings pending the results of the
re-examination process. eSoft joined in that motion and on February
12, 2007, the Court granted our motion for stay. On September 15,
2008, the Patent and Trademark Office (the “PTO”) issued its first office action
as part of the re-examination process. Counsel for eSoft has requested an
extension to December 15, 2008 to respond to the PTO office action. The length
of time that the stay will remain in effect is uncertain given the ongoing
re-examination process. As a result, no loss has been accrued in the
Company’s financial statements as of September 30, 2008.
On
October 8, 2008, Northpeak Wireless, LLC filed a complaint captioned Northpeak
Wireless, LLC v. 3Com Corporation, et al, No. CV-08-J-1813-NE, in the United
States District Court for the Northern District of Alabama. The complaint names
thirty one (31) defendants, including the Company. The complaint alleges that
the Company makes, uses, sells, offers to sell, and/or imports products that
incorporate and/or utilize direct sequence spread spectrum wireless technology
that infringes U.S. Patent No. 4,977,577 (the “577 Patent”) and U.S. Patent No.
5,987,058 (the “058 Patent”) and seeks a judgment that the Company has
infringed, actively induced infringement and/or contributorily infringed the 577
Patent and the 058 Patent. The complaint seeks an award of unspecified damages,
pre-judgment and post-judgment interest together with costs, expenses and
attorneys’ fees. The Company is currently reviewing the complaint and intends to
defend the case vigorously. No estimate can be made of the possible loss or
possible range of loss, if any, associated with the resolution of this
matter.
Additionally,
the Company is, from time to time, a party to routine litigation incidental to
its business. The Company believes that none of these legal
proceedings will have a material adverse effect on the Company’s consolidated
financial statements taken as a whole or its results of operations, financial
position, and cash flows.
8. INCOME
TAXES
As part
of the process of preparing the Company’s consolidated financial statements, the
Company is required to estimate its income taxes in each of the jurisdictions in
which it operates. This process involves determining the Company’s
income tax expense (benefit) together with calculating the deferred income tax
expense (benefit) related to temporary differences resulting from differing
treatment of items, such as deferred revenue or deductibility of certain
intangible assets, for tax and accounting purposes. These differences
result in deferred tax assets and liabilities, which are included within the
consolidated balance sheet. The Company must then assess the
likelihood that the deferred tax assets will be recovered through the generation
of future taxable income.
As of
September 30, 2008, the Company continued to have a partial valuation allowance
against its net deferred tax assets. The Company believes that its deferred tax
assets will more likely than not be realized with the exception of certain
acquired net operating losses. Valuation allowances have been recorded for this
portion of the deferred tax assets as a result of the uncertainties regarding
realization of the assets based upon the limitation on the use of the net
operation losses in the future. For the three and nine month periods
ended September 30, 2008, the Company’s income before income taxes was earned in
domestic and foreign jurisdictions.
The
interim effective income tax rate is based on management’s best estimate of the
annual effective income tax rate. For the nine months ended September 30, 2008,
the effective income tax rate was 68.8%, compared to 37.5% for the nine months
ended September 30, 2007. The effective income tax rate for the period
ended September 30, 2008 was different from the statutory United States federal
income tax rate of 35% primarily due to non-deductible share-based compensation
expense and state income taxes which were offset by state research and
development tax credits. The effective income tax rate for the period
ended September 30, 2007 was different from the statutory United States federal
income tax rate of 35% primarily due to non-deductible share-based compensation
expense, state income taxes, non-deductible meals and entertainment costs,
offset by federal and state research and development tax credits, and the
Company's full valuation allowance position against its net deferred tax
assets.
Page 11
of 39
SONICWALL, INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
9. SHAREHOLDERS’
EQUITY
Stock
Repurchase Program
During
the nine month period ended September 30, 2008, the Company repurchased a total
of 9.7 million shares at an aggregate purchase price of $79.4 million. As of
September 30, 2008, the Company’s Stock Repurchase Program has been
completed.
10. EMPLOYEE
BENEFITS
1999
Employee Stock Purchase Plan
The 1999
Employee Stock Purchase Plan (ESPP) is designed to enable eligible employees to
purchase shares of the Company’s common stock at a discount. Each
offering period is for one year and consists of two six-month purchase
periods. The purchase price for shares of common stock under the ESPP
is 85% of the lesser of the fair market value of the Company’s common stock on
the first day of the applicable offering period or the last day of each purchase
period. At September 30, 2008, 1,311,550 shares were available for future
issuance under the ESPP.
Stock
Option Plans
Stock
Option Plan Descriptions
As of
September 30, 2008, the Company had two stock incentive plans (together the
“Stock Option Plans”): the shareholder approved 2008 Equity Incentive Plan (the
“2008 Plan”) and the Board approved 2008 Inducement Equity Incentive Plan (the
“2008 Inducement Plan”). The 2008 Plan, which was approved by the Company’s
shareholders on June 10, 2008, replaced the 1998 Stock Option Plan (the “1998
Plan”) which was expiring. No further awards were made under the 1998 Plan. In
connection with the acquisitions of various companies, the Company assumed the
share-based awards granted under stock incentive plans of the acquired
companies. Share-based awards are designed to reward employees for their
long-term contributions to the Company and provide incentives for them to remain
with the Company. The number and frequency of share-based awards are based on
competitive practices, operating results of the Company, government regulations
and the other factors disclosed by the Company in its filings under the
Securities Exchange Act of 1934, as amended. The Company’s primary stock
incentive plans are summarized as follows:
2008
Plan
The 2008
Plan permits the granting of stock options, restricted stock, restricted stock
units, stock appreciation rights, and performance shares to employees,
consultants of the Company and its subsidiaries and affiliates, and non-employee
directors of the Company. As approved by the shareholders on June 10, 2008, the
maximum number of shares issuable over the term of the 2008 Plan is 800,000
shares. Stock options granted under the 2008 Plan have an exercise price of at
least 100% of the fair market value of the underlying stock on the grant date
and expire no later than seven years from the grant date. Stock options granted
under the 2008 Plan will generally become exercisable for 25% of the option
shares one year from the date of grant and then ratably over the following 36
months. Subject to the annual per-person limit, shares granted under the 2008
Plan, including applicable vesting schedules, shall be granted as determined by
the Board of Directors, or any of its committees administering the 2008 Plan, in
its sole discretion. Shares subject to stock options or similar awards granted
under the 1998 Plan that expire or otherwise terminate without having been
exercised in full and shares issued pursuant to awards granted under the 1998
Plan that are forfeited to, or repurchased by the Company, up to a maximum of
5,000,000 shares may be added to the 2008 Plan.
2008 Inducement Plan The 2008
Inducement Plan permits the granting of nonstatutory stock options, restricted
stock, restricted stock units, performance shares and stock appreciation rights
to new employees of the Company, its subsidiaries and affiliates, as material
inducements to accept an offer of employment. As adopted by the Board on June
10, 2008, the maximum number of shares issuable over the term of the 2008
Inducement Plan is 500,000 shares. Nonqualified stock options granted under the
2008 Inducement Plan have an exercise price of at least 100% of the fair market
value of the underlying stock on the grant date and expire no later than seven
years from the grant date.
SONICWALL, INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
The
stock options awarded under the 2008 Inducement Plan will generally become
exercisable as to 25% of the option shares, one year after the date of grant and
then ratably over the following 36 months. The Board of Directors or other
committees administering the plan, have the discretion to use a different
vesting schedule.
1998
Plan
The 1998
Plan expired on June 10, 2008 upon shareholder approval of the 2008 Plan, and
the Company can no longer make equity awards under the 1998 Plan. As amended on
August 24, 1999 and October 12, 2000, the maximum number of shares issuable over
the term of the 1998 Plan was 38.9 million shares. Incentive stock options
granted under the 1998 Plan have an exercise price of at least 100% of the fair
market value of the underlying stock on the grant date and expire no later than
ten years from the grant date. Nonqualified stock options are granted at a price
that is not to be less than 85% of the fair market value of the common stock on
the date of grant, as determined by the Board of Directors or other committees
administering the plan, and expire no later than ten years from the date of
grant. The stock options generally become exercisable for 25% of the
option shares one year from the date of grant, and then ratably over the
following 36 months. The Board of Directors or other committees administering
the plan had the discretion to use a different vesting schedule and did so from
time to time.
The
following table summarizes the Company’s first, second and third quarter option
activity under the Stock Option Plans:
Page 13
of 39
The
following table summarizes significant ranges of outstanding and exercisable
options as of September 30, 2008:
The
aggregate intrinsic value in the preceding table represents the total pre-tax
intrinsic value, based on options with an exercise price less than the Company’s
closing stock price of $5.24 as of September 30, 2008, which would have been
received by the option holders had all option holders exercised their options as
of that date. The total number of in-the-money options exercisable as
of September 30, 2008 was approximately 3.5 million.
Valuation
and Expense Information under SFAS 123R
SFAS 123R
requires the measurement and recognition of compensation expense based on
estimated fair value for all share-based payment awards made to employees and
directors including employee stock options and employee stock purchases
plan. The Company estimates the fair value of stock options using a
Black-Scholes option-pricing model to determine the fair value of share-based
awards under SFAS 123R. The Black-Scholes option-pricing model
incorporates various and highly subjective assumptions including expected
volatility, expected term and interest rates. The impact on the
Company’s results of operations of recording share-based compensation by
function was as follows (in thousands):
The
weighted average fair value per share of options granted, the intrinsic value of
options exercised and total fair value of the shares vested are as follows (in
thousands except for weighted average fair value per share):
Page 14
of 39
SONICWALL, INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
The
weighted average remaining contractual term for options exercisable at September
30, 2008 was 5.9 years. The Company issues new shares of common stock
upon exercise of stock options. The total compensation cost (gross)
related to non-vested awards not yet recognized at September 30, 2008 was $22.0
million, and the weighted-average period over which this amount is expected to
be recognized is 2.95 years.
The
Company has assumed certain option plans in connection with business
combinations. Generally, the options granted under these plans have
terms similar to the Company’s own options. The exercise prices of
such options have been adjusted to reflect the relative exchange
ratios.
The
assumptions used to estimate the fair value of stock options granted under the
Company’s Option Plans and stock purchase rights granted under the ESPP are as
follows:
Pension
Plan
The
Company has a defined contribution retirement plan covering substantially all of
its eligible United States employees. The Company’s contribution to
this plan is discretionary. The Company provides for a discretionary
matching contribution amount which is currently 50% of the employee contribution
up to a maximum of $2,000 annually for each participant. All such
employer contributions vest immediately. The Company has expensed
approximately $93,000 and $106,000 during the three month periods ended
September 30, 2008 and 2007, respectively. The Company has expensed
approximately $632,000 and $526,000 during the nine month periods ended
September 30, 2008 and 2007, respectively.
Deferred
Compensation Plan
SonicWALL
has a deferred compensation plan (DCP) to provide specified benefits to, and
help retain, a select group of management and highly compensated employees and
directors (Participants) who contribute materially to the Company’s continued
growth, development, and future business success. Under the DCP,
Participants may defer up to 80% of their salary and up to 100% of their annual
bonus and commission. Each Participant’s deferral account is credited
with an amount equal to the net investment return of one or more equity or bond
funds selected by the Participant. Amounts in a Participant’s
deferral account represent an unsecured claim against the Company’s assets and
are paid, pursuant to the Participant’s election, in a lump-sum or in quarterly
installments at a specified date during the participant’s employment or upon the
Participant’s termination of employment with the Company. The Company
pays for the insurance coverage provided under this plan, but does not make any
contributions to this plan. At September 30, 2008, the trust assets
and the corresponding deferred compensation liability were $3.9 million and $4.2
million, respectively, and are included in other current assets and other
current liabilities, respectively. The Compensation Committee of our Board
approved an amended and restated DCP to comply with the requirements of Section
409A of the Internal Revenue Code.
11. NEW
ACCOUNTING PRONOUNCEMENTS
In
September 2006, the Financial Accounting Standards Board, or FASB, issued
Statement of Financial Accounting Standards, or SFAS No. 157, Fair Value Measurements
(SFAS 157).
Page 15
of 39
SONICWALL, INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
SFAS 157
defines fair value, establishes a framework for measuring fair value under
generally accepted accounting principles, and expands disclosures about fair
value measurements. The Company has adopted SFAS 157 to account for
its financial assets and liabilities for the fiscal year beginning January 1,
2008. In
Feburary 2008, the FASB issued Staff Position 157-2, which delays the effective
date of SFAS 157 for nonfinancial assets and liabilities until January 1, 2009.
The Company is in the process of evaluating this standard and has not yet
determined the impact that the adoption of SFAS 157 related to nonfinancial
assets and liabilities will have on its consolidated financial position, results
of operations and cash flows. In October 2008, the FASB issued Staff Position
157-3 effective upon issuance, which clarifies the application of SFAS 157 in a
market that is not active. The adoption of Staff Position 157-3 did not have a
material impact on the Company’s financial position or results of
operations.
Effective
January 1, 2008, the Company adopted SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities (SFAS 159). SFAS 159 allows an entity
the irrevocable option to elect fair value for the initial and subsequent
measurement for specified financial assets and liabilities on a
contract-by-contract basis. The Company did not elect to adopt the fair value
option under this Statement.
12. FAIR
VALUE OF FINANCIAL INSTRUMENTS
In
September 2006, the FASB issued statement No. 157, Fair Value Measurements (SFAS
157). SFAS 157 defines fair value, establishes a framework for measuring fair
value in accordance with accounting principles generally accepted in the United
States, and expands disclosures about fair value measurements. The Company has
adopted the provisions of SFAS 157 as of January 1, 2008 for financial
instruments. Although the adoption of SFAS 157 did not materially impact its
financial condition, results of operations, or cash flow, the Company provides
the following disclosures as part of its financial statements.
SFAS 157
establishes a three-tier fair value hierarchy, which prioritizes the inputs used
in measuring fair value. These tiers include: Level 1, defined as observable
inputs such as quoted prices in active markets; Level 2, defined as inputs other
than quoted prices in active markets that are either directly or indirectly
observable; and Level 3, defined as unobservable inputs in which little or no
market data exists, therefore requiring an entity to develop its own
assumptions.
The
Company’s assets measured at fair value on a recurring basis subject to the
disclosure requirements of SFAS 157 at September 30, 2008, were as follows (in
thousands):
We have included our investments related to auction rate securities (ARS) and asset backed securities (ABS) in the Level 2 category, as there are significant observable inputs associated with these items as discussed below. The ARS are floating rate securities with longer-term maturities which are marketed by financial institutions with auction reset dates at primarily 28 or 35 day intervals to provide short-term liquidity. The credit ratings for all of our ARS are AAA. The underlying collateral of the ARS consists primarily of student loans, which are supported by the federal government as part of the Federal Family Education Loan Program (FFELP). Beginning in February 2008, auctions for the ARS began to fail due to insufficient bids from buyers. We may not be able to access these funds until future auctions for these ARS are successful, or until we sell the securities in a secondary market which currently is very volatile and has experienced discount rates of up to 25%. Although there have been recent instances of redemptions at par by municipalities through refinance of new debt and the federal government is considering incentive plans to spur the refinancing activities, the Company continues to believe that certain of these investments currently lack short-term liquidity and should be classified as noncurrent on the September 30, 2008 balance sheet. Brokerage statements received from the two investment firms that hold our ARS included their estimated market value as of September 30, 2008. One investment firm valued our ARS at par and the other one valued our ARS at approximately 91% of par utilizing an in-house level 3 pricing model. Although there is uncertainty with regard to the short-term liquidity of these securities, the Company continues to believe that the par value represents the fair value of these investments because of the overall quality of the underlying investments and the anticipated future market for such investments. Page 16
of 39
SONICWALL, INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
In
October 2008, the Company received an offer (the “Offer”) from one of its
investment providers, to sell at par value ARS originally purchased from the
investment bank in an amount equal to approximately $45 million. The
sale at par value may occur at anytime during a two-year period beginning June
30, 2010. The Offer is non-transferable and expires on November 14, 2008. The
Offer would be treated as a put-option and acceptance of that Offer will likely
result in a credit to income for the difference between the value of the Offer
and the quoted price of the ARS held by that investment bank. As of September
30, 2008, that amount would be approximately $4.2 million. Simultaneously, the
Company would elect a one-time transfer of these ARS from available-for-sale to
trading and recognize an other-than-temporary charge to income for the
difference between the quoted price and the par value of the ARS, which was
approximately $4.2 million as of September 30, 2008. The Company is in the
process of evaluating the Offer and its potential financial statements
impact.
As of
September 30, 2008, all of the ABS were rated AAA/Aaa and the underlying assets
are all prime mortgages, and approximately 65% are securities that are backed by
agencies of the federal government. None of the ABS investments are
subprime mortgages or have a collateralized debt obligation
exposure. Substantially all of the Company’s fixed income securities
are rated investment grade or better. The Company believes that there is a
market for these government-backed securities and that they can be sold within a
three to six month period. Conversely, approximately $11.7 million of the ABS
that are not backed by the US government were reclassified to long-term
investments as that market continues to have liquidity issues.
The
Company has the intent and ability to hold these securities until the earlier
of: the market for auction rate securities stabilizes, the issuer refinances the
underlying security, or the maturity of the underlying securities. As noted
above, the Company received the investment manager’s monthly statement that
contains a valuation for the ARS, which equals roughly 91% of the par value as
of September 30, 2008, however, the Company does not believe such reported
values represent fair value of the ARS and accordingly, the Company has not
recorded any unrealized loss for its ARS. The Company made this decision based
on the inherent flaws of such valuation models, the fact that the Company was
able to liquidate $25.5 million of its ARS portfolio at par value during the
period subsequent to February 8, 2008, the date when ARS auctions began to fail,
and the other factors outlined above. Based on the cash and short-term
investments balance of $99.1 million and expected positive operating cash flows,
the Company does not anticipate a lack of liquidity associated with the ARS will
adversely affect the Company’s ability to conduct business, and the Company has
the ability to hold the securities (to maturity or) throughout the currently
estimated recovery period. In the event that the Company has to liquidate the
remainder of the investments in ARS while the short-term liquidity of these
securities remained uncertain, the Company may not be able to do so without a
loss of principal. The Company has determined that the other observable inputs
discussed above are consistent with a Level 2 classification in accordance with
FAS 157. The Company will continue to evaluate any changes in the market value
of the failed ARS that have not been liquidated subsequent to quarter-end.
Depending upon future market conditions, the Company may be required to record
an other-than-temporary decline in fair value at that
time. 13. RESTRUCTURING
CHARGES
2008
Restructuring Plan
During
the first quarter of fiscal year 2008, the Company commenced the implementation
of a 2008 restructuring plan associated primarily with the relocation of support
activities, the closure of facilities in Pune, India and Sunnyvale, California,
and other employee reductions for the purpose of better integration and
alignment of Company functions. The restructuring activities were
recorded in accordance with Statement of Financial Accounting Standards
No. 146 Accounting for
Costs Associated with Exit or Disposal Activities (SFAS 146).
Accordingly, the Company recorded $1.0 million in restructuring expenses related
to costs associated with the termination of 21 employees across multiple
geographic regions and functions, primarily related to severance, benefits and
related costs. Furthermore, the Company recorded additional
restructuring costs of $0.8 million in connection with facilities and property
and equipment that was disposed of or removed from service. At
September 30, 2008, the Company’s restructuring accrual was $96,000 and included
as a component of “Other accrued liabilities” in the Company’s Condensed
Consolidated Balance Sheets.
SONICWALL,
INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
The
following tables set forth an analysis of the components of the 2008
restructuring plan and the payments made from December 31, 2007 to September 30,
2008 (in thousands):
ITEM
2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This
Form 10-Q contains forward-looking statements which relate to future events or
our future financial performance. In many cases you can identify
forward-looking statements by terminology such as “may”, “will,” “should,”
“expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,”
“intend” or “continue,” or the negative of such terms and other comparable
terminology. In addition, forward-looking statements in this document include,
but are not limited to, those regarding the dedication of resources to develop
new products and services and marketing those products and services to channel
partners and customers, the introduction of more service offerings on our
platforms as a vehicle to generate additional revenue from our installed base of
products; our ability to deliver comprehensive and profitable solutions to our
channel partners, the growth opportunity associated with sales through our
indirect channel to larger distributed enterprises, weakening
economic conditions that could lead to decreases in IT spending that could
adversely impact operating results, the level of comfort of our channel partners
in offering our solutions to their customers, the growth of the Network
Security, Secure Content Management and Business Continuity markets, the impact
of a failure to achieve greater international sales ,our ability to
maintain and enhance current product lines, develop new products, maintain
technological competitiveness and meet the expanding range of customer
requirements; the market opportunity for license and service revenue
growth; our ability to deliver comprehensive solutions to channel
partners, the positive characteristics of our software license and service
revenue model on future revenue growth and the predictability of our revenue
stream,; expected growth in license and subscription service revenue; the impact
on revenue of the combination of subscription services sold in conjunction with
new product offerings; expected competition in the Internet security market and
our ability to compete in markets in which we participate; impact of service
renewal rates on lowering selling and marketing expense, our ability to achieve
increased incremental revenue per transaction through success of our software
license and service revenue model, the impact of IT spending on demand for our
products and services, the current and likely future impact of share based
compensation expense as required by SFAS 123R on reported operating results,
anticipated revenue contributions of new products including continuous data
protection, email security and SSL-VPN products and related services; the impact
of growth in international operations on our exposure to foreign currency
fluctuations; the possible impact of uncertainties in the auction rate and asset
backed securities markets on the Company’s financial performance, our ability to
access funds held as auction rate securities in our investment portfolio pricing
pressures on our solution based offerings; anticipated higher gross margins
associated with our license and service offerings; the probability of
realization of all deferred tax assets; assessment of future effective tax rates
and the continued need for a partial tax valuation allowance; the potential for
product gross margins to erode based upon changes in product mix, downward
pressure on product pricing or upward pressure on production costs, the impact
of product mix on product gross profits; the impact of the completion of “in
sourcing” certain technical support functions on period over period comparisons
of cost of license and service revenue and gross margin; our ability to maintain
investment in current and future product development and enhancement efforts,
the introduction of new products and the broadening of existing product
offerings, planned investments and expenses in current and future product
development, production costs and sales volume comparisons between the NSA and
SSL-VPN products and other hardware appliances; the rate of change of general
and administrative expenses, the impact of geopolitical and
macro-economic conditions on demand for our offerings; the ability of our
contract manufacturers to meet our requirements; the belief that existing cash,
cash equivalents and short-term investments will be sufficient to meet our cash
requirements at least through the next twelve months; factors potentially
impacting operating cash flows in future periods; and expected fluctuations in
day sales outstanding. These statements are only predictions, and they are
subject to risks and uncertainties. Our actual results may differ
materially from those anticipated in these forward-looking statements as a
result of a variety of factors, including, but not limited to, those set forth
herein under the heading “Risk Factors” and also under the heading “Risk
Factors” in our Form 10-K filed with the Securities and Exchange Commission for
the fiscal year ended December 31, 2007. References to “we,” “our,”
and “us” refer to SonicWALL, Inc. and its subsidiaries.
Overview
SonicWALL
provides network security, content security, and business continuity solutions
for businesses of all sizes. Our solutions are typically deployed at
the edges of networks. These networks are often aggregated into
broader distributed deployments to support companies that do business in
multiple physical locations, interconnect their networks with trading partners,
or support a mobile or remote workforce. Our solutions are sold in
over 50 countries worldwide.
The
Company groups revenue into the following primary product categories of similar
products:
We
generate revenue within these product categories primarily from: (1) the sale of
products, (2) software licensing, (3) the sale of subscriptions for services,
and (4) the sale of other services.
We
currently outsource our hardware manufacturing and assembly to contract
manufacturers in the U.S. and Taiwan. Outsourcing our manufacturing
and assembly enables us to reduce fixed overhead and personnel costs and to
provide flexibility in meeting market demand.
We design
and develop the key components for the majority of our products. In
addition, we generally determine the components that are incorporated in our
products and select the appropriate suppliers of these
components. Product testing and burn-in are performed by our contract
manufacturers using tests that we typically specify.
We sell
our solutions primarily through distributors and value-added resellers, who in
turn sell our products to end-users. Some of our resellers are
carriers or service providers who provide solutions to the end-user customers as
managed services. Channel sales accounted for 99% of the total revenue in the
three and nine month periods ended September 30, 2008 compared to 97% and 99%,
respectively, for the same period last year. Alternative Technology,
Tech Data, and Ingram Micro, all of whom are technology product distributors,
collectively accounted for approximately 50% and 49% of our revenue in the three
and nine month periods ended September 30, 2008, respectively, compared to
approximately 50% and 51%, respectively, of our total revenue in the same
periods last year.
We seek
to provide our channel partners and customers with differentiated solutions that
are innovative, easy to use, reliable, and provide good value. To
support this commitment, we dedicate significant resources to developing new
products and marketing our products to our channel partners and
customers.
Key
Success Factors of our Business
We
believe that there are several key success factors of our business and that we
create value in our business by focusing on our execution in these
areas.
Channel
Our
distributors and authorized resellers provide a valuable service in assisting
end-users in the design, implementation, and service of our network security,
content security, and business continuity solutions. We support our
distribution and channel partners with sales, marketing, and technical support
to help them create and fulfill demand for our offerings. We also
focus on helping our channel partners succeed with our solutions by
concentrating on comprehensive reseller training and certification, and support
for our channel’s sales activities.
Product
and Service Platform
Our
products serve as a platform for revenue generation for both us and our channel
partners. Most product sales can result in additional revenue through
the simultaneous or subsequent acquisition of software licenses, such as our
Global Management System, or through the sale of additional value-added
subscription services, such as Content Filtering; client Anti-Virus and
integrated Gateway Anti-Virus; Anti-Spyware and Intrusion Prevention Services;
email protection and off-site data backup.
Distributed
Architecture
Our
security solutions are based on a distributed architecture, which we believe
allows our offerings to be deployed and managed at the most efficient location
in the network. We are providing our customers and their service
providers with mechanisms to enforce the networking and security policies they
have defined for their business. We also use the flexibility of a
distributed architecture to allow us to enable new functionality in
already-deployed platforms through the provisioning of an electronic key, which
may be distributed through the Internet.
Market
Acceptance
We began
offering integrated security appliances in 1997, and since that time we have
shipped about 1.3 million revenue units. When measured by units
shipped, we are typically among the top three suppliers in the markets in which
we compete. Our experience in serving a broad market and our
installed base of customers provides us with opportunities to sell our new
network security, content security, and business continuity solutions as they
become available. The market acceptance of our current solutions
provides our current and prospective channel partners with an increased level of
comfort when deciding to offer our new solutions to their
customers.
Integrated
Design
Our
platforms utilize a highly integrated design in order to improve ease-of-use,
lower acquisition and operational costs for our customers, and enhance
performance. Various models also integrate functionality to support
different internet connection alternatives. Every appliance also
ships with pre-loaded firmware to provide for rapid set up and easy
installation. Each of these tasks can be managed through a simple
web-browser session.
Our
Opportunities, Challenges, and Risks
We serve
substantial and growing markets for network security, content security, and
business continuity. Our goal is to deliver comprehensive and
profitable solutions to our channel partners which address their customers'
needs. We pursue the creation of these solutions through a blend of
organic and inorganic growth strategies including internal development efforts,
licensing and OEM opportunities, and acquisition of other
companies. To the extent that these efforts result in solutions which
fit well with our channel and end-users, we would expect to generate increasing
sales. To the extent that these efforts are not successful, we would
expect to see loss of sales and/or increased expenses without commensurate
return.
International
Growth
We expect
that international revenue will continue to represent a substantial portion of
our total revenue in the foreseeable future. Our percentage of sales
from international territories does not represent the same degree of penetration
of those markets as we have achieved domestically. We believe that a
significant opportunity exists to grow our revenue by increasing our
international penetration rate to match our penetration rate in the domestic
market.
If we
fail to structure our distribution relationships in a manner consistent with
marketplace requirements and on favorable terms, the percentage of sales from
international territories will decline and the revenue from our international
operations may decrease.
Growth
in Enterprises
We
believe that sales through our indirect channel to larger end-customers
represent a growth opportunity for the Company. Our percentage of
revenues from such customers does not represent the same degree of penetration
of that segment as we have achieved with small to medium sized
businesses. We believe that a significant opportunity exists to grow
our revenue by increasing our penetration rate with this segment by leveraging
the company’s technological and channel strengths.
If we
fail to establish competitive products and services for this segment, or fail to
develop the correct channel partners and resources, the percentage of our
revenue derived from larger end-customers will not increase, and may, in fact,
decrease.
License
and Services Revenue
We
believe that the software license and services component of our revenue has
several characteristics that are positive for our business as a whole: our
license and services revenue is associated with a higher gross profit than our
product revenue; the subscription services component of license and services
revenue is recognized ratably over the services period, and thus provides, in
the aggregate, a more predictable revenue stream than product or license
revenue, which are generally recognized at the time of the sale; to the extent
that we are able to effect renewals, we have the opportunity to lower our
selling and marketing expenses as a percentage of revenue attributable to that
segment. We have increased the rate at which we have been able to sell our
services to both our installed base and in conjunction with new product
sales. As a result, we have been able to increase the average value
of an end user customer transaction. We have experienced significant
growth in the percentage of our total revenue from software licenses and
services. Achieving further growth in this percentage will be determined by our
success in increasing the rates of selling services to our installed base or as
part of new solution sales along with the relative growth rate associated with
product sales.
Macro-Economic
Factors Affecting IT Spending
We
believe that our products and services are subject to the macro-economic factors
that affect much of the information technology (“IT”) market. Growing
IT budgets and an increased funding for projects to provide security, mobility,
data protection, and productivity could drive product upgrade cycles and/or
create demand for new applications of our solutions. Contractions in
IT spending can affect our revenue by causing projects incorporating our
products and services to be delayed and/or canceled. We believe that
demand for our solutions correlate with increases or decreases in global IT
spending and we believe that current economic uncertainties, including
fluctuating energy prices, difficulties in the financial sector, the
availability of credit, softness in the housing market, underlying market
liquidity, and geopolitical uncertainties may have an adverse impact on IT
spending in the markets in which we do business. Critical Accounting Policies and Critical Accounting Estimates The
preparation of our financial statements and related disclosures in conformity
with accounting principles generally accepted in the United States requires us
to make judgments, assumptions, and estimates that affect the amounts reported
in our consolidated financial statements and accompanying notes. We
believe that the judgments, assumptions and estimates upon which we rely are
reasonable based upon information available to us at the time that these
judgments, assumptions and estimates are made. However, any
differences between these judgments, assumptions and estimates and actual
results could have a material impact on our statement of operations and
financial condition. The accounting policies that reflect our most
significant judgments, assumptions and estimates and which we believe are
critical in understanding and evaluating our reported financial results include:
(1) revenue recognition; (2) sales returns and other allowances, allowance for
doubtful accounts and warranty reserve; (3) valuation of inventory; (4)
accounting for income taxes; (5) valuation of long-lived and intangible assets
and goodwill, (6) share-based compensation, and (7) fair value of
investments. There have been no material changes to any of our
critical accounting policies and critical accounting estimates as disclosed in
Part II, Item 7 of our annual report on Form 10-K for the year ended December
31, 2007.
RESULTS
OF OPERATIONS
The
following table sets forth certain consolidated financial data for the periods
indicated as percentage of total revenue:
The
following table shows SFAS 123R share-based compensation cost before taxes as a
percent of total revenue for the periods indicated:
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