Quarterly Report

Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the quarterly period ended January 26, 2013
OR  
¨
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: 000-25601
 
Brocade Communications Systems, Inc.
(Exact name of registrant as specified in its charter)
 
Delaware
 
77-0409517
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
130 Holger Way
San Jose, CA 95134
(408) 333-8000
(Address, including zip code, of principal
executive offices and 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   ý     No   ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes   ý     No   ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  
Large accelerated filer
 
ý
 
Accelerated filer
 
¨
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   ý
The number of shares outstanding of the registrant’s common stock as of February 22, 2013 was 451,058,020 shares.

Table of Contents

BROCADE COMMUNICATIONS SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED JANUARY 26, 2013
INDEX
 
 
Page
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 6.
 
 

2
Table of Contents

Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements regarding future events and future results. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including, but not limited to, statements regarding future revenue, margins, expenses, tax provisions, earnings, cash flows, benefit obligations, debt repayments, share repurchases or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning expected development, performance or market share relating to products or services; any statements regarding future economic conditions or performance; any statements regarding pending litigation, including claims or disputes; any statements of expectation or belief; and any statements of assumptions underlying any of the foregoing. Words such as “expects,” “anticipates,” “assumes,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “continues,” “may,” variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are based on current expectations, estimates, forecasts and projections about the industries in which Brocade operates, and the beliefs and assumptions of management. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to predict, including those identified below under “Part II - Other Information, Item 1A. Risk Factors” and elsewhere herein. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Further, Brocade undertakes no obligation to revise or update any forward-looking statements for any reason.

3
Table of Contents

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

BROCADE COMMUNICATIONS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)  
 
Three Months Ended
 
January 26,
2013
 
January 28,
2012
 
(In thousands, except per share amounts)
Net revenues
 
 
 
Product
$
502,247

 
$
476,302

Service
86,482

 
84,340

Total net revenues
588,729

 
560,642

Cost of revenues
 
 
 
Product
174,375

 
175,407

Service
40,429

 
40,466

Total cost of revenues
214,804

 
215,873

Gross margin
373,925

 
344,769

Operating expenses:
 
 
 
Research and development
97,690

 
89,319

Sales and marketing
149,011

 
152,688

General and administrative
19,077

 
18,350

Amortization of intangible assets
14,856

 
14,993

Total operating expenses
280,634

 
275,350

Income from operations
93,291

 
69,419

Interest expense
(26,368
)
 
(13,046
)
Interest and other income (loss), net
66

 
(996
)
Income before income tax
66,989

 
55,377

Income tax expense (benefit)
88,244

 
(3,207
)
Net income (loss)
$
(21,255
)
 
$
58,584

Net income (loss) per share — basic
$
(0.05
)
 
$
0.13

Net income (loss) per share — diluted
$
(0.05
)
 
$
0.12

Shares used in per share calculation — basic
454,843

 
452,494

Shares used in per share calculation — diluted
454,843

 
468,738


See accompanying notes to condensed consolidated financial statements.

4


BROCADE COMMUNICATIONS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited)
 
Three Months Ended
 
January 26,
2013
 
January 28,
2012
 
(In thousands)
Net income (loss)
$
(21,255
)
 
$
58,584

Other comprehensive loss:
 
 
 
Change in net unrealized losses on cash flow hedges, net of tax
(255
)
 
(2,845
)
Change in cumulative translation adjustments, net of tax
(380
)
 
(1,560
)
Total other comprehensive loss
(635
)
 
(4,405
)
Total comprehensive income (loss)
$
(21,890
)
 
$
54,179

 
See accompanying notes to condensed consolidated financial statements.


5

BROCADE COMMUNICATIONS SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
 
January 26,
2013
 
October 27,
2012
 
(In thousands, except par value)
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
683,616

 
$
713,226

Restricted cash
311,926

 
—

Accounts receivable, net of allowances for doubtful accounts of $798 and $833 at January 26, 2013 and October 27, 2012, respectively
216,706

 
233,139

Inventories
59,891

 
68,179

Deferred tax assets
64,981

 
91,539

Prepaid expenses and other current assets
53,839

 
49,496

Total current assets
1,390,959

 
1,155,579

Property and equipment, net
510,282

 
518,940

Goodwill
1,648,722

 
1,624,089

Intangible assets, net
108,948

 
109,265

Non-current deferred tax assets
80,420

 
136,175

Other assets
32,851

 
37,213

Total assets
$
3,772,182

 
$
3,581,261

Liabilities and Stockholders’ Equity

 
 
Current liabilities:
 
 
 
Accounts payable
$
101,808

 
$
117,350

Accrued employee compensation
114,593

 
182,597

Deferred revenue
218,303

 
216,283

Current portion of long-term debt
302,198

 
1,977

Other accrued liabilities
91,264

 
92,261

Total current liabilities
828,166

 
610,468

Long-term debt, net of current portion
597,440

 
599,203

Non-current deferred revenue
77,739

 
76,907

Non-current income tax liability
57,171

 
55,387

Other non-current liabilities
3,383

 
3,476

Total liabilities
1,563,899

 
1,345,441

Commitments and contingencies (Note 9)


 


Stockholders’ equity:
 
 
 
Preferred stock, $0.001 par value, 5,000 shares authorized, no shares issued and outstanding
—

 
—

Common stock, $0.001 par value, 800,000 shares authorized:
 
 
 
Issued and outstanding: 455,874 and 456,913 shares at January 26, 2013 and October 27, 2012, respectively
456

 
457

Additional paid-in capital
2,003,544

 
2,009,190

Accumulated other comprehensive loss
(10,499
)
 
(9,864
)
Retained earnings
214,782

 
236,037

Total stockholders’ equity
2,208,283

 
2,235,820

Total liabilities and stockholders’ equity
$
3,772,182

 
$
3,581,261

See accompanying notes to condensed consolidated financial statements.

6

BROCADE COMMUNICATIONS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
Three Months Ended
 
January 26,
2013
 
January 28,
2012
 
(In thousands)
Cash flows from operating activities:
 
 
 
Net income (loss)
$
(21,255
)
 
$
58,584

Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Excess tax benefits from stock-based compensation
(2,192
)
 
(1,147
)
Non-cash tax charges
78,206

 
—

Depreciation and amortization
49,394

 
50,105

Loss on disposal of property and equipment
1,989

 
256

Amortization of debt issuance costs and original issue discount
397

 
1,234

Call premium cost and original issue discount and debt issuance costs related to lenders that did not participate in refinancing
15,299

 
—

Net gains on investments
—

 
(12
)
Provision for doubtful accounts receivable and sales allowances
2,354

 
2,700

Non-cash compensation expense
19,150

 
21,819

Changes in assets and liabilities:
 
 
 
Restricted cash
(11,926
)
 
—

Accounts receivable
14,250

 
27,078

Inventories
9,625

 
(6,826
)
Prepaid expenses and other assets
(1,702
)
 
1,611

Deferred tax assets
165

 
22

Accounts payable
(14,960
)
 
(9,556
)
Accrued employee compensation
(72,570
)
 
(13,013
)
Deferred revenue
1,519

 
8,010

Other accrued liabilities
(8,253
)
 
(13,814
)
Net cash provided by operating activities
59,490

 
127,051

Cash flows from investing activities:
 
 
 
Proceeds from sale of subsidiary
—

 
(215
)
Purchases of property and equipment
(18,486
)
 
(17,556
)
Net cash paid in connection with acquisition

(44,629
)
 
—

Net cash used in investing activities
(63,115
)
 
(17,771
)
Cash flows from financing activities:
 
 
 
Proceeds from senior unsecured notes
296,250

 
—

Payment of principal related to the term loan
—

 
(70,000
)
Payment of principal related to capital leases
(484
)
 
(456
)
Common stock repurchases
(47,530
)
 
—

Proceeds from issuance of common stock
23,812

 
31,941

Excess tax benefits from stock-based compensation
2,192

 
1,147

Increase in restricted cash
(300,000
)
 
—

Net cash used in financing activities
(25,760
)
 
(37,368
)
Effect of exchange rate fluctuations on cash and cash equivalents
(225
)
 
(1,875
)
Net increase (decrease) in cash and cash equivalents
(29,610
)
 
70,037

Cash and cash equivalents, beginning of period
713,226

 
414,202

Cash and cash equivalents, end of period
$
683,616

 
$
484,239

Supplemental disclosures of cash flow information:
 
 
 
Cash paid for interest
$
20,490

 
$
22,227

Cash paid for income taxes
$
1,848

 
$
1,173

See accompanying notes to condensed consolidated financial statements.

7

BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1 . Basis of Presentation
Brocade Communications Systems, Inc. (“Brocade” or the “Company”) has prepared the accompanying Condensed Consolidated Financial Statements pursuant to the rules and regulations of the United States (“U.S.”) Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations. The Condensed Consolidated Balance Sheet as of October 27, 2012 was derived from the Company’s audited consolidated financial statements, but does not include all disclosures required by U.S. GAAP. These unaudited Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended October 27, 2012 .
The accompanying Condensed Consolidated Financial Statements are unaudited but, in the opinion of the Company’s management, reflect all adjustments, including normal recurring adjustments, that management considers necessary for a fair presentation of these Condensed Consolidated Financial Statements. The results for the interim periods presented are not necessarily indicative of the results for the full fiscal year or any other future period.
The Company’s fiscal year is a 52 or 53 week period ending on the last Saturday in October. Fiscal year 2013 is a 52-week fiscal year, and the first quarter of 2013 was a 13-week quarter. Fiscal year 2012 was a 52-week year, and the first quarter of 2012 was a 13-week quarter.
The Condensed Consolidated Financial Statements include the accounts of Brocade and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Use of Estimates in Preparation of Condensed Consolidated Financial Statements
The preparation of condensed consolidated financial statements and related disclosures in conformity with U.S. GAAP requires management to make estimates and judgments that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Estimates are used for, but not limited to, revenue recognition, sales allowances and programs, allowance for doubtful accounts, stock-based compensation, purchase price allocations, warranty obligations, inventory valuation and purchase commitments, restructuring costs, commissions, facilities lease losses, impairment of goodwill and intangible assets, litigation, income taxes and investments. Actual results may differ materially from these estimates. Certain reclassifications have been made to prior period amounts in order to conform to the current period’s presentation.

2 . Summary of Significant Accounting Policies
There have been no material changes in the Company’s significant accounting policies for the three months ended January 26, 2013 as compared to the significant accounting policies disclosed in Brocade’s Annual Report on Form 10-K for the fiscal year ended October 27, 2012 .
New Accounting Pronouncements or Updates Recently Adopted
In June 2011 and December 2011, the FASB issued updates to ASC 220 Comprehensive Income (“ASC 220”): Presentation of Comprehensive Income. The amendments from these updates increase the prominence of items reported in other comprehensive income and eliminate the option to present components of other comprehensive income as part of the statement of equity. The Company adopted these updates in the first quarter of fiscal year 2013, presenting the required information in the Condensed Consolidated Statements of Comprehensive Income (Loss).

8

Recent Accounting Pronouncements or Updates That Are Not Yet Effective
In February 2013, the FASB issued an update to ASC 220: Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. Under this update, an entity is required to provide information about the amounts reclassified out of accumulated other comprehensive income (”AOCI”) by component. In addition, an entity is required to present, either on the face of the financial statements or in the notes, significant amounts reclassified out of AOCI by the respective line items of net income, but only if the amount reclassified is required to be reclassified in its entirety in the same reporting period. For amounts that are not required to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures that provide additional details about those amounts. The update to ASC 220 should be applied prospectively and will be adopted by the Company in the second quarter of fiscal year 2013. The Company does not expect the adoption of ASC 220 to have a material impact on its financial position, results of operations or cash flows.
Concentrations
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents, and accounts receivable. The Company’s cash and cash equivalents are primarily maintained at five major financial institutions. Deposits held with banks may be redeemed upon demand and may exceed the amount of insurance provided on such deposits.
A majority of the Company’s accounts receivable balance is derived from sales to original equipment manufacturer (“OEM”) partners in the computer storage and server industry. As of January 26, 2013 , three customers accounted for 14% , 12% , and 11% , respectively, of total accounts receivable, for a combined total of 37% of total accounts receivable. As of October 27, 2012 , three customers accounted for 16% , 12% , and 10% , respectively, of total accounts receivable, for a combined total of 38% of total accounts receivable. The Company performs ongoing credit evaluations of its customers and generally does not require collateral on accounts receivable balances. The Company has established reserves for credit losses, sales allowances, and other allowances.
For the three months ended January 26, 2013 , three customers accounted for 18% , 18% , and 10% , respectively, of the Company’s total net revenues for a combined total of 46% of total net revenues. For the three months ended January 28, 2012 , three customers accounted for 20% , 15% and 13% , respectively, of the Company’s total net revenues for a combined total of 48% of total net revenues.
The Company currently relies on single and limited sources for multiple key components used in the manufacture of its products. Additionally, the Company relies on contract manufacturers (“CMs”) for the manufacturing of its products. Although the Company uses standard parts and components for its products where possible, the Company’s CMs currently purchase, on the Company’s behalf, several key product components from single or limited supplier sources.

3 . Acquisitions
On November 9, 2012 , the Company completed its acquisition of Vyatta, Inc. (“Vyatta”), a privately held developer of a software-based network operating system suite headquartered in Belmont, California, which became a wholly-owned subsidiary of the Company as a result of the acquisition. The Vyatta operating suite is relevant for multiple applications in network virtualization, software-defined networking (“SDN”) and private/public cloud computing platforms. This acquisition complements Brocade’s investments in Ethernet switches and routers fabrics and enables Brocade to pursue new market opportunities in data center virtualization, public cloud, enterprise virtual private cloud, and managed services.
The results of operations of Vyatta are included in the Company’s Condensed Consolidated Statement of Operations from the date of the acquisition. The Company does not consider the acquisition of Vyatta to be material to its results of operations or financial position, and therefore, Brocade is not presenting pro-forma financial information of combined operations.

9

The total purchase price was $44.8 million , consisting of $43.6 million cash consideration and $1.2 million related to prepaid license fees paid by the Company to Vyatta which was effectively settled at the recorded amount as a result of the acquisition. Of the cash consideration paid, $7.0 million will be held in escrow for a period of 18 months from the closing of the acquisition and will be released subject to resolution of certain contingencies. In addition, the Company paid direct acquisition costs of $0.4 million .
In connection with this acquisition, the Company allocated the total purchase consideration to the net assets and liabilities acquired, including identifiable intangible assets, based on their respective fair values at the acquisition date. The following table summarizes the allocation of the purchase price to the fair value of the assets and liabilities acquired (in thousands):
Assets acquired
 
Cash
$
140

Accounts receivable
511

Identifiable intangible assets:
 
In-process technology
21,700

Customer relationships
1,280

Core/Developed technology
1,050

Non-compete agreements
830

Trade name
460

Total identifiable intangible assets
25,320

Goodwill (1)
25,373

Other assets
1,017

Total assets acquired
52,361

Liabilities assumed
 
Deferred tax liability
3,528

Deferred revenue
1,333

Accounts payable and other accrued liabilities
2,731

Total liabilities assumed
7,592

Net assets acquired
$
44,769

(1)
None of the goodwill recognized is expected to be deductible for income tax purposes.
The allocation of the purchase price reflects the Company’s preliminary estimate in relation to the fair value of the Company’s identifiable intangible assets and deferred tax liability which is subject to change during the Vyatta acquisition’s measurement period.


10

4 . Goodwill and Intangible Assets
The following table summarizes goodwill activity by reportable segment for the three months ended January 26, 2013 (in thousands):
 
SAN 
Products
 
IP Networking Products
 
Global Services
 
Total
Balance at October 27, 2012
 
 
 
 
 
 
 
Goodwill
$
176,956

 
$
1,337,549

 
$
155,416

 
$
1,669,921

Accumulated impairment losses
—

 
(45,832
)
 
—

 
(45,832
)
 
176,956

 
1,291,717

 
155,416

 
1,624,089

Acquisitions
—

 
25,373

 
—

 
25,373

Tax and other adjustments during the three months ended January 26, 2013 (1)
(2
)
 
(738
)
 
—

 
(740
)
Balance at January 26, 2013
 
 
 
 
 
 
 
Goodwill
176,954

 
1,362,184

 
155,416

 
1,694,554

Accumulated impairment losses
—

 
(45,832
)
 
—

 
(45,832
)
 
$
176,954

 
$
1,316,352

 
$
155,416

 
$
1,648,722

 
(1)
The goodwill adjustments during the three months ended January 26, 2013 were primarily a result of tax benefits from the exercise of stock awards of acquired companies.
The Company conducts its goodwill impairment test annually, as of the first day of the second fiscal quarter, and whenever events or changes in facts and circumstances indicate that the fair value of the reporting unit may be less than its carrying amount. For the annual goodwill impairment test, the Company uses the income approach, the market approach, or a combination thereof, to determine each reporting unit’s fair value. The income approach provides an estimate of fair value based on discounted expected future cash flows (“DCF”). The market approach provides an estimate of fair value using various prices or market multiples applied to the reporting unit’s operating results and then applying an appropriate control premium. For the fiscal year 2012 annual goodwill impairment test, the Company used a combination of approaches to estimate each reporting unit’s fair value. The Company believed that at the time of impairment testing performed in the second fiscal quarter of 2012, the income approach and the market approach were equally representative of a reporting unit’s fair value.
Determining the fair value of a reporting unit or an intangible asset requires judgment and involves the use of significant estimates and assumptions. The Company based its fair value estimates on assumptions it believes to be reasonable, but inherently uncertain. Estimates and assumptions with respect to the determination of the fair value of its reporting units using the income approach include, among other inputs:
•
The Company’s operating forecasts;
•
Revenue growth rates; and
•
Risk-commensurate discount rates and costs of capital.
The Company’s estimates of revenues and costs are based on historical data, various internal estimates and a variety of external sources, and are developed as part of our regular long-range planning process. The control premium used in market or combined approaches is determined by considering control premiums offered as part of the acquisitions that have occurred in the reporting units’ comparable market segments. Based on the results of the annual goodwill impairment analysis performed during the second fiscal quarter of 2012, the Company determined that no impairment needed to be recorded. During the three months ended January 26, 2013 , there were no facts and circumstances that indicated that the fair value of the reporting units may be less than their current carrying amount. Consistent with prior years, the Company will perform its annual goodwill impairment test using measurement data as of the first day of the second fiscal quarter of 2013 .

11

Intangible assets other than goodwill are amortized on a straight-line basis over the following estimated remaining useful lives, unless the Company has determined these lives to be indefinite. The following tables present details of the Company’s intangible assets (in thousands, except for weighted-average remaining useful life):
January 26, 2013
Gross
Carrying
Value
 
Accumulated
Amortization
 
Net
Carrying
Value
 
Weighted-
Average
Remaining
Useful Life
(in years)
Trade name
$
10,901

 
$
10,466

 
$
435

 
3.76

Core/developed technology
338,908

 
302,863

 
36,045

 
0.97

Customer relationships
353,860

 
303,877

 
49,983

 
1.03

Non-compete agreements
1,200

 
415

 
785

 
3.76

In-process research and development (1)
21,700

 
—

 
21,700

 
—

Total intangible assets
$
726,569

 
$
617,621

 
$
108,948

 
1.04

 
 
 
 
 
 
 
 
October 27, 2012
Gross
Carrying
Value
 
Accumulated
Amortization
 
Net
Carrying
Value
 
Weighted-
Average
Remaining
Useful Life
(in years)
Trade name
$
10,441

 
$
10,438

 
$
3

 
0.17

Core/developed technology
337,858

 
292,083

 
45,775

 
1.14

Customer relationships
352,581

 
289,094

 
63,487

 
1.16

Total intangible assets
$
700,880

 
$
591,615

 
$
109,265

 
1.16

(1)
Acquired in-process research and development (“IPRD”) is an intangible asset accounted for as an indefinite-lived asset until the completion or abandonment of the associated research and development effort. While accounted as an indefinite-lived asset, the IPRD intangible asset is subject to testing for impairment annually or when there are indicators of impairment. If the IPRD project is successfully completed, then the IPRD intangible asset will be amortized over its estimated useful life to be determined at the date the project is completed. During the three months ended January 26, 2013 , the IPRD intangible asset was not amortized due to the current stage of the associated research and development effort.
The following table presents the amortization of intangible assets included in the Condensed Consolidated Statements of Income (in thousands):
 
Three Months Ended
 
January 26, 2013
 
January 28, 2012
Cost of revenues
$
10,780

 
$
14,090

Operating expenses
14,856

 
14,993

Total
$
25,636

 
$
29,083


12

The following table presents the estimated future amortization of intangible assets, including IPRD that is currently estimated to be amortized in 2014 and thereafter, as of January 26, 2013 (in thousands):
Fiscal Year
Estimated
Future
Amortization
2013 (remaining nine months)
$
68,371

2014
21,423

2015
5,269

2016
4,930

2017
4,607

Thereafter
4,348

Total
$
108,948


5 . Balance Sheet Details
The following table provides details of selected balance sheet items (in thousands):
 
January 26,
2013
 
October 27,
2012
Inventories:
 
 
 
Raw materials
$
17,564

 
$
24,240

Finished goods
42,327

 
43,939

Total
$
59,891

 
$
68,179

 
January 26,
2013
 
October 27,
2012
Property and equipment, net:
 
 
 
Computer equipment
$
19,045

 
$
17,953

Software
54,098

 
51,680

Engineering and other equipment (1)
407,756

 
409,524

Furniture and fixtures (1)
31,913

 
30,516

Leasehold improvements
26,531

 
26,306

Land and building
384,666

 
384,666

Subtotal
924,009

 
920,645

Less: Accumulated depreciation and amortization  (1), (2)
(413,727
)
 
(401,705
)
Total
$
510,282

 
$
518,940

 
(1)     Engineering and other equipment, furniture and fixtures and accumulated depreciation and amortization include the following amounts under capital leases as of January 26, 2013 and October 27, 2012 (in thousands):
 
January 26,
2013
 
October 27,
2012
Cost
$
11,612

 
$
10,613

Accumulated depreciation
(4,026
)
 
(3,647
)
Total
$
7,586

 
$
6,966


13


(2)    The following table presents the depreciation of property and equipment included in the Condensed Consolidated Statements of Income (in thousands):
 
Three Months Ended
 
January 26,
2013
 
January 28,
2012
Depreciation expense
$
23,758

 
$
21,022


6 . Fair Value Measurements
The Company applies fair value measurements for both financial and nonfinancial assets and liabilities. The Company has no nonfinancial assets and liabilities that are required to be measured at fair value on a recurring basis as of January 26, 2013 .
The fair value accounting guidance permits companies to elect fair value measurement for many financial instruments and certain other items that are otherwise not required to be accounted for at fair value. The Company did not elect to measure any eligible financial instruments or other assets at fair value as of January 26, 2013 and October 27, 2012 .
Fair Value Hierarchy
The Company utilizes a fair value hierarchy that maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
Assets and liabilities measured and recorded at fair value on a recurring basis as of January 26, 2013 were as follows (in thousands):
 
 
 
Fair Value Measurements Using
 
 Balance as of
 January 26, 2013
 
Quoted Prices in
Active Markets
For Identical
Instruments
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Assets:
 
 
 
 
 
 
 
Money market funds (1)
$
233,975

 
$
233,975

 
$
—

 
$
—

Derivative assets
3,316

 
—

 
3,316

 
—

Total assets measured at fair value
$
237,291

 
$
233,975

 
$
3,316

 
$
—

Liabilities:
 
 
 
 
 
 
 
Derivative liabilities
$
944

 
$
—

 
$
944

 
$
—

Total liabilities measured at fair value
$
944

 
$
—

 
$
944

 
$
—

 
(1)
Money market funds are reported within “Cash and cash equivalents” in the Condensed Consolidated Balance Sheets.

14

Assets and liabilities measured and recorded at fair value on a recurring basis as of October 27, 2012 were as follows (in thousands):
 
 
 
Fair Value Measurements Using
 
 Balance as of
 October 27, 2012
 
Quoted Prices in
Active Markets
For Identical
Instruments
(Level 1)
 
Significant  Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Assets:
 
 
 
 
 
 
 
Money market funds (1)
$
308,960

 
$
308,960

 
$
—

 
$
—

Derivative assets
2,941

 
—

 
2,941

 
—

Total assets measured at fair value
$
311,901

 
$
308,960

 
$
2,941

 
$
—

Liabilities:
 
 
 
 
 
 
 
Derivative liabilities
$
296

 
$
—

 
$
296

 
$
—

Total liabilities measured at fair value
$
296

 
$
—

 
$
296

 
$
—

 
(1)
Money market funds are reported within “Cash and cash equivalents” in the Condensed Consolidated Balance Sheets.
During the three months ended January 26, 2013 , the Company had no transfers between levels of the fair value hierarchy of its assets measured at fair value.

7 . Liabilities Associated with Facilities Lease Losses
The Company reevaluates its estimates and assumptions on a quarterly basis and makes adjustments to the reserve balance if necessary. The following table summarizes the activity related to the facilities lease loss reserve included in “Other accrued liabilities” and “Other non-current liabilities” in the Condensed Consolidated Balance Sheets, net of expected sublease income (in thousands):
 
Lease Loss
Reserve
Reserve balance at October 27, 2012
$
2,582

Cash payments on facilities leases
(191
)
Reserve balance at January 26, 2013
$
2,391


Cash payments for facilities that are part of our lease loss reserve are expected to be paid over the respective lease terms through fiscal year 2017.


15

8 . Borrowings
The following table provides details of the Company’s long-term debt (in thousands, except percentages):
 
 
 
 
 
 
 
January 26, 2013
 
October 27, 2012
 
 
Maturity
 
Stated Annual Interest Rate
 
Amount
 
Effective Interest Rate
 
Amount
 
Effective Interest Rate
Senior Secured Notes:
 
 
 
 
 
 
 
 
 
 
 
 
 
2018 Notes
 
2013
 
6.625%
 
$
300,000

 
9.17
%
 
$
300,000

 
7.05
%
2020 Notes
 
2020
 
6.875%
 
300,000

 
7.26
%
 
300,000

 
7.26
%
Senior Unsecured Notes:
 
 
 
 
 
 
 
 
 
 
 
 
2023 Notes
 
2023
 
4.625%
 
300,000

 
4.82
%
 
—

 
—
%
Capital lease obligations
 
2016
 
5.699%
 
5,431

 
5.58
%
 
4,916

 
5.80
%
Total long-term debt
 
 
 
 
 
 
905,431

 
 
 
604,916

 
 
Less:
 
 
 
 
 
 
 
 
 
 
 
 
 
Unamortized discount
 
 
 
 
 
 
5,793

 
 
 
3,736

 
 
Current portion of long-term debt
 
 
 
 
 
 
302,198

 
 
 
1,977

 
 
Long-term debt, net of current portion
 
 
 
 
 
 
$
597,440

 
 
 
$
599,203

 
 
Senior Unsecured Notes
In January 2013, the Company issued 4.625% senior unsecured notes in the aggregate principal amount of $300.0 million due 2023 (the “2023 Notes”) pursuant to an Indenture, dated as of January 22, 2013 (the “2023 Indenture”) between the Company, certain domestic subsidiaries of the Company that have guaranteed the Company’s obligations under the 2023 Notes (as described in Note 15 , “ Guarantor and Non-Guarantor Subsidiaries ”) and Wells Fargo Bank, National Association as the trustee. The Company irrevocably deposited the net proceeds from this offering, together with cash on hand, with the trustee to redeem all of the Company’s outstanding 6.625% senior secured notes due 2018 (“2018 Notes”) as described below under “ Senior Secured Notes ”.
The 2023 Notes bear interest payable semi-annually on January 15 and July 15 of each year. No payments were made towards the principal of the 2023 Notes during the three months ended January 26, 2013 .
As of January 26, 2013 , the fair value of the Company’s 2023 Notes was approximately $300.8 million , estimated based on broker trading prices.
On or after January 15, 2018, the Company may redeem all or a part of the 2023 Notes at the redemption prices set forth in the 2023 Indenture, plus accrued and unpaid interest, if any, up to but excluding the redemption date. At any time prior to January 15, 2018, the Company may redeem all or a part of the 2023 Notes at a price equal to 100% of the principal amount of the 2023 Notes, plus an applicable premium and accrued and unpaid interest, if any, up to but excluding the redemption date. In addition, at any time prior to January 15, 2016, the Company may redeem up to 35% of the principal amount of the 2023 Notes, using the net cash proceeds of one or more sales of the Company’s capital stock at a redemption price equal to 104.625% of the principal amount of the 2023 Notes redeemed, plus accrued and unpaid interest, if any, up to but excluding the redemption date.
If the Company experiences a specified change of control triggering event, it must offer to repurchase the 2023 Notes at a repurchase price equal to 101% of the principal amount of the 2023 Notes repurchased, plus accrued and unpaid interest, if any, up to but excluding the repurchase date.

16

The 2023 Indenture contains covenants that, among other things, restrict the ability of the Company and its subsidiaries to:
•
incur certain liens and enter into certain sale leaseback transactions;
•
create, assume, incur or guarantee additional indebtedness of the Company’s subsidiaries without such subsidiary guaranteeing the 2023 Notes on a pari passu basis; and
•
consolidate or merge with, or convey, transfer or lease all or substantially all of the Company’s or its subsidiaries’ assets.
These covenants are subject to a number of limitations and exceptions set forth in the 2023 Indenture. The 2023 Indenture also includes customary events of default, including cross-defaults to other debt of the Company and its subsidiaries. The Company was in compliance with all applicable covenants of the 2023 Indenture as of January 26, 2013 .
Senior Secured Notes
In January 2010, the Company issued $300.0 million aggregate principal amount of the 2018 Notes and $300.0 million in aggregate principal amount of 6.875% senior secured notes due 2020 (the “2020 Notes” and together with the 2018 Notes, the “Senior Secured Notes”) pursuant to separate indentures, each dated as of January 20, 2010, between the Company, certain domestic subsidiaries of the Company that have guaranteed the Company's obligations under the Senior Secured Notes and Wells Fargo Bank, National Association as the trustee (the “2020 Indenture” and “2018 Indenture”, respectively). The Senior Secured Notes bear interest payable semi-annually. No payments were made towards the principal of the Senior Secured Notes during the three months ended January 26, 2013 . The Company’s obligations under the 2020 Notes are, and prior to January 22, 2013, the Company’s obligations under the 2018 Notes were, guaranteed by certain of the Company’s domestic subsidiaries and secured by a lien on substantially all of the Company’s and the subsidiary guarantors’ assets. See Note 15 , “ Guarantor and Non-Guarantor Subsidiaries .”
As of January 26, 2013 and October 27, 2012 , the fair value of the Senior Secured Notes was approximately $638.6 million and $638.3 million , respectively, estimated based on broker trading prices.
On January 22, 2013, the Company called the 2018 Notes for redemption at a redemption price equal to 103.313% of the principal amount of the 2018 Notes and irrevocably deposited $311.9 million with the trustee for the 2018 Notes to discharge the 2018 Indenture. As a result of the deposit and discharge, the guarantees provided by certain of the Company’s domestic subsidiaries and the liens granted by the Company and the subsidiary guarantors to secure their obligations in respect of the 2018 Notes were released as of the date of the deposit. The amount deposited with the trustee included $300.0 million to repay the principal amount of the 2018 Notes, $9.9 million representing the difference between the redemption price and the principal amount of the 2018 Notes (“Call Premium”) and $2.0 million of unpaid interest payable up to the redemption date of February 21, 2013, but excluding the date of redemption. The trustee will use the deposited amounts to redeem the 2018 Notes on February 21, 2013. The Company reported the deposited amounts as “Restricted cash” in the Condensed Consolidated Balance Sheet as of January 26, 2013 .
In accordance with the applicable accounting guidance for debt modification and extinguishment, and for interest costs accounting, the Company expensed the Call Premium, remaining debt issuance costs and remaining original issue discount relating to the 2018 Notes, which totaled $15.3 million . The Company reported this expense within “Interest expense” in the Condensed Consolidated Statements of Operations for the three months ended January 26, 2013 .
On or after January 2015, the Company may redeem all or a part of the 2020 Notes at the redemption prices set forth in the 2020 Indenture, plus accrued and unpaid interest and special interest, if any, to the applicable redemption date. In addition, at any time prior to January 2015, the Company may, on one or more than one occasion, redeem some or all of the 2020 Notes at any time at a redemption price equal to 100% of the principal amount of the 2020 Notes redeemed, plus a “make-whole” premium determined as of, and accrued and unpaid interest and special interest, if any, to the applicable redemption date.

17

If the Company experiences specified change of control triggering events, it must offer to repurchase the 2020 Notes at a repurchase price equal to 101% of the principal amount of the 2020 Notes repurchased, plus accrued and unpaid interest and special interest, if any, to the applicable repurchase date. If the Company or its subsidiaries sell assets under certain specified circumstances, the Company must offer to repurchase the 2020 Notes at a repurchase price equal to 100% of the principal amount of the 2020 Notes repurchased, plus accrued and unpaid interest and special interest, if any, to the applicable repurchase date.
The 2020 Indenture contains covenants that, among other things, restrict the ability of the Company and its restricted subsidiaries to:
•
pay dividends, make investments or make other restricted payments;
•
incur additional indebtedness;
•
sell assets;
•
enter into transactions with affiliates;
•
incur liens;
•
permit consensual encumbrances or restrictions on the Company’s restricted subsidiaries’ ability to pay dividends or make certain other payments to the Company;
•
consolidate, merge, sell or otherwise dispose of all or substantially all of the Company’s or its restricted subsidiaries’ assets; and
•
designate subsidiaries as unrestricted.
These covenants are subject to a number of limitations and exceptions set forth in the 2020 Indenture. The 2020 Indenture also includes customary events of default, including cross-defaults to other debt of the Company and its subsidiaries. The Company was in compliance with all applicable covenants of the 2020 Indenture as of January 26, 2013 and October 27, 2012 . Prior to discharge, the 2018 Indenture contained substantially similar covenants and events of default to those in the 2020 Indenture. The Company was in compliance with all applicable covenants of the 2018 Indenture as of the date of discharge.
Senior Secured Credit Facility
In October 2008, the Company entered into a credit facility agreement for (i) a five -year $1,100.0 million term loan facility and (ii) a five -year $125.0 million revolving credit facility, which includes a $25.0 million swing line loan sub-facility and a $25.0 million letter of credit sub-facility (”Senior Secured Credit Facility”). The Company’s obligations under the Senior Secured Credit Facility are guaranteed by certain of the Company’s domestic subsidiaries and secured by a lien on substantially all of the Company’s and the subsidiary guarantors’ assets. The credit facility agreement was subsequently amended in January 2010 and June 2011 extending the maturity date of the Senior Secured Credit Facility to October 31, 2014.
There was no principal amount outstanding under the term loan facility as of either January 26, 2013 or October 27, 2012 .
The Company may draw additional proceeds from the revolving credit facility in the future for ongoing working capital and other general corporate purposes. There were no principal amounts outstanding under the revolving credit facility and the full $125 million was available for future borrowing under the revolving credit facility as of January 26, 2013 and October 27, 2012 .
The credit agreement contains financial covenants that require the Company to maintain a minimum consolidated fixed charge coverage ratio, a maximum consolidated leverage ratio and a maximum consolidated senior secured leverage ratio. The credit agreement also includes customary non-financial covenants (similar in nature to those under the Senior Secured Notes) and customary events of default, including cross-defaults to the Company’s material indebtedness and change of control. The Company was in compliance with all applicable Senior Secured Credit Facility’s covenants as of January 26, 2013 and October 27, 2012 .

18

Debt Maturities
As of January 26, 2013 , our aggregate debt maturities based on outstanding principal were as follows (in thousands):
Fiscal Year
Principal
Balances
2013 (remaining nine months)
$
301,659

2014
2,417

2015
1,181

2016
174

2017
—

Thereafter
600,000

Total
$
905,431



9 . Commitments and Contingencies
Product Warranties
The Company’s accrued liability for estimated future warranty costs is included in “Other accrued liabilities” in the accompanying Condensed Consolidated Balance Sheets. The following table summarizes the activity related to the Company’s accrued liability for estimated future warranty costs during the three months ended January 26, 2013 and January 28, 2012 (in thousands):
 
Accrued Warranty
 
Three Months Ended
 
January 26,
2013
 
January 28,
2012
Beginning balance
$
14,453

 
$
11,298

Liabilities accrued for warranties issued during the period
970

 
1,777

Warranty claims paid and used during the period
(1,995
)
 
(229
)
Changes in liability for pre-existing warranties during the period
(1,101
)
 
(479
)
Ending balance
$
12,327

 
$
12,367


In addition, the Company has standard defense and indemnification clauses contained within its various customer contracts. As such, the Company indemnifies the parties to whom it sells its products with respect to the Company’s product, alone or potentially in combination with others, infringing upon any patents, trademarks, copyrights, or trade secrets, as well as against bodily injury or damage to real or tangible personal property caused by a defective Company product. As of January 26, 2013 , there have been no known events or circumstances that have resulted in a material customer contract-related indemnification liability to the Company.
Manufacturing and Purchase Commitments
Brocade has manufacturing arrangements with CMs under which Brocade provides twelve-month product forecasts and places purchase orders in advance of the scheduled delivery of products to Brocade’s customers. The required lead time for placing orders with the CMs depends on the specific product. Brocade issues purchase orders and the CMs then generate invoices based on prices and payment terms mutually agreed upon and set forth in those purchase orders. Although the purchase orders Brocade places with its CMs are cancellable, the terms of the agreements require Brocade to purchase all inventory components not returnable, usable by, or sold to other customers of the CMs.

19

As of January 26, 2013 , the Company’s aggregate commitment to the CMs for inventory components used in the manufacture of Brocade products was $193.2 million , which the Company expects to utilize during future normal ongoing operations, net of a purchase commitments reserve of $4.3 million . The Company’s purchase commitments reserve reflects the Company’s estimate of purchase commitments it does not expect to consume in normal ongoing operations within the next twelve months .
Income Taxes
The Company has several ongoing income tax audits. For additional discussions, see Note 12 , “ Income Taxes ,” of the Notes to Condensed Consolidated Financial Statements. The Company believes it has adequate reserves for all open tax years.

Legal Proceedings

Stockholder Litigation

In March 2012, a stockholder filed a complaint in Santa Clara County Superior Court captioned Stephen Knee vs. Brocade Communications Systems, Inc., et al. alleging that the proposal in Brocade’s proxy for its 2012 annual meeting of stockholders seeking additional shares for the 2009 Stock Plan pool was misleading and incomplete; the plaintiff claimed the right to enjoin the stockholders’ vote. In early April 2012, the plaintiff filed a motion for preliminary injunction seeking to enjoin the stockholders’ vote on the proposal. Brocade filed an opposition to the plaintiff’s motion for preliminary injunction. On April 10, 2012, the Court held a hearing and issued an order granting the plaintiff’s motion. On April 12, 2012, the Court entered a stipulation and order regarding settlement in which Brocade agreed to postpone the vote on the proposal at least seven days and to issue supplemental disclosures regarding the proposal. The supplemental disclosures were filed with the SEC on April 12, 2012. Brocade’s stockholders approved the proposal on April 20, 2012. On July 26, 2012, the parties signed a Stipulation of Settlement regarding the matter. On August 10, 2012, the plaintiff filed a Motion for Preliminary Approval of Settlement. On December 7, 2012 the plaintiff filed a Motion for Final Approval of Settlement. On December 13, 2012 the Court issued a tentative ruling to grant the Motion for Final Approval of Settlement. The Court granted Final Approval of Settlement on December 14, 2012. Final Judgment was entered on December 19, 2012. Brocade has completed payment of attorney fees and expenses to plaintiff's counsel in an amount immaterial to Brocade in accordance with the settlement and the Final Judgment.

Intellectual Property Litigation
On June 21, 2005, Enterasys Networks, Inc. (“Enterasys”) filed a lawsuit against Foundry Networks, LLC (formerly Foundry Networks, Inc.) (“Foundry”) (and Extreme Networks, Inc.) in the United States District Court for the District of Massachusetts alleging that certain of Foundry’s products infringe six of Enterasys’ patents and seeking injunctive relief, as well as unspecified damages. The Court severed the claims against Extreme from the claims against Foundry for trial, and Enterasys subsequently added Brocade as a defendant. On August 28, 2007, the Court granted Foundry’s motion to stay the case based on petitions that Foundry had filed with the United States Patent and Trademark Office (“USPTO”) in 2007 for reexamination of five of the six Enterasys patents. Two of the patents received final rejections during their respective reexaminations, in which the USPTO held that the claims were invalid. Enterasys filed appeals of those rejections with the USPTO’s Board of Patent Appeals and Interferences in 2009. The USPTO’s Board partially affirmed and partially reversed the other of those two rejections on January 24, 2011, and Enterasys did not appeal further, which ended the proceedings on those two patents. The USPTO has issued reexamination certificates for the remaining three patents undergoing reexamination indicating that the patents were valid over the references that had been submitted. Meanwhile, on May 21, 2010, the Court lifted the stay of the litigation, and Enterasys subsequently dropped from the litigation the two patents it appealed at the USPTO. Accordingly, four patents remain at issue in the litigation. No trial date has been set.

20

On September 6, 2006, Chrimar Systems, Inc. (“Chrimar”) filed a lawsuit against Foundry (and D-Link Corporation and PowerDsine, Ltd.) in the United States District Court for the Eastern District of Michigan alleging that certain of Foundry’s products infringe Chrimar’s U.S. Patent 5,406,260 and seeking injunctive relief, as well as unspecified damages. Discovery has been completed. On June 1, 2012, Brocade filed its second Supplemental Statement of Material Facts In Support of the Motion for Summary Judgment of Invalidity of Paradigm Claim 17 of the 5,406,260 patent. On August 1, 2012, the Court issued its Memorandum and Order Granting Defendant’s Motion for Summary Judgment of Invalidity and dismissed the case. On August 30, 2012, Chrimar filed a notice of appeal and on November 5, 2012 filed its appeal brief. The Company filed its responsive brief on December 20, 2012. Chrimar filed its Reply Brief on January 22, 2013. The appeal is currently pending in the U.S. Court of Appeals for the Federal Circuit, Case No. 2012-1641.
On August 4, 2010, Brocade and Foundry (collectively and for this paragraph only, "Brocade") filed a lawsuit against A10 Networks, Inc. (“A10”), A10’s founder and other individuals in the United States District Court for the Northern District of California. On October 29, 2010, Brocade filed an amended complaint. In the amended complaint, Brocade alleged that A10 and the individual defendants have misappropriated Brocade’s trade secrets, infringed Brocade’s copyrighted works, interfered with existing contracts between Brocade and their employees, whereby certain of Brocade's current and ex-employees breached contracts, breached their fiduciary duties and duties of loyalty to Brocade, and that certain of A10’s products infringe 13 of Brocade’s patents. Brocade is seeking injunctive relief, as well as monetary damages. On May 16, 2011, A10 filed an answer and counterclaim alleging that certain of Brocade’s products infringe a patent recently acquired by A10 and seeking injunctive relief, as well as unspecified damages. In addition, A10 filed petitions with the USPTO to have each of 13 of the patents reexamined, in view of prior art that A10 alleges invalidates the patents. The petitions were granted, and reexaminations of the patents are in progress. On January 6, 2012, the Court granted Brocade’s summary judgment motion of non-infringement of the A10 patent. Trial on Brocade’s claims against A10 and the individual defendants commenced on July 16, 2012. On August 6, 2012, the jury found A10 responsible for intellectual property infringement and unfair competition, and awarding damages to Brocade. On November 8, 2012 the Court heard argument on the parties’ post-trial motions. On January 11, 2013, the Court issued an order that affirmed the jury’s finding of A10’s liability for patent and copyright infringement, trade secret misappropriation, and unfair competition due to A10’s interference with the employment contract of a Foundry Networks employee beginning in 2007. The Court also confirmed the jury’s award of $60 million to Brocade in damages for copyright infringement. The Court did, however, vacate the jury's award of damages for patent infringement, and its award of punitive damages for A10's and Lee Chen's interference with the employment contract of the Foundry employee, and ordered a new trial to re-determine the amounts of any such damages. No trial date has been set. On January 11, 2013, the Court also issued a permanent injunction prohibiting A10 from shipping any A10 products that infringe Brocade’s patents. On January 23, 2013, the Court issued a permanent injunction prohibiting A10 from further use of the misappropriated trade secrets. On February 8, 2013, A10 filed a Notice of Appeal of the permanent injunctions. A10 also asked the Court to stay both of the injunctions pending appeal. On February 12, 2013, the Court denied A10’s request to stay the injunctions. Both of the Court-ordered permanent injunctions against A10 are in effect and, among other restrictions imposed by the Court, prohibit A10 from shipping any of its infringing products.
On September 9, 2011, A10 filed a lawsuit against Brocade in the United States District Court for the Northern District of California. A10 alleged that certain of Brocade’s products infringed two patents acquired by A10. After Brocade moved to dismiss the complaint, A10 dismissed one of its patents-in-suit, leaving only one patent at issue. In lieu of answering the complaint, Brocade filed a new motion to dismiss the complaint, which was granted. On June 27, 2012, the Court entered a Final Judgment dismissing A10’s action. A10 has appealed the Judgment and the appeal is pending before the U.S. Court of Appeals for the Federal Circuit.


21

General
From time to time, the Company is subject to other legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks, copyrights, patents and/or other intellectual property rights and commercial contract disputes. Third parties assert patent infringement claims against the Company from time to time in the form of letters, lawsuits and other forms of communication. In addition, from time to time, the Company receives notification from customers claiming that they are entitled to indemnification or other obligations from the Company related to infringement claims made against them by third parties. Litigation, even if the Company is ultimately successful, can be costly and divert management’s attention away from the day-to-day operations of the Company.
On a quarterly basis, the Company reviews relevant information with respect to litigation contingencies and updates its accruals, disclosures and, when possible, estimates of reasonably possible losses or ranges of loss based on such reviews. However, litigation is inherently unpredictable, and outcomes are typically uncertain, and the Company’s past experience does not provide any additional visibility or predictability to estimate the range of loss that may occur because the costs, outcome and status of these types of claims and proceedings have varied significantly in the past. Other than in the Stephen Knee v. Brocade litigation matter for which the Company has paid the settlement amount, the Company is not currently able to reasonably estimate the possible loss or range of loss from the above legal proceedings and, accordingly, the Company is unable to estimate the effects of the above on its financial condition, results of operations or cash flows.
The Company records a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated.

10 . Derivative Instruments and Hedging Activities
In the normal course of business, the Company is exposed to fluctuations in interest rates and the exchange rates associated with foreign currencies. The Company’s primary objective for holding derivative financial instruments is to manage foreign currency exchange rate risk. The Company currently does not enter into derivative instruments to manage credit risk. However, the Company manages its exposure to credit risk through its investment policies. The Company generally enters into derivative transactions with high-credit quality counterparties and, by policy, limits the amount of credit exposure to any one counterparty based on its analysis of that counterparty’s relative credit standing.
The amounts subject to credit risk related to derivative instruments are generally limited to the amounts, if any, by which counterparty’s obligations exceed the Company’s obligations with that counterparty.
Foreign Currency Exchange Rate Risk
A majority of the Company’s revenue, expense and capital purchasing activities is transacted in U.S. dollars. However, the Company is exposed to foreign currency exchange rate risk inherent in conducting business globally in numerous currencies. The Company is primarily exposed to foreign currency fluctuations related to operating expenses denominated in currencies other than the U.S. dollar, of which the most significant to its operations for the three months ended January 26, 2013 were the Chinese yuan, the euro, the Japanese yen, the Indian rupee, the British pound, the Singapore dollar and the Swiss franc. The Company has established a foreign currency risk management program to protect against the volatility of future cash flows caused by changes in foreign currency exchange rates. This program reduces, but does not always entirely eliminate, the impact of foreign currency exchange rate movements. The Company’s foreign currency risk management program includes foreign currency derivatives with cash flow hedge accounting designation that utilizes foreign currency forward and option contracts to hedge exposures to the variability in the U.S. dollar equivalent of anticipated non-U.S. dollar-denominated cash flows. These instruments generally have a maturity of less than fifteen months . For these derivatives, the Company reports the after-tax gain or loss from the effective portion of the hedge as a component of accumulated other comprehensive loss in stockholders’ equity and reclassifies it into earnings in the same period in which the hedged transaction affects earnings.

22

Net gains (losses) relating to the effective portion of foreign currency derivatives recorded in the condensed consolidated statements of income are as follows (in thousands):
 
Three Months Ended
 
January 26, 2013
 
January 28, 2012
Cost of revenues
$
33

 
$
(195
)
Research and development
(5
)
 
(165
)
Sales and marketing
166

 
(1,063
)
General and administrative
8

 
(75
)
Total
$
202

 
$
(1,498
)
Alternatively, we may choose not to hedge the foreign currency risk associated with our foreign currency exposures if we believe such exposure acts as a natural foreign currency hedge for other offsetting amounts denominated in the same currency or if the currency is difficult or too expensive to hedge. The net foreign currency exchange gains and losses recorded as part of “Interest and other income (loss), net” were gains of $0.1 million for the three months ended January 26, 2013 , and losses of $1.2 million for the three months ended January 28, 2012 .
Gross unrealized loss positions are recorded within “Other accrued liabilities” and “Other non-current liabilities,” and gross unrealized gain positions are recorded within “Prepaid expenses and other current assets.” As of January 26, 2013 , the Company had gross unrealized loss positions of $0.9 million and gross unrealized gain positions of $3.3 million included in “Other accrued liabilities” and “Prepaid expenses and other current assets,” respectively. Effective cash flow hedges are reported as a component of accumulated other comprehensive loss. Ineffective cash flow hedges are included in the Company’s net income as part of “Interest and other income (loss), net.” The amount recorded on ineffective cash flow hedges was not significant.
Volume of Derivative Activity
Total gross notional amounts, presented by currency, are as follows (in thousands):
 
Derivatives Designated
as Hedging Instruments
 
Derivatives Not Designated
as Hedging Instruments
In United States Dollars
    As of January 26, 2013
 
As of October 27, 2012
 
    As of January 26, 2013
 
As of October 27, 2012
Euro
$
29,758

 
$
43,357

 
$
—

 
$
—

British pound
15,012

 
20,499

 
—

 
—

Indian rupee
11,890

 
16,046

 
—

 
—

Singapore dollar
9,331

 
12,918

 
—

 
—

Japanese yen
9,760

 
3,776

 
9,258

 
12,068

Swiss franc
6,351

 
8,575

 
—

 
—

Total
$
82,102

 
$
105,171

 
$
9,258

 
$
12,068


The Company utilizes a rolling hedge strategy for the majority of its foreign currency derivative instruments with cash flow hedge accounting designation that hedges exposures to the variability in the U.S. dollar equivalent of anticipated non-U.S. dollar-denominated cash flows. All of the Company’s foreign currency forward contracts are single delivery, which are settled at maturity involving one cash payment exchange.


23

11 . Stock-Based Compensation
Stock-based compensation expense, net of estimated forfeitures, was included in the following line items of the Condensed Consolidated Statements of Income as follows (in thousands):
 
Three Months Ended
 
January 26, 2013
 
January 28, 2012
Cost of revenues
$
3,946

 
$
4,375

Research and development
4,685

 
5,028

Sales and marketing
8,145

 
9,776

General and administrative
2,374

 
2,640

Total stock-based compensation
$
19,150

 
$
21,819

 
The following table presents stock-based compensation expense, net of estimated forfeitures, by grant type (in thousands):
 
Three Months Ended
 
January 26, 2013
 
January 28, 2012
Stock options, including variable options
$
209

 
$
275

Restricted stock awards and restricted stock units (“RSUs”)
13,670

 
17,071

Employee stock purchase plan (“ESPP”)
5,271

 
4,473

Total stock-based compensation
$
19,150

 
$
21,819

The following table presents unrecognized compensation expense, net of estimated forfeitures, of the Company’s equity compensation plans as of January 26, 2013 , which is expected to be recognized over the following weighted-average periods (in thousands, except for weighted-average period):
 
Unrecognized
Compensation
Expense
 
Weighted-
Average Period
(in years)
Stock options
$
5,550

 
1.91
RSUs
$
92,645

 
2.06
ESPP
$
14,896

 
1.00

The following table presents details on grants made by the Company for the following periods:
 
Three Months Ended
 
Three Months Ended
 
January 26, 2013
 
January 28, 2012
 
Granted
(in  thousands)
 
Weighted-Average
Grant Date  Fair Value
 
Granted
(in  thousands)
 
Weighted-Average
Grant Date  Fair Value
Stock options
2,400

 
$
2.40

 
—

 
$
—

RSUs
3,777

 
$
5.58

 
812

 
$
5.55

The total intrinsic value of stock options exercised for the three months ended January 26, 2013 and January 28, 2012 was $5.1 million and $8.8 million , respectively.


24

12 . Income Taxes
In general, the Company’s provision for income taxes differs from the tax computed at the U.S. federal statutory income tax rate due to state taxes, the effect of non-U.S. operations, non-deductible stock-based compensation expense and adjustments to unrecognized tax benefits.
For the three months ended January 26, 2013 , the Company recorded an income tax expense of $88.2 million . The tax reported for this period was primarily due to a discrete charge of $78.2 million to reduce our previously recognized California deferred tax assets, partially offset by a discrete benefit from an increase in the federal research and development tax credit of $5.7 million which was reinstated on January 2, 2013 for two years, and made retroactive to January 1, 2012. The discrete charge is as a result of the passage of Proposition 39 which revised certain provisions of the California State Tax Code, requiring mandatory single sales factor apportionment in California for most multi-state taxpayers for tax years beginning on or after January 1, 2013. We currently expect that in fiscal year 2013 and beyond, our income subject to tax in California will be lower than under prior tax law and that our California deferred tax assets are, therefore, less likely to be realized. This charge will not impact cash tax outlays and conformance to the new law is not expected to have a material impact on our future tax provision.
For the three months ended January 28, 2012 , the Company recorded an income tax benefit of $3.2 million , primarily due to a discrete benefit from net reserve releases related to settling tax audits and from expiring statutes of limitations, offset by a decrease to the federal research and development tax credit which expired on December 31, 2011 and, therefore, was inapplicable in 2012.
The total amount of unrecognized tax benefits of $89.4 million , net of federal benefit, as of January 26, 2013 would affect the Company’s effective tax rate, if recognized. Although the timing of the closure of audits is highly uncertain, it is reasonably possible that the balance of unrecognized tax benefits could significantly change during the remainder of fiscal year 2013.
The IRS and other tax authorities regularly examine our income tax returns. The IRS is currently examining fiscal years 2009 and 2010. In addition, the IRS has also examined our income tax returns for fiscal years 2007 and 2008, and in May 2011, we received the IRS revenue agent’s report. The IRS is contesting our transfer pricing for the cost sharing and buy-in arrangements with our foreign subsidiaries. The IRS’ proposed adjustment would offset approximately $317.4 million of our net operating loss carryforwards. We have filed a protest to appeal the amount of proposed adjustments in the Revenue Agent’s Report with the Appeals Office of the IRS. We believe we have sufficient reserves recorded for the ultimate settlement of this issue. Furthermore, we are in negotiations with foreign tax authorities to obtain correlative relief on transfer pricing adjustments previously settled with the IRS. We believe that our reserves for unrecognized tax benefits are adequate for all open tax years. The timing of income tax examinations, as well as the amounts and timing of related settlements, if any, are highly uncertain. We believe that before the end of fiscal year 2013, it is reasonably possible that either certain audits will conclude or the statutes of limitations relating to certain income tax examination periods will expire, or both. After we reach settlement with the tax authorities, we expect to record a corresponding adjustment to our unrecognized tax benefits. Taking into consideration the inherent uncertainty as to settlement terms, the timing of payments and the impact of such settlements on other uncertain tax positions, we estimate the range of potential decreases in underlying uncertain tax positions is between $0 and  $25.0 million in the next twelve months.
We believe that sufficient positive evidence exists from historical operations and projections of taxable income in future years to conclude that it is more likely than not that we will realize our deferred tax assets except for California deferred tax assets and capital loss carryforwards. Accordingly, we apply a valuation allowance to the California deferred tax assets due to the recent change in California law and to capital loss carryforwards due to the limited carryforward periods of these tax assets.


25

13 . Segment Information
Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker (“CODM”), or decision-making group, in deciding how to allocate resources and in assessing performance. Currently, the Company’s CODM is its Chief Executive Officer.
Brocade is organized into four operating segments, of which  two are individually reportable segments: Storage Area Networking (“SAN”) Products, formerly referred to as Data Storage Products, and Global Services. The other two operating segments, Ethernet Switching & Internet Protocol (“IP”) Routing and Application Delivery Products (“ADP”), combine to form a third reportable segment: IP Networking Products, formerly referred to as Ethernet Products. These segments are organized principally by product category.
Financial decisions and the allocation of resources are based on the information from the Company’s internal management reporting system. At this point in time, the Company does not track all of its assets by operating segments. The majority of the Company’s assets as of January 26, 2013 were attributable to its United States operations.
Summarized financial information by reportable segment for the three months ended January 26, 2013 and January 28, 2012 , based on the internal management reporting system, is as follows (in thousands):
 
SAN
Products
 
IP Networking Products
 
Global Services
 
Total
Three months ended January 26, 2013
 
 
 
 
 
 
 
Net revenues
$
361,734

 
$
140,513

 
$
86,482

 
$
588,729

Cost of revenues
96,953

 
77,422

 
40,429

 
214,804

Gross margin
$
264,781

 
$
63,091

 
$
46,053

 
$
373,925

Three months ended January 28, 2012
 
 
 
 
 
 
 
Net revenues
$
352,872

 
$
123,430

 
$
84,340

 
$
560,642

Cost of revenues
95,838

 
79,569

 
40,466

 
215,873

Gross margin
$
257,034

 
$
43,861

 
$
43,874

 
$
344,769



26

14 . Net Income (Loss) per Share
The following table presents the calculation of basic and diluted net income (loss) per share (in thousands, except per share amounts):
 
Three Months Ended
 
January 26,
2013
 
January 28,
2012
Basic net income (loss) per share
 
 
 
Net income (loss)
$
(21,255
)
 
$
58,584

Weighted-average shares used in computing basic net income (loss) per share
454,843

 
452,494

Basic net income (loss) per share
$
(0.05
)
 
$
0.13

Diluted net income (loss) per share
 
 
 
Net income (loss)
$
(21,255
)
 
$
58,584

Weighted-average shares used in computing basic net income (loss) per share
454,843

 
452,494

Dilutive potential common shares in the form of stock options
—

 
9,890

Dilutive potential common shares in the form of other share-based awards
—

 
6,354

Weighted-average shares used in computing diluted net income (loss) per share
454,843

 
468,738

Diluted net income (loss) per share
$
(0.05
)
 
$
0.12

Antidilutive potential common shares in the form of (1)
 
 
 
Stock options
22,225

 
19,818

Other share based awards
5,573

 
1,076


(1)
These amounts are excluded from the computation of diluted net income (loss) per share.

15 . Guarantor and Non-Guarantor Subsidiaries
On January 20, 2010 , the Company issued $600.0 million aggregate principal amount of the 2018 Notes and 2020 Notes. In addition, on January 22, 2013, the Company issued $300.0 million aggregate principal amount of the 2023 Notes. The Company’s obligations under the 2023 Notes and the 2020 Notes are, and prior to January 22, 2013, the Company’s obligations under the 2018 Notes were, guaranteed by certain of the Company’s domestic subsidiaries (the “Subsidiary Guarantors”). Each of the Subsidiary Guarantors is 100% owned by the Company and all guarantees are joint and several. The senior secured notes are not guaranteed by certain of the Company’s domestic subsidiaries and all of the Company’s foreign subsidiaries (the “Non-Guarantor Subsidiaries”).
Pursuant to the terms of the Indentures governing Senior Secured Notes, the guarantees are full and unconditional,   but are subject to release under the following circumstances:
•
upon the sale of the subsidiary or all or substantially all of its assets;
•
upon the discharge of the guarantees under the credit facility and any other debt guaranteed by the applicable subsidiary provided that the credit facility has been paid in full and the applicable series of senior secured notes have an investment grade rating from both Standard & Poor’s and Moody’s;
•
upon designation of the subsidiary as an “unrestricted subsidiary” under the applicable Indenture;
•
upon the merger, consolidation or liquidation of the subsidiary into the Company or another subsidiary guarantor; and
•
upon legal or covenant defeasance or the discharge of the Company’s obligations under the applicable indenture.
The guarantees of the 2018 Notes were released on January 22, 2013 upon the discharge of the 2018 Indenture.

27

Pursuant to the terms of the Indenture governing the 2023 Notes, the guarantees are full and unconditional, but are subject to release under the following circumstances:
•
upon the sale of the subsidiary or all or substantially all of its assets;
•
upon the discharge of the guarantees under the Senior Secured Credit Facility, the 2020 Notes and any other debt guaranteed by the applicable subsidiary;
•
upon the merger, consolidation or liquidation of the subsidiary into the Company or another subsidiary guarantor; and
•
upon legal or covenant defeasance or the discharge of the Company’s obligations under the applicable indenture.
Because the guarantees are subject to release under the above described circumstances, they would not be deemed “full and unconditional” for purposes of Rule 3-10 of Regulation S-X. However, as these circumstances are customary, the Company concluded that it may rely on Rule 3-10 of Regulation S-X, as the other requirements of Rule 3-10 have been met.
The following tables present condensed consolidated financial statements for the parent company, the Subsidiary Guarantors and the Non-Guarantor Subsidiaries, respectively.
The following is the condensed consolidated balance sheet as of January 26, 2013 (in thousands):
 
Brocade
Communications
Systems, Inc.
 
Subsidiary
Guarantors
 
Non-Guarantor Subsidiaries
 
Consolidating
Adjustments
 
Total
Assets
 
 
 
 
 
 
 
 
 
Current assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
208,609

 
$
3,293

 
$
471,714

 
$
—

 
$
683,616

Restricted cash
311,926

 
—

 
—

 
—

 
311,926

Accounts receivable, net
127,656

 
535

 
88,515

 
—

 
216,706

Inventories
49,802

 
—

 
10,089

 
—

 
59,891

Intercompany receivables
—

 
479,426

 
—

 
(479,426
)
 
—

Other current assets
102,723

 
777

 
14,344

 
976

 
118,820

Total current assets
800,716

 
484,031

 
584,662

 
(478,450
)
 
1,390,959

Property and equipment, net
492,699

 
824

 
16,759

 
—

 
510,282

Investment in subsidiaries
953,755

 
—

 
—

 
(953,755
)
 
—

Other non-current assets
1,744,376

 
125,401

 
1,164

 
—

 
1,870,941

Total assets
$
3,991,546

 
$
610,256

 
$
602,585

 
$
(1,432,205
)
 
$
3,772,182

Liabilities and Stockholders’ Equity
 
 
 
 
 
 
 
 
 
Current liabilities:
 
 
 
 
 
 
 
 
 
Accounts payable
$
80,357

 
$
132

 
$
21,319

 
$
—

 
$
101,808

Current portion of long-term debt
302,198

 
—

 
—

 
—

 
302,198

Intercompany payables
424,868

 
—

 
54,558

 
(479,426
)
 
—

Other current liabilities
286,819

 
9,092

 
127,273

 
976

 
424,160

Total current liabilities
1,094,242

 
9,224

 
203,150

 
(478,450
)
 
828,166

Long-term debt, net of current portion
597,440

 
—

 
—

 
—

 
597,440

Other non-current liabilities
91,581

 
2,428

 
44,284

 
—

 
138,293

Total liabilities
1,783,263

 
11,652

 
247,434

 
(478,450
)
 
1,563,899

Total stockholders’ equity
2,208,283

 
598,604

 
355,151

 
(953,755
)
 
2,208,283

Total liabilities and stockholders’ equity
$
3,991,546

 
$
610,256

 
$
602,585

 
$
(1,432,205
)
 
$
3,772,182


28

The following is the condensed consolidated balance sheet as of October 27, 2012 (in thousands):
 
Brocade
Communications
Systems, Inc.
 
Subsidiary
Guarantors
 
Non-Guarantor Subsidiaries
 
Consolidating
Adjustments
 
Total
Assets
 
 
 
 
 
 
 
 
 
Current assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
284,466

 
$
680

 
$
428,080

 
$
—

 
$
713,226

Accounts receivable, net
150,367

 
(1,847
)
 
84,619

 
—

 
233,139

Inventories
55,084

 
—

 
13,095

 
—

 
68,179

Intercompany receivables
—

 
478,133

 
—

 
(478,133
)
 
—

Other current assets
124,690

 
514

 
15,606

 
225

 
141,035

Total current assets
614,607

 
477,480

 
541,400

 
(477,908
)
 
1,155,579

Property and equipment, net
500,530

 
213

 
18,197

 
—

 
518,940

Investment in subsidiaries
871,157

 
—

 
—

 
(871,157
)
 
—

Other non-current assets
1,814,729

 
90,766

 
1,247

 
—

 
1,906,742

Total assets
$
3,801,023

 
$
568,459

 
$
560,844

 
$
(1,349,065
)
 
$
3,581,261

Liabilities and Stockholders’ Equity
 
 
 
 
 
 
 
 
 
Current liabilities:
 
 
 
 
 
 
 
 
 
Accounts payable
$
92,661

 
$
—

 
$
24,689

 
$
—

 
$
117,350

Current portion of long-term debt
2,226

 
(249
)
 
—

 
—

 
1,977

Intercompany payables
434,981

 
—

 
43,152

 
(478,133
)
 
—

Other current liabilities
346,959

 
7,628

 
136,329

 
225

 
491,141

Total current liabilities
876,827

 
7,379

 
204,170

 
(477,908
)
 
610,468

Long-term debt, net of current portion
599,203

 
—

 
—

 
—

 
599,203

Other non-current liabilities
89,173

 
2,429

 
44,168

 
—

 
135,770

Total liabilities
1,565,203

 
9,808

 
248,338

 
(477,908
)
 
1,345,441

Total stockholders’ equity
2,235,820

 
558,651

 
312,506

 
(871,157
)
 
2,235,820

Total liabilities and stockholders’ equity
$
3,801,023

 
$
568,459

 
$
560,844

 
$
(1,349,065
)
 
$
3,581,261



29

The following is the condensed consolidated statement of income for the three months ended January 26, 2013 (in thousands):
 
Brocade
Communications
Systems, Inc.
 
Subsidiary
Guarantors
 
Non-Guarantor Subsidiaries
 
Consolidating
Adjustments
 
Total
Revenues
$
363,055

 
$
1,067

 
$
224,607

 
$
—

 
$
588,729

Intercompany revenues
9,781

 
—

 
3,355

 
(13,136
)
 
—

Total net revenues
372,836

 
1,067

 
227,962

 
(13,136
)
 
588,729

Cost of revenues
136,622

 
10,564

 
65,565

 
2,053

 
214,804

Intercompany cost of revenues
(9,119
)
 
—

 
22,255

 
(13,136
)
 
—

Total cost of revenues
127,503

 
10,564

 
87,820

 
(11,083
)
 
214,804

Gross margin (loss)
245,333

 
(9,497
)
 
140,142

 
(2,053
)
 
373,925

Operating expenses
213,763

 
10,821

 
58,103

 
(2,053
)
 
280,634

Intercompany operating expenses (income)
(32,604
)
 
(6,831
)
 
39,435

 
—

 
—

Total operating expenses
181,159

 
3,990

 
97,538

 
(2,053
)
 
280,634

Income (loss) from operations
64,174

 
(13,487
)
 
42,604

 
—

 
93,291

Other income (expense)
(25,931
)
 
(94
)
 
114

 
(391
)
 
(26,302
)
Income (loss) before income tax provision and equity in net earnings (losses) of subsidiaries
38,243

 
(13,581
)
 
42,718

 
(391
)
 
66,989

Income tax expense
85,852

 
—

 
2,392

 
—

 
88,244

Equity in net earnings (losses) of subsidiaries
26,744

 
—

 
—

 
(26,744
)
 
—

Net income (loss)
$
(20,865
)
 
$
(13,581
)
 
$
40,326

 
$
(27,135
)
 
$
(21,255
)
The following is the condensed consolidated statement of income for the three months ended January 28, 2012 (in thousands):
 
Brocade
Communications
Systems, Inc.
 
Subsidiary
Guarantors
 
Non-Guarantor Subsidiaries
 
Consolidating
Adjustments
 
Total
Revenues
$
340,144

 
$
1,489

 
$
219,009

 
$
—

 
$
560,642

Intercompany revenues
10,660

 
—

 
6,720

 
(17,380
)
 
—

Total net revenues
350,804

 
1,489

 
225,729

 
(17,380
)