Quarterly Report

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

 

 

 

Commission file number: 000-23993

 

 

 

 

5300 California Avenue
Irvine, California 92617-3038
(Address of Principal Executive Offices) (Zip Code)

 

 

(949) 926-5000

(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  þ      No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o      No  þ

 

As of June 30, 2007 the registrant had 468.1 million shares of Class A common stock, $0.0001 par value, and 71.1 million shares of Class B common stock, $0.0001 par value, outstanding.

 

 

BROADCOM CORPORATION

 

QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2007

 

TABLE OF CONTENTS

 

 

 

Broadcom ^® , the pulse logo and SystemI/O ^tm are among the trademarks of Broadcom Corporation and/or its affiliates in the United States, certain other countries and/or the EU. Any other trademarks or trade names mentioned are the property of their respective owners.

 

^© 2007 Broadcom Corporation. All rights reserved.

 

 

The following table presents details of total stock-based compensation expense included in each functional line item in the unaudited condensed consolidated statements of income above:

 

 

See accompanying notes.

 

See accompanying notes.

BROADCOM CORPORATION

 

 

BROADCOM CORPORATION

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Revenue Recognition

 

The Company’s net revenue is generated principally by sales of its semiconductor products. The Company derives the remaining balance of its net revenue predominantly from software licenses, development agreements, support and maintenance agreements and cancellation fees. The majority of the Company’s sales occur through the efforts of its direct sales force. The remaining balance of its sales occurs through distributors.

 

The following table presents details of the Company’s revenue:

 

 

 

In accordance with Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 101, Revenue Recognition in Financial Statements (“SAB 101”), and SAB No. 104, Revenue Recognition (“SAB 104”), the Company recognizes product revenue when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price to the customer is fixed or determinable, and (iv) collection of the resulting receivable is reasonably assured. These criteria are usually met at the time of product shipment. However, the Company does not recognize revenue until all customer acceptance requirements have been met, when applicable. A portion of the Company’s sales are made through distributors under agreements allowing for pricing credits and/or rights of return. Product revenue on sales made through these distributors is not recognized until the distributors ship the product to their customers. The Company records reductions to revenue for estimated product returns and pricing adjustments, such as competitive pricing programs and rebates, in the same period that the related revenue is recorded. The amount of these reductions is based on historical sales returns, analysis of credit memo data, specific criteria included in rebate agreements, and other factors known at the time. The Company also maintains inventory (hubbing) arrangements with certain of its customers. Pursuant to these arrangements the Company delivers products to a customer or a designated third party warehouse based upon the customer’s projected needs, but does not recognize product revenue unless and until the customer reports that it has removed the Company’s product from the warehouse to incorporate into its end products.

 

In arrangements that include a combination of hardware and software products that are also sold separately, where software is more than incidental and essential to the functionality of the product being sold, the Company follows the guidance in Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force (“EITF”) Issue No. 03-05, Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software , accounts for the entire arrangement as a sale of software and software-related items, and follows the revenue recognition criteria in accordance with the American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, Software Revenue Recognition (“SOP 97-2”), and related interpretations.

 

BROADCOM CORPORATION

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Revenue under development agreements is recognized when applicable contractual milestones have been met, including deliverables, and in any case, does not exceed the amount that would be recognized using the percentage-of-completion method in accordance with SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. The costs associated with development agreements are included in cost of revenue. Revenue from software licenses and maintenance agreements is recognized in accordance with the provisions of SOP 97-2, as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions. Revenue from cancellation fees is recognized when cash is received from the customer.

 

Inventory

 

Inventory consists of work in process and finished goods and is stated at the lower of cost (first-in, first-out) or market. The Company establishes inventory reserves for estimated obsolete or unmarketable inventory equal to the difference between the cost of inventory and the estimated realizable value based upon assumptions about future demand and market conditions. Shipping and handling costs are classified as a component of cost of revenue in the consolidated statements of income.

 

Rebates

 

The Company accounts for rebates in accordance with EITF Issue No. 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products) , and, accordingly, records reductions to revenue for rebates in the same period that the related revenue is recorded. The amount of these reductions is based upon the terms included in the Company’s various rebate agreements.

 

Warranty

 

The Company’s products typically carry a one to three year warranty. The Company establishes reserves for estimated product warranty costs at the time revenue is recognized based upon its historical warranty experience, and additionally for any known product warranty issues.

 

Guarantees and Indemnifications

 

In some agreements to which the Company is a party, it has agreed to indemnify the other party for certain matters such as product liability. The Company also includes intellectual property indemnification provisions in its standard terms and conditions of sale for its products and has also included such provisions in certain agreements with third parties. To date, there have been no known events or circumstances that have resulted in any material costs related to these indemnification provisions, and as a result, no liabilities have been recorded in the accompanying condensed financial statements.

 

The Company also has obligations to indemnify certain of its present and former employees, officers and directors to the maximum extent permitted by law. The maximum potential amount of the future payments the Company could be required to make under these indemnification obligations could be significant; however, the Company maintains directors’ and officers’ insurance policies that should limit the Company’s exposure and enable the Company to recover a portion of amounts paid with respect to such obligations.

 

Stock-Based Compensation

 

The Company has in effect stock incentive plans under which incentive stock options have been granted to employees and restricted stock units and non-qualified stock options have been granted to employees and non-employee members of the Board of Directors. The Company also has an employee stock purchase plan for all eligible employees. Effective January 1, 2006 the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”), which requires all share-based payments to employees, including grants of employee stock options, restricted stock units and employee stock purchase rights,

 

BROADCOM CORPORATION

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

to be recognized in the financial statements based upon their respective grant date fair values and does not allow the previously permitted pro forma disclosure-only method as an alternative to financial statement recognition. SFAS 123R supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations and amends SFAS No. 95, Statement of Cash Flows. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under previous literature. In March 2005 the SEC issued SAB No. 107, Share-Based Payment (“SAB 107”), which provides guidance regarding the interaction of SFAS 123R and certain SEC rules and regulations. The Company has applied the provisions of SAB 107 in its adoption of SFAS 123R.

 

SFAS 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense ratably over the requisite service periods. The Company has estimated the fair value of stock options and stock purchase rights as of the date of grant or assumption using the Black-Scholes option pricing model, which was developed for use in estimating the value of traded options that have no vesting restrictions and that are freely transferable. The Black-Scholes model considers, among other factors, the expected life of the award and the expected volatility of the Company’s stock price. Although the Black-Scholes model meets the requirements of SFAS 123R and SAB 107, the fair values generated by the model may not be indicative of the actual fair values of the Company’s equity awards, as it does not consider other factors important to those awards to employees, such as continued employment, periodic vesting requirements, and limited transferability.

 

On November 10, 2005 the FASB issued Staff Position No. SFAS 123R-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards (“SFAS 123R-3”). The Company has elected to adopt the alternative transition method provided in SFAS 123R-3 for calculating the tax effects of stock-based compensation pursuant to SFAS 123R. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC Pool”) related to the tax effects of employee stock-based compensation expense, and to determine the subsequent impact on the APIC Pool and unaudited condensed consolidated statements of cash flows of the tax effects of employee stock-based compensation awards that were outstanding at the Company’s adoption of SFAS 123R. In addition, in accordance with SFAS 123R, SFAS No. 109, Accounting for Income Taxes (“SFAS 109”), and EITF Topic D-32, Intraperiod Tax Allocation of the Tax Effect of Pretax Income from Continuing Operations , the Company has elected to recognize excess income tax benefits from stock option exercises in additional paid-in capital only if an incremental income tax benefit would be realized after considering all other tax attributes presently available to the Company.

 

Income Taxes

 

In July 2006 the FASB issued Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 provides detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with SFAS 109. Income tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. The Company adopted FIN 48 effective January 1, 2007, and the provisions of FIN 48 will be applied to all income tax positions commencing from that date. The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits within operations as income tax expense. The cumulative effect of applying the provisions of FIN 48 has been reported as an adjustment to the opening balance of retained earnings as of January 1, 2007.

 

Net Income Per Share

 

Net income per share (basic) is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Net income per share (diluted) is calculated by adjusting

 

BROADCOM CORPORATION

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

outstanding shares, assuming any dilutive effects of options and restricted stock units calculated using the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s Class A common stock results in a greater dilutive effect from outstanding options and restricted stock units. Additionally, the exercise of employee stock options and the vesting of restricted stock units results in a greater dilutive effect on net income per share.

 

Business Enterprise Segments

 

The Company operates in one reportable operating segment, wired and wireless broadband communications. SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”), establishes standards for the way public business enterprises report information about operating segments in annual consolidated financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. Although the Company had four operating segments at June 30, 2007, under the aggregation criteria set forth in SFAS 131 the Company operates in only one reportable operating segment, wired and wireless broadband communications.

 

Under SFAS 131, two or more operating segments may be aggregated into a single operating segment for financial reporting purposes if aggregation is consistent with the objective and basic principles of SFAS 131, if the segments have similar economic characteristics, and if the segments are similar in each of the following areas:

 

 

The Company meets each of the aggregation criteria for the following reasons:

 

 

All of the Company’s operating segments share similar economic characteristics as they have a similar long term business model, operate at similar gross margins, and have similar research and development expenses and similar selling, general and administrative expenses. The causes for variation among each of the operating segments are the same and include factors such as (i) life cycle and price and cost fluctuations, (ii) number of competitors, (iii) product differentiation and (iv) size of market opportunity. Additionally, each operating segment is subject to the overall cyclical nature of the semiconductor industry. The number and composition of employees and the amounts and types of tools and materials required are similar for each operating segment. Finally, even though the Company periodically reorganizes its operating segments based upon changes in customers, end markets or products, acquisitions, long-term growth strategies, and the experience and bandwidth of the senior executives in charge, the common financial goals for each operating segment remain constant.

 

Because the Company meets each of the criteria set forth in SFAS 131 and its four operating segments as of June 30, 2007 share similar economic characteristics, the Company aggregates its results of operations into one reportable operating segment.

 

BROADCOM CORPORATION

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

The following table presents details of the amortization of purchased intangible assets by expense category:

 

 

The following table presents details of the Company’s future amortization of purchased intangible assets. Should the Company acquire additional purchased intangible assets in the future, its cost of revenue or operating expenses will increase by the amortization of those assets.

 

 

 

 

 

 

 

 

 

 

At June 30, 2007 common share equivalents were calculated based on (i) stock options to purchase 135.2 million shares of Class A or Class B common stock outstanding with a weighted average exercise price of $24.28 per share and (ii) 19.0 million restricted stock units that entitle the holder to receive a like number of freely transferable shares of Class A common stock as the awards vest.

 

Supplemental Cash Flow Information

 

The Company repurchased $13.2 million of its Class A common stock in one or more transactions that had not settled by June 30, 2007. In addition, billings of $6.6 million for capital equipment were accrued but not yet paid as of June 30, 2007. These amounts have been excluded from the unaudited condensed consolidated statements of cash flows.

 

 

In January 2007 the Company completed the acquisition of LVL7 Systems, Inc, a privately-held developer of production-ready networking software that enables networking original equipment manufacturers and original

 

BROADCOM CORPORATION

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

design manufacturers to reduce development expenses and compress development timelines, for $62.5 million. In May 2007 the Company completed the acquisition of Octalica, Inc., a privately-held fabless semiconductor company that specializes in the design and development of networking technologies based on the MoCA ^tm (Multimedia over Coax Alliance) standard, which enables distribution of high quality digital multimedia content throughout the home over existing coaxial cable, for $30.8 million.

 

The Company recorded charges of $0.3 million in the three months ended March 31, 2007 for LVL7 and $10.2 million in the three months ended June 30, 2007 for Octalica for purchased in-process research and development (“IPR&D”) expense. The amount allocated to IPR&D was determined through established valuation techniques used in the high technology industry and was expensed upon acquisition as it was determined that the underlying projects had not reached technological feasibility and no alternative future uses existed.

 

The Company acquired $1.3 million in net assets and recorded $44.4 million in goodwill and $16.5 million of completed technology in connection with the acquisition of LVL7. The Company also assumed $1.2 million in net liabilities and recorded $21.8 million in goodwill in connection with the acquisition of Octalica.

 

The Company’s primary reasons for the LVL7 and Octalica acquisitions were to reduce the time required to develop new technologies and products and bring them to market, incorporate enhanced functionality into and complement the Company’s existing product offerings, augment its engineering workforce, and enhance its technological capabilities. Certain of the cash consideration paid in each of the above acquisitions is currently held in escrow pursuant to the terms of the applicable acquisition agreement.

 

The unaudited condensed consolidated financial statements for the six months ended June 30, 2007 include the results of operations of LVL7 and Octalica commencing as of their respective acquisition dates. No supplemental pro forma information is presented for these acquisitions due to the immaterial effect of the acquisitions on the Company’s results of operations.

 

In addition, during the three months ended March 31, 2007 the Company received $14.0 million in connection with an escrow settlement from its acquisition of Siliquent Technologies, Inc., which resulted in a reduction of goodwill.

 

 

The Company recorded a tax benefit of $2.2 million and a tax provision of $1.3 million for the three and six months ended June 30, 2007, respectively, and tax provisions of $4.7 million and $8.1 million for the three and six months ended June 30, 2006, respectively. The effective tax rates for the Company were (6.9)% and 1.4% for the three and six months ended June 30, 2007, respectively, and 4.2% and 3.5% for the three and six months ended June 30, 2006, respectively. The difference between the Company’s effective tax rates and the 35% federal statutory rate resulted primarily from domestic losses recorded without income tax benefit and foreign earnings taxed at rates lower than the federal statutory rate for the three and six months ended June 30, 2007 and June 30, 2006. In addition, the Company recorded $4.6 million of tax benefits for the three and six months ended June 30, 2007, resulting primarily from the expiration of the statutes of limitations for the assessment of taxes in various foreign jurisdictions.

 

The Company utilizes the liability method of accounting for income taxes as set forth in SFAS 109. The Company records net deferred tax assets to the extent it believes these assets will more likely than not be realized. In making such determination, the Company considers all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial performance. SFAS 109 further states that forming a conclusion that a valuation allowance is not required is difficult when there is negative evidence such as cumulative losses in recent years. As a result of the Company’s recent cumulative losses in the U.S. and certain foreign jurisdictions, and the full utilization of its loss carryback opportunities, the Company has concluded that a full valuation allowance should be recorded in such jurisdictions. In certain other foreign jurisdictions where the Company does not have cumulative losses, the Company had net

 

BROADCOM CORPORATION

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

deferred tax assets of $2.9 million and $1.8 million, at June 30, 2007 and December 31, 2006, respectively, in accordance with SFAS 109.

 

As a result of applying the provisions of FIN 48, the Company recognized a decrease of $3.9 million in the liability for unrecognized tax benefits, and a $4.7 million increase in retained earnings, as of January 1, 2007. The Company’s unrecognized tax benefits totaled $36.5 million at January 1, 2007 and relate to various foreign jurisdictions. This amount included $14.5 million of potential penalties and $1.1 million of interest. Included in the balance at January 1, 2007 are $34.3 million of tax benefits that, if recognized, would reduce the Company’s annual effective income tax rate. The Company does not expect its unrecognized tax benefits to change significantly over the next 12 months.

 

The Company files U.S., state and foreign income tax returns in jurisdictions with varying statutes of limitations. The 2003 through 2007 tax years generally remain subject to examination by federal and most state tax authorities. In significant foreign jurisdictions, the 2001 through 2007 tax years generally remain subject to examination by tax authorities.

 

 

Share Repurchase Program

 

In February 2007 the Company’s Board of Directors authorized a new program to repurchase shares of the Company’s Class A common stock for cash. The Board approved the repurchase of shares having an aggregate market value of up to $1.0 billion, depending on market conditions and other factors. Repurchases under the program may be made at any time and from time to time during the 18 month period that commenced February 12, 2007. From the time the new program was implemented through June 30, 2007, the Company repurchased a total of 19.8 million shares at a weighted average price of $33.03 per share, of which $641.3 million was settled in cash during the six months ended June 30, 2007 and the remaining $13.2 million was included in accrued liabilities. At June 30, 2007, $345.5 million remained available to repurchase shares under the authorized program.

 

 

Accumulated other comprehensive income (loss) reflected on the unaudited condensed consolidated balance sheets at June 30, 2007 and December 31, 2006 represents accumulated translation adjustments.

 

 

Equity Awards

 

The Company granted employee stock options to purchase 14.6 million shares of its Class A common stock and awarded 7.4 million restricted stock units in the three months ending June 30, 2007 as part of the Company’s regular annual equity compensation review program. In total, the Company granted employee stock options to

 

BROADCOM CORPORATION

 

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purchase 18.4 million shares of its Class A common stock and awarded 10.0 million restricted stock units in the six months ended June 30, 2007.

 

Stock-Based Compensation Expense

 

The amount of unearned stock-based compensation currently estimated to be expensed from 2007 through 2011 related to unvested share-based payment awards at June 30, 2007 is $1.144 billion. Of this amount, $265.1 million, $399.5 million, $285.9 million, $155.4 million and $38.4 million are currently estimated to be recorded in the remainder of 2007, in 2008, 2009, 2010 and 2011, respectively. The weighted-average period over which the unearned stock-based compensation is expected to be recognized is approximately 1.5 years. Approximately 97% of the total unearned stock-based compensation at June 30, 2007 will be expensed by the end of 2010. If there are any modifications or cancellations of the underlying unvested awards, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that the Company grants additional equity awards to employees or assumes unvested equity awards in connection with acquisitions.

 

Charges Related to the Voluntary Review of the Company’s Equity Award Practices

 

In connection with the Company’s equity award review completed in January 2007, the Company determined that the accounting measurement dates for most of its options granted between June 1998 and May 2003, covering options to purchase 232.9 million shares of its Class A or Class B common stock differed from the measurement dates previously used for such awards. As a result, there are potential adverse tax consequences that may apply to holders of affected options. By amending or replacing these options, the potential adverse tax consequences could be eliminated.

 

In March 2007 the Company offered to amend or replace affected options by adjusting the exercise price for each such option to the lower of (i) the fair market value per share of its Class A common stock on the revised measurement date applied to that option as a result of its equity award review and (ii) the closing selling price per share of its Class A common stock on the date on which the option is amended. If the adjusted exercise price for an affected option was lower than the original exercise price, that option was not amended but instead was replaced with a new option that had the same exercise price, vesting schedule and expiration date as the affected option, but a new grant date. The offer expired April 20, 2007. Participants whose affected options were amended pursuant to the offer are entitled to a special cash payment with respect to those options. The amount payable will be determined by multiplying (i) the amount of the increase in exercise price by (ii) the number of shares for which a participant’s options were amended. As a result, the Company will make payments of $29.6 million in January 2008 to reimburse affected employees for the increases in their exercise prices. A liability has been recorded for these payments and is included in wages and related benefits as of June 30, 2007.

 

In accordance with SFAS 123R, the Company recorded total estimated charges of $3.4 million in the six months ended June 30, 2007 and a reduction of additional paid-in capital in the amount of $26.2 million in connection with the offer. Charges of $0.1 million, $1.5 million and $1.8 million are included in cost of revenue, research and development expense and selling, general and administrative expense, respectively, as wages and related benefits for the six months ended June 30, 2007.

 

 

Intellectual Property Proceedings.   In May 2005 the Company filed a complaint in the U.S. International Trade Commission (“ITC”) asserting that Qualcomm Incorporated (“Qualcomm”) engaged in unfair trade practices by importing integrated circuits and other products that infringe, both directly and indirectly, five of the Company’s patents relating generally to wired and wireless communications. The complaint seeks an exclusion order to bar importation of those Qualcomm products into the United States and a cease and desist order to bar further sales of infringing Qualcomm products that have already been imported. In June 2005 the ITC instituted

 

BROADCOM CORPORATION

 

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an investigation of Qualcomm based upon the allegations made in the Company’s complaint. The investigation was later limited to asserted infringement of three Broadcom patents. At Qualcomm’s request, the U.S. Patent and Trademark Office (“USPTO”) is reexamining one of the patents. In December 2006 the full Commission upheld the ITC administrative law judge’s October 2006 Initial Determination finding all three patents valid and one infringed. In June 2007 the Commission issued an exclusion order banning the importation into the United States of infringing Qualcomm chips and certain cellular phone models incorporating those chips. The Commission also issued a cease and desist order prohibiting Qualcomm from engaging in certain activities related to the infringing chips. The orders are subject to a 60-day Presidential review period.

 

In May 2005 the Company filed two complaints against Qualcomm in the United States District Court for the Central District of California. The first complaint asserts that Qualcomm has infringed, both directly and indirectly, the same five patents asserted by Broadcom in the ITC complaint. The District Court complaint seeks preliminary and permanent injunctions against Qualcomm and the recovery of monetary damages, including treble damages for willful infringement, and attorneys’ fees. In July 2005 Qualcomm answered the complaint and asserted counterclaims seeking a declaratory judgment that the Company’s patents are invalid and not infringed. In December 2005 the court transferred the causes of action relating to two of the patents to the United States District Court for the Southern District of California. Pursuant to statute, the court has stayed the remainder of this action pending the outcome of the ITC action.

 

A second District Court complaint asserts that Qualcomm has infringed, both directly and indirectly, five other Broadcom patents relating generally to wired and wireless communications and multimedia processing technologies. The complaint seeks preliminary and permanent injunctions against Qualcomm and the recovery of monetary damages, including treble damages for willful infringement, and attorneys’ fees. In July 2005 Qualcomm answered the second complaint and asserted counterclaims seeking a declaratory judgment that the Company’s patents are invalid and not infringed. In November 2006 Broadcom withdrew one of the patents from the case. In December 2006 the court granted a motion to stay proceedings on a second patent pending the outcome of a USPTO reexamination of that patent initiated at Qualcomm’s request. In May 2007 a jury returned a verdict that Qualcomm willfully infringed the three remaining patents and awarded the Company $19.6 million in past damages. These amounts have not been recognized in the Company’s unaudited condensed consolidated income statement. The Company is petitioning the court to have (i) the damages award trebled, (ii) Qualcomm pay the Company’s attorneys’ fees, and (iii) Qualcomm enjoined from future infringement.

 

In July 2005 Qualcomm filed a complaint against the Company in the United States District Court for the Southern District of California alleging that certain Broadcom products infringed, both directly and indirectly, seven Qualcomm patents relating generally to the transmission, reception and processing of communication signals, including radio signals and/or signals for wireless telephony. The Company filed an answer in September 2005 denying the allegations in Qualcomm’s complaint and asserting counterclaims. The counterclaims sought a declaratory judgment that the seven Qualcomm patents were invalid and not infringed, and asserted that Qualcomm had infringed, both directly and indirectly, six Broadcom patents relating generally to wired and wireless communications. In March 2007 the court granted the parties’ joint motion to dismiss this case.

 

In August 2005 Qualcomm filed a second complaint against the Company in the United States District Court for the Southern District of California alleging that Broadcom breached a contract relating to Bluetooth development and seeking a declaration that two of the Company’s patents relating to Bluetooth technology were invalid and not infringed. The Company filed an answer in April 2006 denying the allegations in the complaint and asserting counterclaims. The counterclaims asserted that Qualcomm had infringed, both directly and indirectly, the same two Broadcom patents, and also alleged breach of the Bluetooth contract by Qualcomm. In February 2007 the court granted the parties’ joint motion to dismiss this case.

 

In October 2005 Qualcomm filed a third complaint against the Company in the United States District Court for the Southern District of California alleging that certain Broadcom products infringe, both directly and indirectly, two Qualcomm patents relating generally to the processing of digital video signals. The complaint seeks preliminary

 

BROADCOM CORPORATION

 

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and permanent injunctions against the Company as well as the recovery of monetary damages and attorneys’ fees. The Company filed an answer in December 2005 denying the allegations in Qualcomm’s complaint and asserting counterclaims seeking a declaratory judgment that the two Qualcomm patents are invalid and not infringed. In January 2007 a jury returned a verdict that the Company did not infringe either patent, and rendered advisory verdicts that Qualcomm committed inequitable conduct before the U.S. Patent and Trademark Office and waived its patent rights in connection with its conduct before an industry standards body. In March 2007 the court adopted the jury’s finding that Qualcomm waived its patent rights. The court is currently considering the appropriate remedy for Qualcomm’s conduct, including whether Qualcomm should pay the Company’s attorneys’ fees.

 

In March 2006 Qualcomm filed a fourth complaint against the Company in the United States District Court for the Southern District of California alleging that the Company had misappropriated certain Qualcomm trade secrets and that certain Broadcom products infringed, both directly and indirectly, a patent related generally to orthogonal frequency division multiplexing technology. The Company filed an answer in May 2006 denying the allegations in Qualcomm’s complaint and asserting counterclaims. The counterclaims sought a declaratory judgment that the Qualcomm patent was invalid and not infringed, and asserted that Qualcomm had infringed, both directly and indirectly, two Broadcom patents relating generally to video technology. The Company amended its answer to add a counterclaim asserting that Qualcomm had misappropriated certain Broadcom trade secrets, and Qualcomm amended its complaint to add three individual Broadcom employees as defendants and include additional allegations of trade secret misappropriation. In March 2007 the court granted the parties’ joint motion to dismiss this case.

 

In December 2006 SiRF Technology, Inc. (“SiRF”) filed a complaint in the United States District Court for the Central District of California against Global Locate, Inc., a wholly-owned subsidiary of the Company acquired in July 2007 (see Note 8), alleging that certain Global Locate products infringe four SiRF patents relating generally to global positioning system (“GPS”) technology. In January 2007 Global Locate filed an answer denying the allegations in SiRF’s complaint and asserting counterclaims. The counterclaims seek a declaratory judgment that the four SiRF patents are invalid and not infringed, assert that SiRF has infringed four Global Locate patents relating generally to GPS technology, and assert unfair competition and antitrust violations related to the filing of sham litigation. In May 2007 the court granted Global Locate’s motion to stay the case until the ITC actions between Global Locate and SiRF, discussed below, become final.

 

In February 2007 SiRF filed a complaint in the ITC asserting that Global Locate engaged in unfair trade practices by importing integrated circuits and other products that infringe, both directly and indirectly, four of SiRF’s patents relating generally to GPS technology. The complaint seeks an exclusion order to bar importation of those Global Locate products into the United States and a cease and desist order to bar further sales of infringing Global Locate products that have already been imported. In March 2007 the ITC instituted an investigation of Global Locate based upon the allegations made in the SiRF complaint. The ITC has set a target date for completion of the investigation in May 2008.

 

In April 2007 Global Locate filed a complaint in the ITC against SiRF and four of its customers, e-TEN Corporation, Pharos Science & Applications, Inc., MiTAC International Corporation and Mio Technology Limited (collectively, the “SiRF Defendants”), asserting that the SiRF Defendants engaged in unfair trade practices by importing GPS devices, including integrated circuits and embedded software, and products containing such products, such as personal navigation devices and GPS-enabled cellular telephones, that infringe, both directly and indirectly, six of Global Locate’s patents relating generally to GPS technology. The complaint seeks an exclusion order to bar importation of the SiRF Defendants’ products into the United States and a cease and desist order to bar further sales of infringing products that have already been imported. In May 2007 the ITC instituted an investigation of the SiRF Defendants based upon the allegations made in the Global Locate’s complaint. The ITC has set a target date for completion of the investigation in August 2008.

 

Antitrust and Unfair Competition Proceedings.   In July 2005 the Company filed a complaint against Qualcomm in the United States District Court for the District of New Jersey asserting that Qualcomm’s licensing and other practices related to cellular technology and products violate federal and state antitrust laws. The complaint also asserts

 

BROADCOM CORPORATION

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

causes of action based on breach of contract, promissory estoppel, fraud, and tortious interference with prospective economic advantage. In September 2005 the Company filed an amended complaint in the action also challenging Qualcomm’s proposed acquisition of Flarion Technologies, Inc. under the antitrust laws and asserting violations of various state unfair competition and unfair business practices laws. In August 2006 the court granted Qualcomm’s motion to dismiss the complaint. In September 2006 Broadcom filed a notice of appeal to the United States Court of Appeals for the Third Circuit. Oral argument on the appeal was held in June 2007.

 

In October 2005 the Company and five other leading mobile wireless technology companies filed complaints with the European Commission requesting that the Commission investigate Qualcomm’s anticompetitive conduct related to the licensing of its patents and the sale of its chipsets for mobile wireless devices and systems. The Commission has commenced a preliminary investigation, and is determining whether to institute a formal investigation, of Qualcomm.

 

In June 2006 the Company and another leading mobile wireless technology company filed complaints with the Korean Fair Trade Commission requesting that the Commission investigate Qualcomm’s anticompetitive conduct related to the licensing of its patents and the sale of its chipsets for mobile wireless devices and systems. The Commission has instituted a formal investigation of Qualcomm.

 

In April 2007 the Company filed a complaint in the Superior Court for Orange County, California alleging that Qualcomm’s conduct before various industry standards organizations constitutes unfair competition, fraud and breach of contract. The complaint seeks an injunction against Qualcomm as well as the recovery of monetary damages. Qualcomm has filed a motion to dismiss the complaint.

 

Securities Litigation.   From March through August 2006 a number of purported Broadcom shareholders filed putative shareholder derivative actions (the “Options Derivative Actions”) against the Company, each of the members of its Board of Directors, certain current or former officers, and Henry T. Nicholas III, its co-founder, alleging, among other things, that the defendants improperly dated certain Broadcom employee stock option grants. Four of those cases, Murphy v. McGregor, et al. (Case No. CV06-3252 R (CWx)), Shei v. McGregor, et al. (Case No. SACV06-663 R (CWx)), Ronconi v. Dull, et al. (Case No. SACV 06-771 R (CWx)) and Jin v. Broadcom Corporation, et al. (Case No. 06CV00573) have been consolidated in the United States District Court for the Central District of California. The plaintiffs filed a consolidated amended complaint in November 2006. In addition, two putative shareholder derivative actions, Pirelli Armstrong Tire Corp. Retiree Med. Benefits Trust v. Samueli, et al. (Case No. 06CC0124) and Servais v. Samueli, et al. (Case No. 06CC0142), were filed in the California Superior Court for the County of Orange. The Superior Court consolidated the state court derivative actions in August 2006, and the plaintiffs filed a consolidated amended complaint in September 2006. The plaintiffs in the Options Derivative Actions contend, among other things, that the defendants’ conduct violated United States and California securities laws, breached defendants’ fiduciary duties, wasted corporate assets, unjustly enriched the defendants, and caused errors in the Company’s financial statements. The plaintiffs seek, among other things, unspecified damages and disgorgement of profits from the alleged conduct, to be paid to Broadcom.

 

In January 2007 the Superior Court granted defendants’ motion to stay the state derivative action pending resolution of the prior-filed federal derivative action. In March 2007 the court in the federal derivative action denied the Company’s motion to dismiss, which motion was based on the ground that the shareholder plaintiffs lack standing to assert claims on behalf of Broadcom. Motions to dismiss filed by the individual defendants were heard, and mostly denied, in May 2007. Additionally, in May 2007 the Board of Directors established a special litigation committee to decide what course of action the Company should pursue in respect of the claims asserted in the Options Derivative Actions. The Company intends to vigorously defend each of the Options Derivative Actions.

 

From August through October 2006 several plaintiffs filed purported shareholder class actions in the United States District Court for the Central District of California against the Company and certain of its current or former officers and directors, entitled Bakshi v. Samueli, et al. (Case No. 06-5036 R (CWx)), Mills v. Samueli, et al. (Case No. SACV 06-9674 DOC R(CWx)), and Minnesota Bakers Union Pension Fund, et al. v. Broadcom Corp., et al. (Case No. SACV 06-970 CJC R (CWx)) (the “Options Class Actions”). The essence of the plaintiffs’

 

BROADCOM CORPORATION

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

allegations is that Broadcom improperly backdated stock options, resulting in false or misleading disclosures concerning, among other things, Broadcom’s business and financial condition. Plaintiffs also allege that Broadcom failed to account for and pay taxes on stock options properly, that the individual defendants sold Broadcom stock while in possession of material nonpublic information, and that the defendants’ conduct caused artificial inflation in Broadcom’s stock price and damages to the putative plaintiff class. The plaintiffs assert claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. In November 2006, the Court consolidated the Options Class Actions and appointed the New Mexico State Investment Council as lead class plaintiff. There is currently a dispute regarding the appointment of lead class counsel, which the lead class plaintiff has appealed to the federal appeals court. The Company’s response to the consolidated class action complaint will not be due until the appeal and the dispute regarding the appointment of class counsel is resolved. The Company intends to defend the consolidated action vigorously.

 

The Company has entered into indemnification agreements with each of its present and former directors and officers. Under these agreements, Broadcom is required to indemnify each such director or officer against expenses, including attorney’s fees, judgments, fines and settlements, paid by such individual in connection with the Options Derivative Actions and Options Class Actions (other than indemnified liabilities arising from willful misconduct or conduct that is knowingly fraudulent or deliberately dishonest).

 

SEC Formal Order of Investigation and United States Attorney’s Office Investigation. In June 2006 the Company received an informal request for information from the staff of the Los Angeles regional office of the Securities and Exchange Commission regarding its historical option granting practices. In December 2006 the SEC issued a formal order of investigation and a subpoena for the production of documents. The SEC continues to depose present and former Company employees, officers and directors as part of its investigation. On July 19, 2007 the Company received a “Wells Notice” from the SEC in connection with this investigation. The Chairman of the Board of Directors and Chief Technical Officer of the Company, Dr. Henry Samueli, also received a Wells Notice. The Wells Notices provide notification that the staff of the SEC intends to recommend to the Commission that it bring a civil action against the recipients for possible violations of the securities laws. Based on discussions with the SEC staff, the Company believes that the issues the staff intends to pursue relate to the Company’s historical option granting processes and the accounting relating to those option grants. Under the process established by the SEC, recipients have the opportunity to respond in writing to a Wells Notice before the SEC staff makes any formal recommendation to the Commission regarding what action, if any, should be brought by the SEC. The Company and Dr. Samueli intend to provide written submissions to the SEC in response to the Wells Notices and may seek meetings with the SEC staff. The Company is continuing to cooperate with the SEC, but does not know when the investigation will be resolved or what, if any, actions the SEC may require it or Dr. Samueli to take as part of that resolution. In August 2006 the Company was informally contacted by the U.S. Attorney’s Office for the Central District of California and asked to produce documents. In 2006, the Company voluntarily provided documents and data to the U.S Attorney’s Office. In 2007 the Company has continued to provide substantial amounts of documents and information to the U.S. Attorney’s Office on a voluntary basis. In addition, the Company has produced documents pursuant to grand jury subpoenas. The U.S. Attorney’s Office continues to interview present and former Company employees, officers and directors as part of its investigation. The Company is continuing to cooperate with the U.S. Attorney’s Office in its investigation. Any action by the SEC, the U.S. Attorney’s Office or other governmental agency could result in civil or criminal sanctions and/or fines against the Company and/or certain of its current or former officers, directors and/or employees.

 

United States Attorney’s Office Investigation and Prosecution.   In June 2005 the United States Attorney’s Office for the Northern District of California commenced an investigation into the possible misuse of proprietary competitor information by certain Broadcom employees. In December 2005 one former employee was indicted for fraud and related activity in connection with computers and trade secret misappropriation. The former employee had been immediately suspended in June 2005, after just two months’ employment, when the Company learned about the government investigation. Following an internal investigation, his employment was terminated, nearly

 

BROADCOM CORPORATION

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

two months prior to the indictment. The indictment does not allege any wrongdoing by Broadcom, which is cooperating fully with the ongoing investigation and the prosecution.

 

General.   The foregoing discussion includes material developments that occurred during the three and six months ended June 30, 2007 or thereafter in material legal proceedings in which the Company and/or its subsidiaries are involved. For additional information regarding certain of these legal proceedings, see Note 11 of Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

 

The Company and its subsidiaries are also involved in other legal proceedings, claims and litigation arising in the ordinary course of business.

 

The pending proceedings involve complex questions of fact and law and will require the expenditure of significant funds and the diversion of other resources to prosecute and defend. The results of legal proceedings are inherently uncertain, and material adverse outcomes are possible. The resolution of any future intellectual property litigation may require the Company to pay damages for past infringement or one-time license fees or running royalties, which could adversely impact gross profit and gross margins in future periods, or could prevent Broadcom from manufacturing or selling some of its products or limit or restrict the type of work that employees involved in such litigation may perform for Broadcom. From time to time the Company may enter into confidential discussions regarding the potential settlement of pending litigation or other proceedings; however, there can be no assurance that any such discussions will occur or will result in a settlement. The settlement of any pending litigation or other proceeding could require Broadcom to incur substantial settlement payments and costs. In addition, the settlement of any intellectual property proceeding may require the Company to obtain a license under the other party’s intellectual property rights that could require one-time license fees and/or royalty payments in the future and/or to grant a license to certain of the Company’s intellectual property rights to the other party under a cross-license agreement. If any of those events were to occur, Broadcom’s business, financial condition and results of operations could be materially and adversely affected.

 

 

Acquisition

 

In July 2007 the Company completed the acquisition of Global Locate, Inc., a privately-held, fabless provider of industry-leading global positioning system (GPS) and assisted GPS (A-GPS) semiconductor products and software. In connection with the acquisition, the Company paid approximately $142.7 million in cash in exchange for all outstanding shares of capital stock and other rights of Global Locate. A portion of the cash consideration payable to the stockholders of Global Locate was placed into escrow pursuant to the terms of the acquisition agreement. Additional consideration of up to $80.0 million in cash will be reserved for future payment to the former holders of Global Locate capital stock and other rights upon satisfaction of certain future performance goals. In connection with the transaction, certain former stockholders of Global Locate purchased 93,750 restricted shares of Broadcom’s Class A common stock for $3.0 million. The Company may record a charge for purchased IPR&D expenses related to the acquisition in the three months ending September 30, 2007. The amount of that charge, if any, has not yet been determined.

 

Patent License Agreement

 

In July 2007 the Company entered into a patent license agreement with a wireless network operator. Under the agreement, royalty payments will be made to the Company at a rate of $6.00 per unit for each applicable unit sold by the operator after the date of the agreement, subject to certain conditions, including without limitation a maximum payment of $40 million per calendar quarter and a lifetime maximum of $200 million.

 

Cautionary Statement

 

You should read the following discussion and analysis in conjunction with our Unaudited Condensed Consolidated Financial Statements and the related Notes thereto contained in Part I, Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our other reports filed with SEC, including our Annual Report on Form 10-K for the year ended December 31, 2006 and subsequent reports on Forms 10-Q and 8-K, which discuss our business in greater detail.

 

The section entitled “Risk Factors” set forth below, and similar discussions in our other SEC filings, describe some of the important risk factors that may affect our business, financial condition, results of operations and/or liquidity. You should carefully consider those risks, in addition to the other information in this Report and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.

 

All statements included or incorporated by reference in this Report, other than statements or characterizations of historical fact, are forward-looking statements. Examples of forward-looking statements include, but are not limited to, statements concerning projected net revenue, costs and expenses and gross margin; our accounting estimates, assumptions and judgments; the impact of the January 2007 restatement of our financial statements for prior periods; estimates related to the amount and/or timing of the expensing of unearned stock-based compensation expense; our success in pending litigation; the demand for our products; the effect that seasonality and volume fluctuations in the demand for our customers’ consumer-oriented products will have on our quarterly operating results; our dependence on a few key customers for a substantial portion of our revenue; our ability to scale operations in response to changes in demand for existing products and services or the demand for new products requested by our customers; the competitive nature of and anticipated growth in our markets; our ability to migrate to smaller process geometries; manufacturing, assembly and test capacity; our ability to consummate acquisitions and integrate their operations successfully; our potential needs for additional capital; inventory and accounts receivable levels; and the level of accrued rebates. These forward-looking statements are based on our current expectations, estimates and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. Forward-looking statements can often be identified by words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” similar expressions, and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, some of which are listed under the section “Risk Factors” contained in Part II, Item 1A of this Report. These forward-looking statements speak only as of the date of this Report. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, except as otherwise required by law.

 

Overview

 

Broadcom Corporation is a major technology innovator and global leader in semiconductors for wired and wireless communications. Our products enable the delivery of voice, video, data and multimedia to and throughout the home, the office and the mobile environment. Broadcom provides the industry’s broadest portfolio of state-of-the-art system-on-a-chip and software solutions to manufacturers of computing and networking equipment, digital entertainment and broadband access products, and mobile devices. Our diverse product portfolio includes solutions for digital cable, satellite and Internet Protocol (IP) set-top boxes and media servers; high definition television (HDTV); high definition DVD players and personal video recording (PVR) devices; cable and DSL modems and residential gateways; high-speed transmission and switching for local, metropolitan, wide area and storage networking; SystemI/O server solutions; broadband network and security processors; wireless and personal area networking; cellular communications; mobile multimedia and applications processors; mobile power management; and Voice over Internet Protocol (VoIP) gateway and telephony systems.

 

Net Revenue.   We sell our products to leading manufacturers of wired and wireless communications equipment in each of our target markets. Because we leverage our technologies across different markets, certain of

our integrated circuits may be incorporated into equipment used in multiple markets. We utilize independent foundries and third-party subcontractors to manufacture, assemble and test all of our semiconductor products.

 

Our net revenue is generated principally by sales of our semiconductor products. We derive the remainder of our net revenue predominantly from software licenses, development agreements, support and maintenance agreements and cancellation fees. The majority of our sales occur through the efforts of our direct sales force. The remaining balance of our sales occur through distributors.

 

The following table presents details of our net revenue:

 

 

 

The demand for our products has been affected in the past, and may continue to be affected in the future, by various factors, including, but not limited to, the following:

 

 

For these and other reasons, our net revenue and results of operations for the three months ended June 30, 2007 and prior periods may not necessarily be indicative of future net revenue and results of operations.

 

From time to time, our key customers place large orders causing our quarterly net revenue to fluctuate significantly. We expect that these fluctuations will continue and that they may be exaggerated by the increasing volume of Broadcom solutions that are incorporated into consumer products, sales of which are typically subject to greater seasonality and greater volume fluctuations than non-consumer OEM products. We also maintain inventory, or hubbing, arrangements with certain of our customers. While we have not shipped a significant amount of product under those arrangements as of June 30, 2007, we anticipate that such amount will increase in the near future. Pursuant to these arrangements we deliver products to a customer or a designated third party warehouse based upon the customer’s projected needs, but do not recognize product revenue unless and until the customer reports that it has removed our product from the warehouse to incorporate into its end products.

Historically we have had good visibility into customer requirements and shipments within a quarter. However, if a customer does not take our products under a hubbing arrangement in accordance with the schedule it originally provided us, our predicted future revenue stream could vary substantially from our forecasts and our results of operations could be materially and adversely affected. Additionally, since we own inventory that is physically located in a third party’s warehouse, our ability to effectively manage inventory levels may be impaired, causing our total inventory turns to decrease, which could increase expenses associated with excess and obsolete product and negatively impact our cash flow.

 

Sales to our five largest customers, including sales to their manufacturing subcontractors, as a percentage of net revenue were as follows:

 

 

Net revenue derived from all independent customers located outside the United States, excluding foreign subsidiaries or manufacturing subcontractors of customers that are headquartered in the United States, as a percentage of total net revenue was as follows:

 

 

Net revenue derived from shipments to international destinations, as a percentage of total net revenue was as follows:

 

 

All of our revenue to date has been denominated in U.S. dollars.

 

Gross Margin.   Our gross margin, or gross profit as a percentage of net revenue, has been affected in the past, and may continue to be affected in the future, by various factors, including, but not limited to, the following:

 

 

 

Net Income (Loss).   Our net income (loss) has been affected in the past, and may continue to be affected in the future, by various factors, including, but not limited to, the following:

 

 

In the three months ended June 30, 2007 our net income was $34.3 million as compared to $106.1 million in the three months ended June 30, 2006, a difference of $71.8 million. This decrease in profitability was the direct result of (i) a 4.6% decrease in net revenue (ii) a $59.8 million increase in operating expenses due principally to an increase in the number of employees engaged in research and development activities, resulting from both direct hiring and acquisitions, and an increase in cash compensation levels since June 30, 2006, as well as a charge for IPR&D in the amount of $10.2 million.

 

In the six months ended June 30, 2007 our net income was $95.2 million as compared to $223.8 million in the six months ended June 30, 2006, a difference of $128.6 million. This decrease in profitability was the direct result of (i) a 2.3% decrease in net revenue (ii) a $120.5 million increase in operating expenses due principally to an increase in the number of employees engaged in research and development activities, resulting from both direct hiring and acquisitions, and an increase in cash compensation levels since June 30, 2006, as well as charges for IPR&D in the amount of $10.5 million.

 

Product Cycles.   The cycle for test, evaluation and adoption of our products by customers can range from three to more than nine months, with an additional three to more than twelve months before a customer commences volume production of equipment incorporating our products. Due to this lengthy sales cycle, we may experience significant delays from the time we incur expenses for research and development, selling, general and administrative efforts, and investments in inventory, to the time we generate corresponding revenue, if any. The rate of new orders may vary significantly from month to month and quarter to quarter. If anticipated sales or shipments in any quarter do not occur when expected, expenses and inventory levels could be disproportionately high, and our results of operations for that quarter, and potentially for future quarters, would be materially and adversely affected.

 

Acquisition Strategy.   An element of our business strategy involves the acquisition of businesses, assets, products or technologies that allow us to reduce the time required to develop new technologies and products and bring them to market, incorporate enhanced functionality into and complement our existing product offerings, augment our engineering workforce, and/or enhance our technological capabilities. We plan to continue to evaluate strategic opportunities as they arise, including acquisitions and other business combination transactions, strategic relationships, capital infusions and the purchase or sale of assets. See Note 3 of Notes to Unaudited Condensed

Consolidated Financial Statements for information related to the acquisitions made during the six months ended June 30, 2007.

 

Business Enterprise Segments.   We operate in one reportable operating segment, wired and wireless broadband communications. SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information , or SFAS 131, establishes standards for the way public business enterprises report information about operating segments in annual consolidated financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. Although we had four operating segments at June 30, 2007, under the aggregation criteria set forth in SFAS 131 we operate in only one reportable operating segment, wired and wireless broadband communications.

 

Under SFAS 131, two or more operating segments may be aggregated into a single operating segment for financial reporting purposes if aggregation is consistent with the objective and basic principles of SFAS 131, if the segments have similar economic characteristics, and if the segments are similar in each of the following areas:

 

 

We meet each of the aggregation criteria for the following reasons:

 

 

All of our operating segments share similar economic characteristics as they have a similar long term business model, operate at similar gross margins, and have similar research and development expenses and similar selling, general and administrative expenses. The causes for variation among each of our operating segments are the same and include factors such as (i) life cycle and price and cost fluctuations, (ii) number of competitors, (iii) product differentiation and (iv) size of market opportunity. Additionally, each operating segment is subject to the overall cyclical nature of the semiconductor industry. The number and composition of employees and the amounts and types of tools and materials required are similar for each operating segment. Finally, even though we periodically reorganize our operating segments based upon changes in customers, end markets or products, acquisitions, long- term growth strategies, and the experience and bandwidth of the senior executives in charge, the common financial goals for each operating segment remain constant.

 

Because we meet each of the criteria set forth in SFAS 131 and our four operating segments as of June 30, 2007 share similar economic characteristics, we aggregate our results of operations into one reportable operating segment.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenue and expenses in the reporting period. We regularly evaluate our estimates and assumptions related to allowances for doubtful accounts, sales returns and allowances, warranty reserves, inventory reserves, stock-based compensation expense, goodwill and purchased intangible asset valuations, strategic investments, deferred income tax asset valuation allowances, restructuring costs,

litigation and other loss contingencies. We base our estimates and assumptions on current facts, historical experience and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the accrual of costs and expenses that are not readily apparent from other sources. The actual results experienced by us may differ materially and adversely from our estimates. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected.

 

We believe the following critical accounting policies require us to make significant judgments and estimates in the preparation of our consolidated financial statements:

 

 

A portion of our sales are made through distributors under agreements allowing for pricing credits and/or rights of return. Product revenue on sales made through these distributors is not recognized until the distributors ship the product to their customers. We also maintain inventory, or hubbing, arrangements with certain of our customers. While we have not shipped a significant amount of product under those arrangements as of June 30, 2007, we anticipate that such amount will increase over time. Pursuant to these arrangements we deliver products to a customer or a designated third party warehouse based upon the customer’s projected needs, but do not recognize product revenue unless and until the customer reports that it has removed our product from the warehouse to incorporate into its end products. Historically we have had good visibility into customer requirements and shipments within a quarter. However, if a customer does not take our products under a hubbing arrangement in accordance with the schedule it originally provided us, our predicted future revenue stream could vary substantially from our forecasts and our results of operations could be materially and adversely affected.

 

 

 

 

Results of Operations for the Three and Six Months Ended June 30, 2007 Compared to the Three and Six Months Ended June 30, 2006

 

The following table sets forth certain consolidated statements of income data expressed as a percentage of net revenue for the periods indicated:

 

 

The following table presents details of total stock-based compensation expense as a percentage of net revenue included in each functional line item in the condensed consolidated statements of income data above:

 

 

 

 

Net Revenue.   Our revenue is generated principally by sales of our semiconductor products. Net revenue is revenue less reductions for rebates and provisions for returns and allowances. The following table presents net revenue from each of our major target markets and its respective contribution to net revenue in the three months ended June 30, 2007 as compared to the three months ended June 30, 2006: