FORM 10-K
| (Mark One) | ||
| [X] | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE | |
| SECURITIES EXCHANGE ACT OF 1934 | ||
OR
| [ ] | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE | |
| SECURITIES EXCHANGE ACT OF 1934 |
Commission File No. 001-31353
EMULEX CORPORATION
| Delaware (State or other jurisdiction |
51-0300558 (I.R.S Employer |
|
| of incorporation or organization) | Identification No.) | |
| 3535 Harbor Boulevard | ||
| Costa Mesa, California | 92626 | |
| (Address of principal executive offices) | (Zip Code) |
(714) 662-5600
(Registrant’s telephone number, including area code)
Common Stock, Par Value $0.10 Per Share
Preferred Stock Purchase Rights
(Title of class)
Securities registered pursuant to Section 12(g) of the Act:
NONE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule12b-2 of the Exchange Act)
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]
The aggregate market value of the voting stock held by nonaffiliates of the registrant, based on the closing price of the New York Stock Exchange on December 27, 2002, which was the last trading day of the second quarter of fiscal 2003, of $19.01, was $1,559,475,806.98.
As of September 16, 2003, the registrant had 82,615,500 shares of common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III (items 10, 11, 12 and 13) is incorporated by reference to portions of the registrant’s definitive proxy statement for the 2002 Annual Meeting of Stockholders which will be filed with the Securities and Exchange Commission within 120 days after the close of the fiscal year ended June 29, 2003.
PART I
All references to years refer to our fiscal years ended June 29, 2003, June 30, 2002, and July 1, 2001, as applicable, unless the calendar year is specified. References to dollar amounts are in thousands, except share and per-share data, unless otherwise specified. References contained in this Annual Report to “Emulex,” the “Company,” the “Registrant,” “we,” “our” and “us,” refer to Emulex Corporation and its subsidiaries.
Item I. Business.
Introduction and Company History
Emulex Corporation is a leading designer, developer and supplier of a broad line of storage networking host bus adapters, or HBAs, and application specific computer chips, or ASICs, that provide connectivity solutions for storage area networks, or SANs, network attached storage, or NAS, and redundant array of independent disks, or RAID, storage. HBAs are the data communication products that enable servers to connect to storage networks by offloading communication-processing tasks as information is delivered and sent to the network. Our products are based on internally developed ASIC and embedded firmware and software technology, and offer support for a wide variety of SAN protocols, configurations, system interfaces and operating systems. Emulex’s architecture offers customers a stable applications program interface, or API, that has been preserved across multiple generations of adapters and to which many of the world’s leading Original Equipment Manufacturers, or OEMs, have customized software for mission-critical server and storage system applications.
Emulex Corporation’s corporate headquarters are located at 3535 Harbor Blvd., Costa Mesa, California 92626, and our telephone number is (714) 662-5600. Our Internet address is www.emulex.com. Our periodic and current reports filed with or furnished to the Securities and Exchange Commission pursuant to the requirements of the Securities and Exchange Act of 1934 are available free of charge through our website as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission.
Emulex was organized as a California corporation in 1979. In 1987, Emulex changed its state of incorporation from California to Delaware by the formation of a Delaware corporation, which acquired all of the stock of the California corporation. The California corporation continues to operate as a wholly owned subsidiary of the Delaware corporation. In 1999 and 2002, Emulex completed a secondary offering of our common stock and completed a private placement of convertible subordinated notes, respectively. See note 9 of the Consolidated Financial Statements for a more complete discussion of the convertible subordinated notes.
In 1998, we began outsourcing the manufacturing of our product lines to an electronics manufacturing service, or EMS, provider. This outsourcing resulted in, among other things, the closing of our manufacturing facility and the consolidating of our operations. See Item 1 — Manufacturers and Suppliers for a more complete discussion of the consolidation.
Substantially all of our revenues during 2003 were comprised of products based on Fibre Channel technology. Our Fibre Channel development efforts began in 1992 and we shipped our first Fibre Channel product in volume in 1996. According to IDC and Gartner Dataquest, in calendar 2002 we were the world’s largest provider of Fibre Channel host bus adapters, in terms of revenue, ports and units shipped. In March 2001, we acquired Giganet, Inc., a privately-held developer of storage networking products based on Ethernet and Internet Protocol, or IP, technologies. Our strategy with this acquisition was to leverage Giganet’s technology and extend our market-leading HBA APIs into Internet Small Computer Systems Interface, or iSCSI, and Virtual Interface, or VI, based storage networking market sectors. Emulex has secured significant customer relationships with the world’s leading storage and server suppliers, including Dell, EMC, Fujitsu-Siemens, Groupe Bull, Hewlett-Packard, Hitachi Data Systems, IBM, NEC, Network Appliance and Unisys. In addition, we include industry leaders Brocade, Computer Associates, Intel, Legato, McDATA, Microsoft and Veritas among our strategic partners.
Industry Background
In recent years, the volume of stored electronic data in enterprises has expanded significantly, due largely to the growth of data-intensive applications such as online transaction processing, data mining, data warehousing, multimedia and Internet applications. As a result, both the capacity and number of storage devices in enterprises have increased. Furthermore, with the increased use of, and reliance on, mission-critical applications such as e-commerce and distributed enterprise software applications, the real-time availability of electronic data has become more important to the daily operations of enterprises. As a result, enterprises face heightened requirements for data storage solutions that enable improved access to, and management of, shared data, including solutions that offer increased connectivity capabilities, higher performance and greater reliability.
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Enterprises currently access, share and manage the rapidly expanding volume of data utilizing two major data communications technologies: local area network, or LAN, and input/output, or I/O. LAN technologies enable communications among servers and client computers, while I/O technologies enable communications between host computers and their attached high-speed peripherals. The emergence of LAN architectures in the mid-1980s brought multiple benefits to client-server data communications, including faster transmission speeds, shared access to multiple servers and greater connectivity capabilities in terms of the number of connected devices, as well as distance between devices. These benefits, and the applications that leverage LAN technologies, drove the rapid adoption of LAN architectures in the corporate enterprise during the 1990’s. As a result, the data communications pathway between servers and client computers became largely networked with LAN technologies.
Although LAN architectures proliferated in client-server applications, until recently, I/O pathways between servers and attached peripherals, notably storage subsystems, failed to evolve to networking architectures. Instead, traditional I/O architectures are server-centric, utilizing a point-to-multipoint architecture, which requires that each storage subsystem in the corporate enterprise be attached to a single server through which all requested data must pass. With this traditional server-centric storage architecture, also known as Direct Attached Storage, or DAS, dedicated storage is attached to each server using I/O technologies such as Small Computer Systems Interface, or SCSI. Remote storage systems are accessed through LAN-attached file servers. Because data requests must traverse the LAN and pass through the file server associated with the specific storage device, the DAS model results in “islands of storage” behind each server. This circuitous method of accessing data degrades network performance, increases latency, or delays, for network users, drains server processing power and is difficult to scale, particularly from a storage management perspective. With the dramatic increase in information storage and retrieval requirements, system performance has become increasingly constrained by the DAS architecture and its inability to overcome communication bottlenecks and management challenges.
The Emergence of Networked Storage
In the late 1990s, in response to the increasing need for storage scalability, manageability and reliability, enterprises began to deploy SANs. In this new model, where the SAN exists as a complementary network to the LAN, I/O-intensive traffic is offloaded from the LAN, enabling a more fail-safe I/O channel, eliminating the bottlenecks that degrade I/O performance and creating a platform for centralized storage management. Furthermore, like nodes on a LAN, attached storage peripherals in a SAN can be managed and diagnosed to detect errors, and traffic can be rerouted accordingly in the event of a failure. A SAN essentially transforms dedicated servers and storage devices into network resources, greatly improving the performance and scalability of enterprise storage. By providing shared server access, the cost of expensive enterprise storage can be spread across entire organizations. SANs are being deployed to support an increasingly wide range of applications such as LAN-free and serverless back-up, storage virtualization and disaster recovery.
More recently, NAS appliances have gained acceptance in the storage marketplace. As a general rule, data is stored in block format in storage devices, but must be converted to files before being used by operating systems and applications. While SANs deliver block data to servers, NAS appliances internally convert block data to files before delivering these files over a LAN to servers or PCs. Although this configuration requires stored data to move first to the NAS server before moving on to its ultimate destination, the NAS architecture offers an easily deployable and scalable storage solution. In high-end environments characterized by NAS file delivery to servers, a SAN may be deployed behind a NAS, making NAS and SAN solutions complementary. Furthermore, next-generation appliances that can deliver both block and file data are beginning to emerge, further blurring the distinction between NAS and SAN solutions.
The majority of SAN and NAS solutions installed today are delivered to end users via integrated systems solutions offered by storage and computer system OEMs. As networked storage gains market acceptance and SAN and NAS installations interconnect increasingly diverse servers and storage subsystems, OEMs are increasingly demanding storage networking products that are optimized for heterogeneous connectivity, scalability, performance, customization and lowest total cost of ownership. Gartner Dataquest expects that an increasing percentage of storage systems revenue will consist of fabric-attached storage, or NAS and SAN solutions.
Fibre Channel
In order to implement storage area networks, a new I/O networking technology capable of interconnecting multiple host servers and storage devices was required. Fibre Channel, an American National Standards Institute, or ANSI, standard communications technology, was introduced in 1994 to address traditional I/O limitations and emerged as the first storage networking technology to be widely adopted by the world’s leading server and storage systems manufacturers. Fibre Channel, now available in both one and two gigabit per second solutions, offers the connectivity, distance and access benefits of networking architectures combined with the high performance and low latency needed for I/O applications.
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Fibre Channel’s advanced capabilities enabled new architectures such as SANs that rely upon Fibre Channel’s ability to connect multiple host computers to multiple storage systems, or storage arrays. Additionally, in order to enable longer distance or higher performance connectivity than what could be provided by SCSI, Fibre Channel has also been deployed in traditional DAS applications such as RAID storage. In such implementations, RAID storage provides for fault-tolerant direct-attached storage through the duplication of data over multiple interconnected disk drives. As a result, Fibre Channel solutions are implemented in both legacy DAS and emerging networked storage environments. According to Gartner Dataquest, the market for Fibre Channel host bus adapters is expected to expand from approximately $570 million in calendar 2002 to $1.4 billion in calendar 2007.
iSCSI
Although Gartner Dataquest expects that Fibre Channel will remain the dominant storage networking interconnect through the 2007 time frame, a new storage networking standard known as iSCSI has emerged that delivers the SCSI storage protocol over the familiar IP, or Internet Protocol, and Ethernet transports commonly deployed in LANs and WANs. The range of iSCSI connectivity solutions spans simple Network Interface Cards, or NICs, that are commonly used for Ethernet LAN applications, up to high performance iSCSI HBAs that offer full protocol processing offload from the host computer. While this technology is expected to remain in the early stages of development and deployment for the next several years, iSCSI may find acceptance in smaller organizations or in selected storage applications such as those requiring long-distance communication transports. Gartner Dataquest forecasts that the market for iSCSI HBAs will expand to approximately $230 million in 2007.
VI and RDMA
VI is a standardized interface designed for high performance, low latency communications that can be layered over a variety of networking transports. One of VI’s key characteristics is its ability to enable remote direct memory access, or RDMA, facilitating higher speed, lower latency communications between adapters and applications residing on servers. RDMA technology reduces data copy operations and latencies by allowing one computer to directly place information in another computer’s memory with minimal demands on memory bus bandwidth and CPU processing overhead, while preserving memory protection semantics. To date, VI’s primary application has been in very high performance clustering environments served by proprietary transports. Our current VI product has entered end-of-life status.
More recently, a proposed new VI-like interface named RDMA over Transmission Control Protocol/Internet Protocol, has emerged, sponsored by the RDMA Consortium. This new specification could result in a potentially more broadly endorsed standard that offers some of the benefits of VI for file transfer and other applications.
Disk Interface Technologies and the Transition to Serial Storage I/O
Traditionally, the hard disk drive industry has primarily utilized parallel I/O interconnects such as SCSI and ATA for the drive I/O interface. Parallel I/O technologies utilize multiple wires, as they require separate channels for control information and actual data, whereas serial I/O technologies, such as Fibre Channel, utilize a single wire over which all control and user data passes. Because of the reduced complexity and higher reliability of serial interfaces, the disk drive industry has begun a transition from parallel to serial I/O. According to Gartner Dataquest, as legacy parallel technologies such as SCSI fade, disk drives utilizing serial I/O are projected to quickly grow from just 13 percent of the multi-user disk storage market in 2002 to a 98 percent share by 2007. The chief serial I/O technologies expected to dominate HDD shipments in the future are Fibre Channel; Serial ATA, or SATA; and Serial Attached SCSI, or SAS, while legacy parallel technologies such as SCSI and ATA are expected to play a diminishing role.
The storage systems, or arrays, that are deployed in external multi-user storage applications such as SANs typically require multiple embedded I/O ASICs to provide an external storage I/O interface and to internally interconnect disks inside the storage array to a controller that provides the array’s intelligence. Because the disks inside of the storage array may utilize a different I/O technology than the external I/O connection, multiple I/O technologies may be required to fully serve storage array requirements. In the past, many storage arrays installed in a Fibre Channel SAN utilized legacy SCSI disks and I/O protocol chips internally, but connected externally to the SAN via an embedded Fibre Channel ASIC. In recent quarters, some SAN-attached storage arrays began to transition from parallel SCSI to serial I/O-based internal architectures. This has created a growing embedded market opportunity for multiprotocol serial I/O ASICs that can serve the full spectrum of emerging serial I/O requirements.
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Our Products
We are a leading designer, developer and supplier of Fibre Channel host bus adapters, ASICs and embedded firmware and software products that enhance access to, and storage of, electronic data and applications. According to IDC and Gartner Dataquest, in calendar 2002 we were the world’s largest provider of Fibre Channel HBAs, in terms of revenue, ports and units shipped. In 2002, after our acquisition of Giganet, we entered the development-stage market for iSCSI HBAs and VI/IP HBAs. We are also a supplier of Fibre Channel hubs, which contribute immaterial revenue, as well as some traditional networking products and cLAN adapters, which have both entered end-of-life status in previous years.
Fibre Channel HBAs
Our HBAs constitute key components for comprehensive Fibre Channel SANs that typically include host adapters, hubs, ASICs, firmware, software and switches. We time our Fibre Channel introductions to address the growing demands of enterprise customers, as well as the evolving speed and capacity capabilities of complementary products.
Leveraging our expertise and experience in networking and I/O technology, we have approached the storage problem with a networking perspective to maximize the performance and management capabilities of our Fibre Channel solutions. We believe the performance results of our HBA products are among the highest in the industry, sustaining speeds in excess of 780 MB/sec and 135,000 I/O transactions per second from a single chip HBA solution. Furthermore, our products support high-performance connectivity features such as concurrent multiprotocol data transmission, context cache for superior performance in complex environments, end-to-end parity protection and other features to enhance data integrity. Lastly, our products offer investment protection for our OEM customers, who often develop specialized software to interface to our adapters, because we have maintained a stable API since our first generation of HBAs was introduced in 1996. More recently, we have expanded our software functionally embedded in our HBAs to deliver high availability and remote centralized management functionality that may be embedded in OEM and independent software vendor, or ISV, SAN management products.
Fibre Channel HBAs connect host computers to a Fibre Channel network. Our adapters support a wide range of operating systems and host computer system interfaces, including both PCI-based Intel platforms and SBus-based Sun Microsystems platforms. Our Fibre Channel host bus adapter line, which has evolved from the LP6000 to the LP10000 in the high end, also encompasses adapters such as the LP850, LP952, LP982 and LP1050, which are targeted at midrange, open system environments. Our high-end HBAs target enterprise systems that require customized software or special features, while our midrange HBAs offer highly featured solutions for standard operating environments. All of our adapter products share the same core ASIC architecture and embedded software and firmware.
Our high-end adapters have always been designed to support a broad implementation of the Fibre Channel specification, encompassing multiple classes of service and all topologies, including full fabric support. Our high end family of adapters support SBus, PCI and PCI-X system interfaces operating at up to 133MHz, single and dual-channel form factors, the Compact PCI form factor, the Low Profile form factor and auto-negotiated one and two gigabit per second transmission speeds. In addition, our enterprise applications strategy has led us to offer a variety of other features in our high-end adapters, including additional context cache to enable high-speed throughput in complex fabric installations, and support for the FICON protocol, a standard for IBM mainframe storage over Fibre Channel SANs. Our high-end HBAs also provide the widest range of physical interface options available, including copper, short-wave optical and long-wave optical, as well as added buffer memory to enable connectivity distances up to 100 kilometers. A broad range of operating systems, including HP-UX, Linux, Netware, Solaris and Windows, are supported as well. Our service level interface, or SLI, which is included with our high-end adapters, is an API that allows our OEM customers to develop highly differentiated products, while maintaining complete software compatibility across product generations, enabling customers to leverage software investments.
Our product line also includes mid-range adapters that support a standard open systems environment based on Windows, Linux or NetWare. These open systems host adapters include our LP850, LP952, LP982 and LP1050. Based on the same ASIC architecture as our high-end adapters, our mid range adapters provide similar throughput, and I/Os per second and many of the same features as our high-end enterprise adapters but offer a cost-optimized, standardized solution for the open systems market. We offer the LP850, LP952, LP982 and LP1050 with fully certified drivers for Windows, Linux and NetWare, as well as basic input/output system, or BIOS, and configuration utilities.
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Fibre Channel ASICs
Emulex HBAs are based upon our internally-developed Fibre Channel I/O ASICs. These ASICs can be utilized not only in HBAs, but in embedded I/O environments as well, such as storage arrays and storage appliances. In addition, these ASICs may also be embedded on computer motherboards where requirements for Fibre Channel connectivity are well defined, including bladed configurations such as blade servers.
While our embedded ASIC revenue remains relatively small, a growing percentage of our total ASIC unit volume is comprised of ASICs that are sold into embedded environments, which deliver incremental economies of scale for our overall business.
The Intel Joint Development Agreement
In April 2003, Emulex and Intel Corporation announced an agreement to develop next-generation storage processors that combine SATA, SAS and Fibre Channel I/O technologies within a single multiprotocol architecture. These new serial storage processors are intended to enable OEMs to utilize common hardware and software components across their entire family of SATA, SAS and Fibre Channel storage products, extending the value of OEM hardware and software investments. Under the agreement, Emulex is developing the protocol controller hardware, firmware and drivers. Intel is contributing its expertise in storage processor technology development and will integrate its high-performance Intel® XScale™ microarchitecture as the core technology for the new processors. Intel also will manufacture the processors utilizing its 90-nanometer (nm) process technology. Emulex will market the resulting Fibre Channel products, and Intel will market the SATA and SAS products. We expect this multiprotocol serial storage architecture to be applicable to our traditional HBA market as well as new embedded markets, including blade server, storage array and storage appliance applications.
iSCSI HBAs
Our GN9000/SI adapter is a one gigabit per second prototype iSCSI HBA that became available in limited quantities for OEM evaluation during 2002. In order to ease the migration between Fibre Channel and iSCSI technologies, the GN9000/SI has been designed to leverage the Emulex SLI API utilized by OEM customers that have developed customized software for our Fibre Channel host bus adapters.
Other Products
Our Fibre Channel hubs provide centralized wiring connection, improved network reliability and a monitoring point in Fibre Channel arbitrated loop environments. In 1996, we became the first company to provide Fibre Channel hubs to the market when we introduced our hub product line. In December 1998, we introduced a line of digital Fibre Channel hubs that complemented our earlier line of analog Fibre Channel hubs. With the growing popularity of Fibre Channel switches, we have focused our Fibre channel efforts in the HBA sector. Total hub revenue was immaterial in 2003.
As part of the traditional VI product family acquired with the Giganet operation, Emulex offered the cLAN family of VI-enabled adapters and switches. These products entered end-of-life status in 2002 and contributed immaterial revenue in 2003. Our GN9000/VI HBA is a VI enabled intelligent Ethernet adapter that has entered end-of-life status.
Our traditional networking products included printer servers and network access products. We supplied both external and embedded printer servers, which provide LAN connectivity for printers. Our network access products were comprised of a variety of products that provided connectivity between computing resources across both LANs and WANs. These networking products contain a set of core technologies that includes drivers supporting a broad array of operating systems and network interface technologies that span many LAN and WAN specifications. We have eliminated resources dedicated to these traditional networking products, and during the fourth quarter of 2000 we issued last time buy notifications to customers for our traditional networking products.
Intellectual Property
Our ability to compete depends in part upon our ability to protect our proprietary information through various means, including ownership of patents, copyrights, trademarks and trade secrets, as well as through contractual provisions.
We have a number of issued patents and pending patent applications in the U.S and abroad. Most of our issued patents and pending patent applications relate to our Fibre Channel technology or products. We maintain an active program of obtaining patent protection for our inventions as development occurs and as new products are introduced. Because of the
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rate of change of technology in our industry, we believe that the duration of the patent protection available to us for our products is adequate to cover the expected market duration for such products.
All of our software products, which are embedded within or provided for use with our hardware products, are marked with copyright notices listing our company as the copyright owner. We have been granted a number of registrations of trademarks in the U.S. and abroad. We also have a number of pending trademark registrations in the U.S. and abroad. We maintain an active practice of marking our products with trademark notices. We have an active program of renewing trademarks so that the duration of trademark protection is maintained for as long as needed. Additionally, we rely on trade secret law and contractual provisions to protect unique intellectual property we possess which we have determined unnecessary or uneconomical to patent or copyright, or which is not otherwise capable of more formal protection. Please also see the information under Part I - Item 1 - “Competition” and Part I - Item 3 - “Legal Proceedings” of this Form 10-K.
Engineering and Development
At June 29, 2003, we employed 243 engineers, other technicians and support personnel engaged in the development of new products and the improvement of existing products. Engineering and development expenses were $61.3 million, $47.6 million and $27.0 million in 2003, 2002 and 2001, respectively.
Selling and Marketing
We sell our products worldwide to OEMs; end users; and through other distribution channels including value-added resellers, or VARs, systems integrators, industrial distributors and resellers. Because the Fibre Channel market has been dominated by OEMs, our focus is to use Fibre Channel sales specialists to expand opportunities with our existing OEMs, as well as to develop new OEM relationships. However, we are also expanding our distribution efforts, leveraging worldwide distribution channels through technical distributors such as VARs and systems integrators, to complement our core OEM relationships. In some cases, OEM partners leverage the distribution channel to deliver solutions to end-users, making our distribution efforts complementary with our OEM-focused strategy.
Order Backlog
Due to an industry practice that allows customers to cancel or change orders with limited advance notice prior to shipment, we do not believe that backlog is a reliable indicator of future revenue levels. Furthermore, purchase order release lead times depend upon the scheduling practices of the individual customer, and the rate of booking new orders fluctuates from month to month. Therefore, the level of backlog at any one time is not necessarily indicative of trends in our business. At June 29, 2003, we had unshipped product orders of approximately $77.6 million compared with approximately $76.8 million at June 30, 2002. At year-end, all orders included in backlog were scheduled for delivery within six months or less.
Seasonality
Our business fluctuates based on economic conditions and industry demand and we do not believe that seasonality is a significant factor in our business.
Concentration of Customers, Revenue by Product Families and Geographic Area
See Note 14 to our Consolidated Financial Statements included in Part IV, Item 14(a) of this Annual Report on Form 10-K for information regarding concentration of our customers as well as information regarding our revenue by product family and geographic area. See also “Risk Factors” contained elsewhere within Part I, Item 1 of this Annual Report on Form 10-K for discussion of the risks associated with the concentration of our customers, as well as the risks associated with our revenue by product family and geographic area.
Competition
The market for HBAs is intensely competitive and is characterized by frequent new product introductions, changing customer preferences and evolving technology and industry standards.
Our competition for Fibre Channel host bus adapter products consists primarily of Agilent, JNI and QLogic. We may also compete indirectly with Fibre Channel HBAs made internally by major systems providers, notably Hewlett-Packard. In the emerging iSCSI marketplace where standards have yet to be finalized, we expect to face competition from established Fibre Channel competitors as well as new entrants, which may include established Ethernet suppliers such as Intel and established
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SCSI vendors such as Adaptec. Across all storage networking technologies, we face the threat of potential competition from new entrants into the storage networking market, including large technology companies that may develop or acquire differentiating technology and then apply their resources, including established distribution channels and brand recognition, to obtain significant market share.
We believe that the principal basis of storage networking HBA competition presently includes interoperability, reliability, scalability, price, performance, technical support and API stability. We believe that we compete favorably with respect to these factors. We also believe that we have a competitive strength in the alliances we have built with customers, particularly our close relationships with OEM customers. We believe that our experience with distribution channels will provide competitive benefits as the storage networking market matures. Some of our other competitive advantages include our early entry into Fibre Channel technology, our workforce of highly experienced researchers and designers, our intellectual property and our technical alliances with strategic partners such as Brocade, Cisco, Computer Associates, Intel, Legato, McDATA, Microsoft and Veritas.
Our Fibre Channel products may also compete at the end-user level with other technology alternatives, such as SCSI, which are available from companies such as Adaptec, LSI Logic and QLogic, as well as a number of smaller companies. In the future, other technologies that we are not currently developing may evolve to address the applications served by Fibre Channel today.
Manufacturing and Suppliers
Our products consist primarily of electronic component parts assembled on internally designed printed circuit boards that are sold as board-level products. Most component parts can be purchased from two or more sources. However, some key components that we use in our products may only be available from single sources with which we do not have contracts. We may obtain sole source components manufactured by companies such as Cypress, E20, Finisar, ICS, Intel, IBM, Lattice, Micrel, Micron, Motorola, NEC, Quicklogic, Samsung, Seiko Epson, Siliconix, Tundra Semiconductor and Vitesse. In addition, we design our own ASICs that are embedded in our products. These ASICs are also sole sourced and manufactured by third-party semiconductor foundries including IBM and LSI Logic. In addition to hardware, we design software to provide functionality to our hardware products. In the past, we have also licensed software from third party providers for use with our traditional networking products, and most of these providers are the sole source for the software. However, both our software and the third party software provided as embedded programs within the hardware products. Additionally, revenue related to our traditional networking products has decreased over the last several years due to the ongoing maturation of these products and a decrease in our focus on these products. We issued last time buy notifications to customers for our traditional networking products during the last quarter of 2000 and expect negligible, if any, revenues in succeeding quarters related to these products.
In 1998, we began outsourcing the manufacturing of our product lines to an electronics manufacturing service, or EMS, provider. This decision resulted in, among other things, the closing of our Puerto Rico manufacturing facility, streamlining the product offerings of some of our more mature, lower volume products (primarily for our traditional networking products) and closing selected sales offices. Suntron Corporation (formerly known as K*Tec Electronics) manufactures for us within the United States and Manufacturers’ Services, Ltd., or MSL, manufacturers for us in both the United States and in Europe at their Global Manufacturing Services production facility in Valencia, Spain.
In July 2002, MSL notified us that they would be closing their facility within the United States that manufactured our products. As a result, the facility has been closed and we have transitioned a portion of the manufacturing of our products to an alternative MSL facility within the United States. The transition was completed during fiscal 2003. In June 2003, we notified Suntron that we intend to discontinue using their services. We expect that we will no longer use Suntron as an EMS provider by the end of the second quarter of fiscal 2004. In June 2003, we selected Benchmark Electronics, Inc., or Benchmark, as an additional EMS provider and expect to begin shipping product to customers from Benchmark’s facility in Guadalajara, Mexico by the end of the second quarter of fiscal 2004. At this time, our customers have yet to qualify the Benchmark facility in Mexico. Although we do not expect these changes to our electronics manufacturing service providers to have a significant impact on us, if we were to experience significant delays in product qualifications, completing production runs or shipping product as a result of these changes, and we were unable to compensate for this disruption elsewhere, it could have a material adverse effect on our business, results of operations and financial condition.
An inability or an unwillingness on the part of any of our suppliers to provide us, or our EMS providers, with the quality and quantity of products, parts or software that we need in a timely fashion could have a material impact on our ability to supply products in accordance with customer requirements.
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The assembly operations required by our products are typical of the electronics industry, and no unusual methods, procedures or equipment are required. The sophisticated nature of the products, in most cases, requires extensive testing by specialized test devices operated by skilled personnel. Our EMS providers provide this testing. However, we also maintain an internal test-engineering group for continuing support of test operations. At June 29, 2003, we had a total of 36 regular full-time manufacturing support employees located at our facilities in Costa Mesa, California and in Bolton, Massachusetts.
Employees
At June 29, 2003, we employed 395 employees as follows: 243 in engineering and development, 55 in selling and marketing, 61 in general and administrative and 36 in manufacturing support operations. None of our employees is represented by a labor union, and we believe our employee relations are good.
Risk Factors
A prolonged downturn in information technology spending in general or spending on high-performance computer and storage systems in particular could adversely affect our revenues and results of operations.
The demand for our Fibre Channel products, which represented 99 percent of our net revenues for fiscal 2003, has been supported by the demand for high-performance networking and data storage solutions that support enterprise computing requirements, including on-line transaction processing, data mining, data warehousing, multimedia and Internet applications. In early calendar 2001, the global economy experienced a significant slowdown that was exacerbated by the terrorist attacks on the United States and the resulting economic and political uncertainty throughout the world. Such downturn has resulted in substantial reductions in demand for networking, data storage and other information technology solutions and products. We are unable to predict the duration or depth of such downturn in technology spending. In the event that such downturn grows more severe or continues for an extended period of time, our business, results of operations and financial condition may be adversely affected. The adverse effects of any sustained downturn in information technology spending on our operating results may be exacerbated by our research and development investments, strategic investments and merger and acquisition activity, as well as customer service and support, which are expected to continue despite any such downturn.
Our business depends upon the continued growth of the storage networking market, and our business will be adversely affected if such growth does not occur or occurs more slowly than we anticipate.
The size of our potential market is dependent upon the broadening acceptance of our storage networking technologies as alternatives to other technologies traditionally utilized for network and storage communications, as well as the overall demand for storage. We believe that our investment in the storage networking market represents our greatest opportunity for revenue growth and profitability for the foreseeable future. However, we cannot be certain that the market for storage networking products will gain broader acceptance or that customers will continue to choose our technology and products. Additionally, since our products are sold as parts of integrated systems, our products’ demand is driven by the demand for these integrated systems, including other companies’ complementary products. A lack of demand for the integrated systems or a lack of complementary products required for these integrated systems could have a material adverse effect on our business, results of operations and financial condition. If the storage networking market does not grow, attracts more competitors than we expect, as discussed below, or if our products do not achieve market acceptance, our business, results of operations and financial condition could be materially adversely affected.
We have secured numerous design wins for our storage networking products from OEM customers. If our customers are unable to or otherwise do not ship systems that incorporate our products, or if their shipped systems were not commercially successful, our business, results of operations and financial condition would be materially adversely affected.
We experienced a downturn in Fibre Channel host bus adapter demand first evidenced by order deferrals experienced and disclosed by us in early February of calendar 2001. In the event such deferrals were to occur again, our business, results of operations and financial condition could be materially adversely affected.
Because a significant portion of our revenues are generated from sales to a limited number of customers, none of which are the subject of exclusive or long-term contracts, the loss of one or more of these customers could adversely affect our business.
We rely almost exclusively on OEMs and sales through distribution channels for our revenue. For fiscal 2003, we derived approximately 66 percent of our net revenues from OEMs and 34 percent from sales through distribution. Furthermore, because the majority of our sales through distribution channels consist of OEM-certified products, we believe that OEM
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customers effectively control more than 85 percent of our revenue. We cannot be certain that we will retain our current OEM and distributor customers or that we will be able to recruit additional or replacement customers. As is common in the technology industry, our agreements with OEMs and distributors are typically non-exclusive, have no volume commitments, and often may be terminated by either party without cause. Indeed, it is increasingly commonplace for our OEM and distributor customers to carry or utilize competing product lines. If we were to lose business from one or more significant OEM or distributor customers to a competitor, our business, results of operations and financial condition could be materially adversely affected.
For fiscal 2003, direct sales to Hewlett-Packard and IBM were each 23 percent of our total net revenues. Direct sales to our top five customers accounted for 68 percent of total net revenues for fiscal 2003. Additionally, some of our larger OEM customers purchased or marketed products indirectly through distributors, resellers or other third parties. Total net revenues, including direct sales to our OEM customers and their OEM-specific models purchased or marketed indirectly through other distribution channels, amounted to 26 percent of our total net revenues for IBM, 23 percent for Hewlett-Packard and 22 percent for EMC for fiscal 2003.
Compaq and Hewlett-Packard consummated their merger in May 2002. Although we cannot predict the remaining effects of such merger on our business, to the extent that such merger results in decreased demand or margins for our products, our business, results of operations and financial condition could be materially and adversely affected.
Although we have attempted to expand our base of customers, we believe our revenues in the future will continue to be similarly derived from a limited number of customers, especially given the consolidation the industry has experienced. As a result, to the extent that sales to any of our significant customers are reduced or impaired, our business, results of operations and financial condition could be materially and adversely affected.
Our markets are highly competitive and our business and results of operations may be adversely affected by entry of new competitors into the markets, aggressive pricing and the introduction or expansion of competitive products and technologies.
The markets for our products are highly competitive and are characterized by rapid technological advances, price erosion, frequent new product introductions and evolving industry standards. We expect that our market will continue to attract new competition. Our current and potential competition consists of major domestic and international companies, some of which have substantially greater financial, technical, marketing and distribution resources than we have. Additional companies may enter the markets for our storage networking products and new or stronger competitors may emerge as a result of consolidation movements in the marketplace. Furthermore, larger companies in other related industries may develop or acquire technologies and apply their significant resources, such as distribution channels and brand recognition, to acquire market share. Emerging companies attempting to obtain a share of the existing markets act as potential competition as well. Additionally, our existing competitors continue to introduce products with improved price/performance characteristics, and we will have to do the same to remain competitive. As the market grows and matures, we expect more customers to qualify multiple sources for OEM or standard products where we have prevailed previously as a single source, thus introducing competition into our existing customer accounts. Increased competition could result in significant price competition, reduced revenues, lower profit margins or loss of market share, any of which would have a material adverse effect on our business, results of operations and financial condition.
Alternative legacy technologies such as SCSI compete with our Fibre Channel and IP storage networking technologies for customers. Our success depends in part on our own ability and on the ability of our OEM customers to develop storage networking solutions that are competitive with these alternative legacy technologies. Some of our competitors already have well-established relationships with our current and potential customers, have extensive knowledge of the markets we serve and may have better name recognition and more extensive development, sales and marketing resources than we have. Additionally, in the future other technologies that we are not currently developing may evolve to address the storage networking applications currently served by our Fibre Channel product line today.
Some of our suppliers, our strategic partners or our OEM customers could become competitors.
Some of our suppliers, our strategic partners and our OEM customers currently have or could develop products internally or could purchase another company with products or technology that would replace or compete with our products and technology. To the extent that our customers or suppliers are successful in developing and marketing competitive solutions, the resulting reductions in sales of our products could have a material adverse effect on our business, results of operations and financial condition.
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Our operating results are difficult to forecast and could be adversely affected by many factors, and our stock price may decline if our results fail to meet expectations.
Our revenues and results of operations have varied on a quarterly basis in the past and may vary significantly in the future. Accordingly, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful, and you should not rely on such comparisons as indications of our future performance. There can be no assurance that we will maintain our current levels of growth or profitability in the future. Our revenues and results of operations are difficult to forecast and could be adversely affected by many factors, including, among others:
| • | The gain or loss of significant OEMs, OEM design wins or other customers; | ||
| • | Changes in the size, timing and terms of OEM and other customer orders; | ||
| • | Changes in the sales and deployment cycles for our products, particularly those sold through our OEM sales channels; | ||
| • | Changes in our significant customers’ desired inventory levels; | ||
| • | The timing and market acceptance of new or enhanced product introductions by us, our OEM customers and our competitors; | ||
| • | Changes in the selling price of our products; | ||
| • | Changes in the mix of product sales or the mix of sales channels; | ||
| • | Difficulties in obtaining incremental market share growth; | ||
| • | Fluctuations in product development and other operating expenses; | ||
| • | Fluctuations in manufacturing cost, including the cost of components we use to produce our products; | ||
| • | Component shortages experienced by us, or reduced demand from our customers if our customers are unable to acquire the components used in conjunction with our products in their deployments; | ||
| • | The ability of our electronics manufacturing service providers to produce and distribute our products in a timely fashion; | ||
| • | Difficulties, disruptions or delays caused by the move of our corporate headquarters in fiscal 2004; | ||
| • | Difficulties with updates, changes or additions to our Enterprise Resource Planning (ERP) System; | ||
| • | Changes in general social and economic conditions, including but not limited to terrorism, public health and slower than expected market growth, with resulting changes in customer technology budgeting and spending; | ||
| • | Changes in technology, industry standards or consumer preferences; | ||
| • | Seasonality; | ||
| • | Changes in our accounting or other policies resulting from the adoption of new laws, regulations or pronouncements; and/or | ||
| • | Fluctuations in foreign currency exchange rates. |
As a result of these and other unexpected factors or developments, it is possible that our future operating results will be below the expectations of investors or market analysts, which could have a material adverse effect on our stock price.
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Unfilled orders and our tendency to generate a large percentage of our quarterly sales near the end of the quarter contributes to possible quarterly fluctuations in our operating results that could have an adverse impact on our results of operations and stock price.
Historically, we have generally shipped products quickly after we receive orders, meaning that we do not always have a significant backlog of unfilled orders. As a result, our revenues in a given quarter may depend substantially on orders booked in that quarter. Alternatively, orders already in backlog may be deferred or cancelled. Also, we have typically generated a large percentage of our quarterly revenues in the last month of the quarter. Our customers may change their accounting practices and purchasing patterns, thus reducing our ability to predict our quarterly sales. Additionally, we use blanket purchase orders with some customers, with customer-provided forecasts and customer controlled just-in-time pulls of products from hub warehouses, thus reducing our ability to predict our quarterly sales. As a result of these and other factors, we may not be able to accurately predict our quarterly sales. Because our expense levels are partially based on our expectations of future sales, in the event we experience unexpected decreases in quarterly sales, our expenses may be disproportionately large relative to our revenues and we may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. A material shortfall in sales in relation to our quarterly expectations or any delay of customer orders would likely have an immediate and adverse impact on our results of operations and may adversely affect our stock price.
The failure of one or more of our significant customers to make payments could adversely affect our business.
We are subject to credit risk associated with the concentration of our accounts receivable from our customers. Our days sales outstanding, or DSOs, were 37 days at both June 29, 2003, and June 30, 2002. There can be no assurance they will remain at this level or improve. If one of our current significant customers were to declare bankruptcy, if we were to lose one of our current significant customers and did not receive their payments due to us, or if one of our current significant customers were to dispute a significant amount owed to us, we could experience a material adverse effect on our business, results of operations and financial condition.
Our industry is subject to rapid technological change, and we must keep pace with the changes to successfully compete.
The markets for our products are characterized by rapidly changing technology, evolving industry standards and the frequent introduction of new products and enhancements. Our future success depends in a large part on our ability to enhance our existing products and to introduce new products on a timely basis to meet changes in customer preferences and evolving industry standards. Currently, new and proposed technologies such as 4 gigabit per second, or Gbps, Fibre Channel solutions; 10 Gbps Fibre Channel solutions; Infiniband; PCI-X 2.0; PCI Express; iSCSI; SATA; SAS; VI; and Remote Direct Memory Access, or RDMA; are in development by many companies and their ultimate acceptance and deployment in the market is uncertain. Emulex is developing some, but not all of these technologies, and we cannot be sure that the technologies we chose to develop will achieve market acceptance, or that technologies that we chose not to develop will be available to purchase or license from third parties or will be immaterial to our business. We cannot be certain that we will be successful in developing, manufacturing and marketing new products or product enhancements that respond to technological changes in a timely manner and achieve market acceptance. We also cannot be certain that we will be able to develop the underlying core technologies necessary to create new products and enhancements, or that we will be able to license the required core technologies with commercially reasonable terms from third parties. In addition, a key element of our current business strategy is to develop ASICs in order to increase system performance, enhance integration and reduce manufacturing costs, thereby enhancing the price/performance of our storage networking products. We cannot be certain that we will be successful at developing and incorporating ASICs effectively and in a timely manner. Additionally, the cost and time required for developing ASICs has been increasing and we cannot be certain of the impact on our business of such increases. If we are unable, for technological or other reasons, to develop new products, enhance or sell existing products, or consume existing products in a timely and cost-effective manner in response to technological and market changes, our business, results of operations and financial condition may be materially adversely affected.
We have experienced losses in our history that may adversely affect our stock price and financial condition.
We have experienced losses in our history, most recently a net loss of $96.2 million in fiscal 2002, and $23.6 million in fiscal 2001. The net loss in fiscal 2002 included $156.2 million of amortization of goodwill and other intangibles related to the acquisition of Giganet, Inc. and a net excess and obsolete inventory charge of $10.1 million. The net loss in fiscal 2001 included $22.3 million of in-process research and development expenses and $52.1 million of amortization of goodwill and other intangibles related to the acquisition of Giganet, Inc. Beginning in the first quarter of fiscal 2003, when we adopted Statement 142, “Goodwill and Other Intangible Assets,” we no longer amortize goodwill and other intangibles that have indeterminate useful lives. We currently have net goodwill related to the Giganet acquisition in the amount of $397.3
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million that will be reviewed at least annually for impairment. Any losses, including losses caused by impairment of goodwill, may adversely affect the perception of our business by analysts and investors, which could adversely affect our stock price. While our recent losses have not been accompanied by negative cash flow from operations, to the extent that we are unable to generate positive operating profits and positive cash flow from operations, our financial condition may be materially adversely affected.
The migration of our customers toward newer product platforms may have a significant adverse effect on our results of operations, including charges for obsolete inventory.
As our customers migrate from one platform to the enhanced price/performance of the next platform, we may experience reduced revenue, gross profit and gross margin levels associated with lower average selling prices and higher relative product costs associated with improved performance. Also, economic conditions during platform migration periods can have a significant impact on results. This was evidenced in late September 2001, as some of our major customers made announcements that general economic conditions, exacerbated by the increase in economic uncertainty in the aftermath of the terrorist events of September 11, 2001, were having a negative impact on their financial results. The announcements made, and forecasts received, indicated deteriorating demand for our one Gbps products as these customers were expected to migrate to two Gbps products for future purchases. As a result, we initially recorded an inventory charge of $13.6 million in 2002 and then reduced this reserve by $3.5 million in 2002 as previously reserved inventory was sold. After initially recording our one Gbps reserve of $13.6 million during the first quarter of fiscal 2002, we subsequently reduced this reserve by a total of $6.9 million through June 29, 2003, as this previously reserved inventory has been sold. Overall, we have been able to recover a significant portion of this reserved inventory that was not expected based on our forecasts and the forecasts received from our customers when this excess and obsolete inventory charge was recorded. In addition to the sale of some of this previously reserved product, we have also scrapped $3.3 million of this reserved inventory and negotiated and paid cancellation charges of $0.2 million through June 29, 2003, related to this excess and obsolete inventory charge since it was initially recorded. As with all inventory, we regularly compare forecasted demand for our one Gbps products against inventory on hand and open purchase commitments and accordingly, we may have to record reductions to the carrying value of excess and obsolete inventory if forecasted demand decreases.
Any failure of our OEM customers to keep up with rapid technological change could adversely affect our business.
Our revenues depend significantly upon the ability and willingness of our OEM customers to develop, promote and deliver, on a timely basis, products that incorporate our technology. OEMs must commit significant resources to develop a product that incorporates our technology or solutions. The ability and willingness of OEM customers to develop, promote and deliver such products are significantly influenced by a variety of factors, many of which are outside of our control. We cannot be certain of the ability or willingness of our OEM customers to continue developing, marketing and selling products that incorporate our technology or solutions. Our business is dependent on our relationships with our OEM and distributor customers, so the inability or unwillingness of any of our significant customers to develop or promote products that use our technology or solutions would have a material adverse effect on our business, results of operations and financial condition.
Rapid changes in the evolution of technology, including the unexpected extent or timing of the transition from HBA solutions to lower-priced ASIC solutions, could adversely affect our business.
Historically, the electronics industry has developed higher performance ASICs that create chip level solutions that replace selected board level solutions at a significantly lower average selling price. We have previously offered ASICs to certain customers for certain applications that has effectively resulted in a lower-priced solution when compared to an HBA solution. This transition may occur for our products in other applications as well. The result of this transition may be an adverse effect on our revenues and profit margin. If this transition is more abrupt or is more widespread than anticipated, there can be no assurance that we will be able to modify our business model in a timely manner, if at all, in order to mitigate the effects of this transition on our business, results of operations and financial position.
Rapid shifts in customer purchases from our high-end server and storage solutions to midrange server and storage solutions could adversely affect our business.
Historically, the majority of our Fibre Channel revenues has come from our high-end server and storage solutions. In recent quarters, an increasing percentage of revenues has come from midrange server and storage solutions, which typically have lower average selling prices than our high-end server and storage solutions. If this trend were to be more abrupt or more widespread than anticipated, there can be no assurance that we would be able to modify our business model in a timely manner, if at all, in order to mitigate the effect of this trend on our business, results of operations and financial position.
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A decrease in the average unit selling prices and/ or an increase in the manufactured cost of our Fibre Channel products could adversely affect our revenue, gross margins and financial performance.
Since we introduced our first Fibre Channel products, we have experienced downward pressure on their average unit selling prices. We may provide pricing discounts to customers based upon volume purchase criteria, and achievement of such discounts may reduce our average unit selling prices. To the extent that growth in unit demand fails to offset decreases in average unit selling prices, our revenues and financial performance could be materially adversely affected. Although historically we have achieved offsetting cost reductions, to the extent that average unit selling prices of our Fibre Channel products decrease without a corresponding decrease in the costs of such products, our gross margins and financial performance could be materially adversely affected. Furthermore, if the manufactured cost of our products were to increase due to inflation or other factors, our gross margins and financial performance could be materially adversely affected.
Delays in product development could adversely affect our business.
We have experienced delays in product development in the past and may experience similar delays in the future. Given the short product life cycles in the markets for our products and the relatively long product development cycles, any delay or unanticipated difficulty associated with new product introductions or product enhancements could have a material adverse effect on our business, results of operations and financial condition. Prior delays have resulted from numerous factors, such as:
| • | Difficulties in hiring and retaining necessary personnel; | ||
| • | Difficulties in reallocating engineering resources and other resource limitations; | ||
| • | Difficulties with independent contractors; | ||
| • | Unanticipated engineering or manufacturing complexity; | ||
| • | Undetected errors or failures in software and hardware; | ||
| • | Changing OEM product specifications; | ||
| • | Delays in the acceptance or shipment of products by OEM customers; and/or | ||
| • | Changing market or competitive product requirements. |
Our products are complex and may contain undetected software or hardware errors that could lead to an increase in our costs, reduce our net revenues or damage our reputation.
Our products are complex and may contain undetected errors, especially when first introduced or as new versions are released. The occurrence of hardware or software errors could adversely affect sales of our products, cause us to incur significant repair costs, divert the attention of our engineering personnel from product development efforts and cause us to lose credibility with current or prospective customers.
Our joint development activities may result in products that are not commercially successful or that are not available in a timely fashion.
We have engaged in joint development projects with third parties in the past and we expect to continue doing so in the future. Joint development can magnify several risks for us, including the loss of control over development of aspects of the jointly-developed products and over the timing of product availability. Accordingly, we face increased risk that joint development activities will result in products that are not commercially successful or that are not available in a timely fashion.
During April 2003 we announced a joint development activity with Intel Corporation relating to storage processors that integrate SATA, SAS and Fibre Channel interfaces within a single architecture. Under the agreement, Emulex will develop the protocol controller hardware, firmware and drivers. Intel will integrate it’s Intel® Xscale™ microarchitecture as the core technology for the new processors and will manufacture the processors on its 90-nanometer process technology. Emulex will market the resulting Fibre Channel products and Intel will market the SATA and SAS product. This activity has risks resulting from unproven new-generation manufacturing technology, from the licensing of SATA and SAS
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technology to Intel, from increased development costs, from reduced flexibility in making design changes in response to market changes and in reduced control over product completion schedules.
A change in our business relationships with our third-party suppliers or our electronics manufacturing service providers could adversely affect our business.
We rely on third-party suppliers for components and the manufacture of our products, and we have experienced delays or difficulty in securing components and finished goods in the past. Delays or difficulty in securing components or finished goods may be caused by numerous factors including, but not limited to:
| • | Discontinued production by a supplier; | ||
| • | Undetected errors, failures or production quality issues; | ||
| • | Timeliness of product delivery; | ||
| • | Financial stability and viability of our suppliers and electronics manufacturing service providers; | ||
| • | Changes in business strategies of our suppliers and electronics manufacturing service providers; | ||
| • | Disruption in shipping channels; | ||
| • | Natural disasters; | ||
| • | Environmental, tax or legislative changes in the location where our products are produced; | ||
| • | Difficulties associated with foreign operations; and/or | ||
| • | Market shortages. |
There is a risk that we will not be able to retain our current suppliers or change to alternative suppliers. An interruption in supply or the cost of shifting to a new supplier or electronics manufacturing service providers could have a material adverse effect on our business, results of operations and financial condition.
Additionally, key components that we use in our products may only be available from single sources with which we do not have contracts. We may obtain sole source components manufactured by companies such as Cypress, E20, Finisar, ICS, Intel, IBM, Lattice, Micrel, Micron, Motorola, NEC, Quicklogic, Samsung, Seiko Epson, Siliconix, Tundra Semiconductor and Vitesse. In addition, we design our own ASICs that are embedded in our products. These ASICs are also sole sourced and manufactured by third-party semiconductor foundries including IBM and LSI Logic. In addition to hardware, we design software to provide functionality to our hardware products. In the past, we have also licensed software from third party providers for use with our traditional networking products, and most of these providers are the sole source for the software. However, both our software and the third party software are provided as embedded programs within the hardware products. The loss of one or more of our sole suppliers or third party foundries could have a material adverse effect on our business, results of operations and financial condition. In addition, an announcement made by one of our sole suppliers or third party foundries that they intend to stop producing a component in the future could cause us, based on forecasted demand that may or may not materialize, to enter into a long-term purchase commitment or make a last-time purchase that could have a material adverse effect on our business, results of operations and financial condition.
Because we outsource the production of our products to electronics manufacturing service providers, or EMS providers, we only manage the supply of a small number of our product components. Currently, we rely upon our EMS providers to complete numerous component purchases for our products. Consequently, we cannot be certain that the necessary components will be available to meet our future requirements at favorable prices, if at all.
In July 2002, MSL, one of our EMS providers, notified us that they would be closing their facility within the United States that manufactured our products. As a result, the facility has been closed and we have transitioned a portion of the manufacturing of our products to an alternative MSL facility within the United States. The transition was completed during fiscal 2003. In June 2003, we notified Suntron that we intend to discontinue using their services. We expect that we will no longer use Suntron as an EMS provider by the end of the second quarter of fiscal 2004. In June 2003, we selected
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Benchmark Electronics, Inc., or Benchmark, as an additional EMS provider and expect to begin shipping product to customers from Benchmark’s facility in Guadalajara, Mexico by the end of the second quarter of fiscal 2004. At this time, our customers have yet to qualify the Benchmark facility in Mexico. Although we do not expect these changes to our electronics manufacturing service providers to have a significant impact on us, if we were to experience significant delays in product qualifications, completing production runs or shipping product as a result of these changes, and we were unable to compensate for this disruption elsewhere, it could have a material adverse effect on our business, results of operations and financial condition. Moreover, because we rely upon our EMS providers to manufacture, store and ship our products, the manufacturing and sale of our products would be temporarily suspended if MSL, Suntron and/or Benchmark are unable or unwilling to complete production runs for us in the future, or experience any significant delays in completing production runs or shipping product. An interruption in supply of our products and the cost of qualifying and shifting production to an alternative manufacturing and distribution facility could have a material adverse effect on our business, results of operations and financial condition. Furthermore, we rely upon the financial stability of our EMS providers and their ability and willingness to continue as our EMS providers.
If our intellectual property protections are inadequate, it could adversely affect our business.
We believe that our continued success depends primarily on continuing innovation, marketing and technical expertise, as well as the quality of product support and customer relations. At the same time, our success is partially dependent on the proprietary technology contained in our products. We currently rely on a combination of patents, copyrights, trademarks, trade secret laws and contractual provisions to establish and protect our intellectual property rights in our products. For a more complete description of our intellectual property, you should read “Business — Intellectual Property.”
We cannot be certain that the steps we take to protect our intellectual property will adequately protect our proprietary rights, that others will not independently develop or otherwise acquire equivalent or superior technology, or that we can maintain such technology as trade secrets. In addition, the laws of some of the countries in which our products are or may be developed, manufactured or sold may not protect our products and intellectual property rights to the same extent as the laws of the United States or at all. Furthermore, we enter into various development projects and arrangements with other companies. In some cases, these arrangements allow for the sharing or use of our intellectual property. Our failure to protect our intellectual property rights could have a material adverse effect on our business, results of operations and financial condition.
Third-party claims of intellectual property infringement could adversely affect our business.
We believe that our products and technology do not infringe on the intellectual property rights of others or upon intellectual property rights that may be granted in the future pursuant to pending applications. We occasionally receive communications from third parties alleging patent infringement, and there is always the chance that third parties may assert infringement claims against us. Any such claims, with or without merit, could result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements, which may or may not be available. However, we have in the past obtained, and may be required in the future to obtain, licenses of technology owned by other parties. We cannot be certain that the necessary licenses will be available or that they can be obtained on commercially reasonable terms. If we were to fail to obtain such royalty or licensing agreements in a timely manner and on reasonable terms, our business, results of operations and financial condition would be materially adversely affected.
The inability to attract or the loss of key managerial and technical personnel could adversely affect our business.
Our success depends to a significant degree upon the performance and continued service of key managers as well as engineers involved in the development of our storage networking technologies and technical support of our storage networking products and customers. Our future success depends upon our ability to attract, train and retain such personnel. We may need to increase the number of key managers as well as technical staff members with experience in high-speed networking applications as we further develop our storage networking product lines. Competition for such highly skilled employees in our local community as well as our industry is intense, and we cannot be certain that we will be successful in recruiting and retaining such personnel. In addition, employees may leave our company and subsequently compete against us. Also, many of these key managerial and technical personnel receive stock options. New regulations, volatility in the stock market and other factors could diminish the value of our stock options, putting us at a competitive disadvantage and forcing us to use more cash compensation. If we are unable to attract new managerial and technical employees, or are unable to retain our current key managerial and technical employees, our business, results of operations and financial condition could be materially adversely affected.
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Our international business activities subject us to risks that could adversely affect our business.
For fiscal 2003, sales in the United States accounted for 60 percent of our total net revenues, sales in Europe accounted for 33 percent of our total net revenues, and sales in the Pacific Rim countries accounted for seven percent of our total net revenues. We expect that sales in the United States and Europe will continue to account for the substantial majority of our net revenues for the foreseeable future. All of our sales are currently denominated in U.S. dollars. As a result, if the value of the U.S. dollar increases relative to foreign currencies, our products could become less competitive in international markets. Additionally, a significant portion of our products is produced at a manufacturing subcontractor’s production facility in Valencia, Spain and in the future products will be produced in Guadalajara, Mexico. As a result, we are subject to the risks inherent in international operations. Our international business activities could be affected, limited or disrupted by a variety of factors, including:
| • | The imposition of governmental controls and regulatory requirements; | ||
| • | The costs and risks of localizing products for foreign countries; | ||
| • | Longer accounts receivable payment cycles; | ||
| • | Changes in the value of local currencies relative to our functional currency; | ||
| • | Trade restrictions; | ||
| • | Changes in tariffs; | ||
| • | Loss of tax benefits due to international production; | ||
| • | General economic and social conditions within foreign countries; and/or | ||
| • | Political instability, war or terrorism. |
In addition, the revenues we earn in various countries in which we do business may be subject to taxation by more than one jurisdiction, thereby adversely affecting our earnings. All of these factors could harm future sales of our products to international customers or future overseas production of our products, and have a material adverse effect on our business, results of operations and financial condition.
Export restrictions may adversely affect our business.
Our products are subject to U.S. Department of Commerce export control restrictions. Neither our customers nor we may export such products without obtaining an export license, where applicable. These U.S. export laws also prohibit the export of our products to a number of countries deemed by the United States to be hostile. These restrictions may make foreign competitors facing less stringent controls on their products more competitive in the global market than our customers or we are. The U.S. government may not approve any pending or future export license requests. In addition, the list of products and countries for which export approval is required, and the regulatory policies with respect thereto, could be revised. The sale of our products could be harmed by our inability or the inability of our customers to obtain the required licenses or by the costs of compliance.
Potential acquisitions or strategic investments may be more costly or less profitable than anticipated and may adversely affect the price of our company stock.
We may pursue acquisitions or strategic investments that could provide new technologies, products or service offerings. Future acquisitions or strategic investments may negatively impact our results of operations as a result of operating losses incurred by the acquired entity, the use of significant amounts of cash, potentially dilutive issuances of equity or equity-linked securities, incurrence of debt or amortization of intangible assets with determinable lives. Furthermore, we may incur significant expenses pursuing acquisitions or strategic investments that ultimately may not be completed. Moreover, to the extent that any proposed acquisition or strategic investment is not favorably received by stockholders, analysts and others in the investment community, the price of our common stock could be adversely affected. In addition, acquisitions or strategic investments involve numerous risks, including:
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| • | Difficulties in the assimilation of the operations, technologies, products and personnel of the acquired company; | ||
| • | The diversion of management’s attention from other business concerns; | ||
| • | Risks of entering markets in which we have no or limited prior experience; | ||
| • | Risks related to the effect that the acquired company’s internal control processes might have on our financial reporting and management’s report on our internal controls over financial reporting; and/or | ||
| • | The potential loss of key employees of the acquired company. |
In the event that an acquisition or strategic investment does occur and we are unable to obtain anticipated profits or successfully integrate operations, technologies, products or personnel that we acquire, our business, results of operations and financial condition could be materially adversely affected.
Our stock price is volatile, which has and may result in lawsuits against us and our officers and directors.
The stock market in general and the stock prices in technology-based companies in particular have experienced extreme volatility that often has been unrelated to the operating performance of any specific public company. The market price of our common stock has fluctuated in the past and is likely to fluctuate in the future as well. Factors that could have a significant impact on the market price of our common stock include, but are not limited to, the following:
| • | Quarterly variations in operating results; | ||
| • | Announcements of new products by us or our competitors; | ||
| • | The gain or loss of significant customers or design wins; | ||
| • | Changes in analysts’ earnings estimates; | ||
| • | Changes in analyst recommendations, price targets or other parameters that may not be related to earnings estimates; | ||
| • | Rumors or dissemination of false information; | ||
| • | Pricing pressures; | ||
| • | Short selling of our common stock; | ||
| • | Dilution resulting from conversion of outstanding convertible subordinated notes into shares of our common stock; | ||
| • | General conditions in the computer, storage or communications markets; and/or | ||
| • | Events affecting other companies that investors deem to be comparable to us. |
In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. In this regard, we and certain of our officers and directors were named as defendants in a number of securities class action lawsuits filed in the United States District Court, Central District of California. The plaintiffs in the actions represent purchasers of our common stock during various periods ranging from January 18, 2001, through February 9, 2001. The complaints allege that we and certain of our officers and directors made misrepresentations and omissions in violation of sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints generally seek compensatory damages, costs and attorney’s fees in an unspecified amount. In addition, we have received inquiries about events giving rise to the lawsuits from the Securities and Exchange Commission and the Nasdaq Stock Market. On April 22, 2003, we entered into two Memoranda of Understanding agreeing to terms of settlement for both the class action and derivative litigation. If we were to be the subject of a securities class action lawsuit in the future it could have a material adverse effect on or results of operations and financial condition. See Part I – Item 3 – “Legal Proceedings” of this Form 10-K for a more complete discussion of such litigation and Memoranda of Understanding.
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The final amount collected for our receivable from our insurance carriers related to the tentative settlements of securities class action and derivative lawsuits may be materially different from the receivable amount.
For the three months ended March 30, 2003, we recorded a $13.5 million receivable from our insurance carriers related to the tentative settlements of securities class action and derivative lawsuits. We had directors and officers insurance with a primary limit of $10.0 million and a possible $10.0 million reinstatement for the period of February 2000 through February 2002; and excess insurance of $10.0 million for the period February 2000 through February 2001; and excess insurance of $20.0 million for the period February 2001 to February 2002. Our insurance carriers have asserted various defenses including coverage exclusions and late notice. Our actual insurance recovery may be materially different from the recorded amount for various reasons, including the strength of the defenses asserted by our insurance carriers. If one or all of our insurance carriers were unable or refused to make some or all payments due to us, or if an arbitrator or court determines that the recovery should be an amount other than the recorded amount, or if ultimately the amount received by us is more or less than the recorded amount, we would be required to record a corresponding gain or loss.
Terrorist activities and resulting military and other actions could adversely affect our business.
The terrorist attacks in New York and Washington, D.C. in September 2001 disrupted commerce throughout the United States and Europe. The continued threat of terrorism within the United States and Europe and the military action and heightened security measures in response to such threat may cause significant disruption to commerce throughout the world. To the extent that such disruptions result in delays or cancellations of customer orders, delays in collecting cash, a general decrease in corporate spending on information technology or our inability to effectively market, manufacture or ship our products, our business, financial condition, and results of operations could be materially and adversely affected. We are unable to predict whether the threat of terrorism or the responses thereto will result in any long-term commercial disruptions or if such activities or responses will have any long-term material adverse effect on our business, results of operations or financial condition.
Our corporate offices and principal product development facilities are located in a region that is subject to earthquakes and other natural disasters.
Our California facilities, including our corporate offices and principal product development facilities, are located near major earthquake faults. Any disruption in our business activities, personal injury or damage to the facilities in excess of our currently insured amounts as a result of earthquakes or other such natural disasters, could have a material adverse effect on our business, results of operations and financial condition.
Our shareholder rights plan, certificate of incorporation and Delaware law could adversely affect the performance of our stock.
Our shareholder rights plan and provisions of our certificate of incorporation and of the Delaware General Corporation Law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. The shareholder rights plan and these provisions of our certificate of incorporation and Delaware law are intended to encourage potential acquirers to negotiate with us and allow our board of directors the opportunity to consider alternative proposals in the interest of maximizing stockholder value. However, such provisions may also discourage acquisition proposals or delay or prevent a change in control, which could harm our stock price. You should read note 12 to the Consolidated Financial Statements contained elsewhere herein, our certificate of incorporation and Delaware law for more information on the anti-takeover effects of provisions of our shareholder rights plan.
Changes in laws, regulations and financial accounting standards may affect our reported results of operations.
The recently enacted Sarbanes-Oxley Act of 2002 and related regulations may result in changes in accounting standards or accepted practices within our industry. New pronouncements and varying interpretations of pronouncements have occurred in the past and are likely to occur in the future as a result of recent Congressional and regulatory actions. New laws, regulations and accounting standards, as well as changes to currently accepted accounting practices in the technology industry might adversely affect our reported financial results, which could have an adverse effect on our stock price. Proposals have been made concerning the expensing of stock options that could result in rules or laws that may adversely affect our reported financial results, which could have an adverse effect on our stock price.
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The final determination of our income tax liability may be materially different from our income tax provisions and accruals.
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