BLUE COAT SYSTEMS INC - FORM 10-Q

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EXCEL - IDEA: XBRL DOCUMENT - BLUE COAT SYSTEMS INC	Financial_Report.xls
EX-31.1 - PRINCIPAL EXECUTIVE OFFICER CERTIFICATION PURSUANT TO SECTION 302 - BLUE COAT SYSTEMS INC	dex311.htm
EX-32.1 - PEO AND PF&A OFFICER CERTIFICATION PURSUANT TO SECTION 906 - BLUE COAT SYSTEMS INC	dex321.htm
EX-31.2 - PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER CERTIFICATION PURSUANT TO SECTION 302 - BLUE COAT SYSTEMS INC	dex312.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED OCTOBER 31, 2010

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 000-28139

BLUE COAT SYSTEMS, INC.

(Exact Name of Registrant as Specified In Its Charter)

DELAWARE

91-1715963

(State or Other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer

Identification No.)

420 NORTH MARY AVENUE

SUNNYVALE, CALIFORNIA 94085

(Address of Principal Executive Offices and Zip Code)

Registrant’s Telephone Number, Including Area Code: (408) 220-2200

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data file required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES x NO ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer x

Accelerated filer ¨

Non-accelerated filer ¨

Smaller reporting company ¨

(Do not check if a smaller

reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) YES ¨ NO x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

There were 43,188,376 shares of the registrant’s Common Stock issued and outstanding as of November 22, 2010.

TABLE OF CONTENTS


		Page

Item 1.	Financial Statements		4

	Condensed Consolidated Balance Sheets as of October 31, 2010 and April 30, 2010		4

	Condensed Consolidated Statements of Operations for the Three and Six Months Ended October 31, 2010 and 2009		5

	Condensed Consolidated Statements of Cash Flows for the Six Months Ended October 31, 2010 and 2009		6

	Notes to Condensed Consolidated Financial Statements		7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		25

Item 3.	Quantitative and Qualitative Disclosures about Market Risk		44

Item 4.	Controls and Procedures		45

PART II. OTHER INFORMATION			46

Item 1.	Legal Proceedings		46

Item 1A.	Risk Factors		46

Item 6.	Exhibits		59

	Signatures		60

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements include, but are not limited to, statements concerning the following: plans to develop and offer new products and services and enter new markets; expectations with respect to future market growth opportunities; changes in and expectations with respect to revenues, gross margins and income tax provisions; future operating expense levels and operating margins; the impact of quarterly fluctuations of revenue and operating results; our ability to achieve expected levels of revenues and profit contributions from acquired businesses; the impact of macroeconomic conditions on our business; the adequacy of our capital resources to fund operations and growth; investments or potential investments in acquired businesses and technologies, as well as internally developed technologies; the effectiveness of our sales force, distribution channel, and marketing activities; the impact of recent changes in accounting standards; and assumptions underlying any of the foregoing. In some cases, forward-looking statements are identified by the use of terminology such as “anticipate,” “expect,” “intend,” “plan,” “predict,” “believe,” “estimate,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” or negatives or derivatives of the foregoing, or other comparable terminology.

The forward-looking statements in this Quarterly Report on Form 10-Q involve known and unknown risks, uncertainties and other factors that may cause industry and market trends, or our actual results, level of activity, performance or achievements, to be materially different from any future trends, results, level of activity, performance or achievements expressed or implied by these statements. For a detailed discussion of these risks, uncertainties and other factors, see the “Risk Factors” section under Part II, Item 1A of this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update forward-looking statements to reflect new information or events or circumstances occurring after the date of this Quarterly Report on Form 10-Q, except as may be required by applicable law.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

BLUE COAT SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value)


	October 31, 2010			April 30, 2010
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	288,774		$	236,347
Accounts receivable, net of allowance of $0 and $235 as of October 31, 2010 and April 30, 2010, respectively		82,180			64,204
Inventory		10,798			6,010
Prepaid expenses and other current assets		11,792			15,526
Current portion of deferred income tax assets		10,969			10,980

Total current assets		404,513			333,067
Property and equipment, net		32,666			33,684
Restricted cash		1,031			986
Goodwill		242,611			242,611
Identifiable intangible assets, net		30,991			37,033
Non-current portion of deferred income tax assets		37,842			41,517
Other assets		6,499			7,140

Total assets	$	756,153		$	696,038

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	19,079		$	15,000
Accrued payroll and related benefits		17,661			16,254
Deferred revenue		109,288			104,050
Other current liabilities		12,315			12,921

Total current liabilities		158,343			148,225
Deferred revenue, less current portion		53,600			50,172
Deferred rent, less current portion		6,108			6,427
Long-term income taxes payable		30,409			25,989
Other non-current liabilities		1,280			1,193
Convertible senior notes		77,689			77,241
Commitments and contingencies
Blue Coat stockholders’ equity:
Preferred stock: $0.0001 par value; issuable in series; 9,958 shares authorized; none issued and outstanding		—			—
Common stock: $0.0001 par value; 200,000 shares authorized; 43,162 and 42,662 shares issued and outstanding at October 31, 2010 and April 30, 2010, respectively		3			3
Additional paid-in capital		1,248,434			1,231,032
Treasury stock, at cost; 442 and 397 shares held at October 31, 2010 and April 30, 2010, respectively		(4,035	)		(3,035	)
Accumulated deficit		(816,033	)		(841,991	)

Total Blue Coat stockholders’ equity		428,369			386,009
Noncontrolling interest		355			782

Total stockholders’ equity		428,724			386,791

Total liabilities and stockholders’ equity	$	756,153		$	696,038

See accompanying Notes to Condensed Consolidated Financial Statements.

BLUE COAT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
Net revenue:
Product	$	73,127		$	76,502		$	148,695		$	150,194
Service		47,920			43,934			94,832			86,231

Total net revenue		121,047			120,436			243,527			236,425
Cost of net revenue:
Product		15,284			19,261			31,248			38,744
Service		10,723			12,947			21,111			24,984

Total cost of net revenue		26,007			32,208			52,359			63,728
Gross profit		95,040			88,228			191,168			172,697
Operating expenses:
Sales and marketing		44,821			45,608			89,476			91,184
Research and development		20,948			19,568			40,803			39,404
General and administrative		10,715			11,176			21,058			23,892
Amortization of intangible assets		1,843			1,822			3,686			3,643
Restructuring		38			—			178			—

Total operating expenses		78,365			78,174			155,201			158,123

Operating income		16,675			10,054			35,967			14,574
Interest income		126			72			290			173
Interest expense		(223	)		(227	)		(447	)		(455	)
Other income (expense), net		158			155			(165	)		139

Income before income taxes		16,736			10,054			35,645			14,431
Provision for income taxes		4,703			1,687			9,687			2,068

Net income	$	12,033		$	8,367		$	25,958		$	12,363

Net income per share:
Basic	$	0.26		$	0.19		$	0.56		$	0.28

Diluted	$	0.25		$	0.19		$	0.55		$	0.28

Weighted average shares used in computing net income per share:
Basic		46,712			43,777			46,520			43,485

Diluted		47,638			45,202			47,594			44,777

See accompanying Notes to Condensed Consolidated Financial Statements.

BLUE COAT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	Six Months Ended October 31,
	2010			2009
Operating Activities
Net income	$	25,958		$	12,363
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		6,953			6,528
Amortization		6,836			6,923
Stock-based compensation		8,985			10,338
Deferred income taxes		3,686			—
Tax benefit of stock option deduction		523			235
Excess tax benefit from stock-based compensation		(521	)		(792	)
Loss on disposition of equipment		18			474
Changes in operating assets and liabilities:
Accounts receivable, net		(17,976	)		1,484
Inventory		(4,788	)		(1,169	)
Prepaid expenses and other assets		4,029			(2,554	)
Accounts payable		4,079			(5,025	)
Accrued expenses and other liabilities		4,989			(2,070	)
Deferred revenue		8,666			2,008

Net cash provided by operating activities		51,437			28,743
Investing Activities
Purchases of property and equipment, and technology licenses		(5,953	)		(10,742	)
Restricted cash		(45	)		(112	)
Acquisitions, net of cash acquired		(427	)		—

Net cash used in investing activities		(6,425	)		(10,854	)
Financing Activities
Net proceeds from issuance of common stock		6,894			8,677
Excess tax benefit from stock-based compensation		521			792

Net cash provided by financing activities		7,415			9,469

Net increase in cash and cash equivalents		52,427			27,358
Cash and cash equivalents at beginning of period		236,347			114,163

Cash and cash equivalents at end of period	$	288,774		$	141,521

See accompanying Notes to Condensed Consolidated Financial Statements.

Notes to Condensed Consolidated Financial Statements

Note 1. Basis of Presentation and Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The unaudited condensed consolidated financial statements include the accounts of Blue Coat Systems, Inc. and our subsidiaries, which, with the exception of S7 Software Solutions Pvt. Ltd. (“S7”), are each wholly owned. All inter-company balances and transactions have been eliminated. We record all acquisitions using the purchase method of accounting and, accordingly, include the acquired company’s results of operations in our consolidated results from the date of acquisition. The condensed consolidated financial statements include the accounts and operating results of S7 beginning January 25, 2010. We classify the noncontrolling interest held in S7 as a separate component of stockholders’ equity in our condensed consolidated balance sheets. The net income attributable to the noncontrolling interest for the three and six months ended October 31, 2010, respectively was not material to our consolidated operating results and, therefore, was not presented separately in the condensed consolidated statements of operations.

In management’s opinion, the accompanying condensed consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of the results for the interim periods presented. The condensed consolidated balance sheet as of April 30, 2010 is derived from the April 30, 2010 audited consolidated financial statements. Certain prior fiscal year amounts have been reclassified to conform to the current period’s presentation. Such reclassifications were not material and did not affect net revenue, operating income or net income. Interim financial results are not necessarily indicative of results anticipated for the full year. These unaudited financial statements should be read in conjunction with our fiscal 2010 audited financial statements and footnotes included in our Annual Report on Form 10-K for the year ended April 30, 2010, as filed with the Securities and Exchange Commission (“SEC”) on June 7, 2010.

The preparation of condensed consolidated financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities, at the dates of the condensed consolidated financial statements, and the reported amounts of net revenue and expenses during the reporting period. Actual results may differ from these estimates, and such differences could be material to our consolidated financial condition and results of operations.

The functional currency of our domestic and foreign operations is the U.S. dollar. Accordingly, the effects of foreign currency transactions, and of remeasuring the financial condition and results of operations from local currencies into the functional currency, are included in other income (expense), net, in the accompanying condensed consolidated statements of operations.

With the exception of the adoption of a new accounting pronouncement related to revenue recognition, discussed below, there have been no material changes to our significant accounting policies, as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended April 30, 2010.

Revenue Recognition

the product’s essential functionality. In addition, the FASB amended the accounting standards for certain multiple element revenue arrangements to:

•

provide updated guidance on whether multiple elements exist, how the elements in an arrangement should be separated, and how the arrangement consideration should be allocated to the separate elements;

•

require an entity to allocate arrangement consideration to each element based on a selling price hierarchy, where the selling price for an element is based on vendor-specific objective evidence (“VSOE”), if available; third-party evidence (“TPE”), if available and VSOE is not available; or the best estimate of selling price (“BESP”), if neither VSOE or TPE is available; and

•

eliminate the use of the residual method and require an entity to allocate arrangement consideration using the selling price hierarchy.

Although the amended standards were not required to be adopted by us until May 1, 2011, the beginning of our fiscal year 2012, we elected to early adopt this accounting guidance at the beginning of our first quarter of fiscal 2011 on a prospective basis for transactions entered into or materially modified after April 30, 2010.

The majority of our products are hardware appliances containing software components that operate together to provide the essential functionality of the product. Therefore, our hardware appliances are considered non-software deliverables and are no longer accounted for under the industry-specific software revenue recognition guidance.

Our product revenue also includes stand-alone software products. Stand-alone software may operate on our hardware appliances, but is not considered essential to the functionality of the hardware and continues to be subject to the industry-specific software revenue recognition guidance, which remains unchanged. This includes the use of the residual method. Certain of our stand-alone software when sold with our appliances is considered essential to its functionality and as a result is no longer accounted for under industry-specific software revenue recognition guidance; however, this same software when sold separately is accounted for under the industry-specific software revenue recognition guidance.

We design, develop and sell products and services that secure and optimize the delivery of business applications and other information to distributed users over a Wide Area Network (“WAN”), or the public Internet (also known as the Web). Our products provide our end user customers with information about the applications and Web traffic running on their networks, including the ability to discover, classify, manage and control communications between users and applications across internal networks, the WAN and the Internet. Our products are also designed to optimize the performance of our end users’ business applications and content, whether used internally or hosted by external providers. In addition to optimizing the performance and delivery of applications, our products enable our end user customers to secure their Internet gateways and remote computer systems by providing protection from malicious code, or malware, and objectionable content.

We operate a multiple tier channel distribution model that includes both distributors and value-added resellers. In most cases, we sell our products to distributors, who in turn sell to value-added resellers and ultimately end users. In these cases, we ship our products from our fulfillment centers to value-added resellers who provide configuration services for end users. In some cases, we sell directly to value-added resellers, who in turn sell to end users. In these cases, we ship our products from our fulfillment centers directly to end users. We do not accept orders from distributors or value-added resellers when we are aware that they do not have an order from an end user. Additionally, we provide unspecified software upgrades for most of our products, on a when-and-if available basis, through post contract customer support (“maintenance”) contracts.

We recognize revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery or performance has occurred; the sales price is fixed or determinable; and collection is probable. We define each of those four criteria as follows:

Persuasive evidence of an arrangement exists. Evidence of an arrangement generally consists of a purchase order issued pursuant to the terms and conditions of a distributor or value-added reseller agreement and, in limited cases, an end user agreement.

Delivery or performance has occurred. We use shipping and related documents, or written evidence of customer acceptance, when applicable, to verify delivery or performance. We do not recognize product revenue until transfer of title and risk of loss, which generally is upon shipment to distributors, value-added resellers or end users as our customers do not carry stock and therefore do not have stock rotation rights. We generally do not have significant obligations for future performance, such as rights of return or pricing credits, associated with our sales.

The sales price is fixed or determinable. We assess whether the sales price is fixed or determinable based on payment terms and whether the sales price is subject to refund or adjustment.

Collection is probable. We assess probability of collection on a customer-by-customer basis. We subject our customers to a credit review process that evaluates their financial condition and ability to pay for our products and services. If we conclude that collection is not probable based upon our initial review, we do not recognize revenue until cash is received.

We enter into multiple element revenue arrangements in which a customer may purchase a combination of hardware, software, hardware and software upgrades, hardware and software maintenance, and professional services.

For transactions entered into prior to our adoption of the amended revenue standards in the first quarter of fiscal 2011, we allocated revenue for arrangements with multiple elements, such as appliances, maintenance or software, to each element using the residual method. Under the residual method, the amount of revenue allocated to delivered elements equals the total arrangement consideration less the aggregate fair value of any undelivered elements, provided VSOE of fair value exists for all undelivered elements. If evidence of the fair value of one or more undelivered elements does not exist, all revenue generally is deferred and recognized at the earlier of delivery of those elements or establishment of fair value for the remaining undelivered elements. When VSOE of fair value cannot be determined for any undelivered maintenance, subscription or service element, revenue for the entire arrangement is recognized ratably over the maintenance, subscription or service period.

For transactions entered into subsequent to the adoption of the amended revenue recognition standards that are multiple element arrangements, we allocate the arrangement fee to each element based upon the relative selling price of such element and, if software and software-related (e.g. maintenance for the software element) elements are also included in the arrangement, we allocate the arrangement fee to each of those software and software-related elements as a group based upon our BESP for those elements. After such allocation is made, the amount of the arrangement fee allocated to the software and software-related elements is accounted for using the residual method. When applying the relative selling price method, we determine the selling price for each element using VSOE of selling price, if it exists, or if not, TPE of selling price, if it exists. If neither VSOE nor TPE of selling price exist for an element, we use our BESP for that element. The revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for that element. The manner in which we account for multiple element arrangements that contain only software and software-related elements remains unchanged.

Consistent with our methodology under previous accounting guidance, we determine VSOE for each element based on historical stand-alone sales to third parties.

determine the VSOE of fair value for hardware and software maintenance by analyzing our stand-alone maintenance renewals and noting that a substantial majority of transactions fall within a narrow range for each stratum. In limited cases, VSOE of fair value has been based on management determined prices.

We typically are not able to determine TPE for our products, maintenance or professional services. TPE is determined based on competitor prices for similar elements when sold separately. Generally, our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, our go-to-market strategy differs from that of our peers and we are unable to reliably determine what similar competitor products’ selling prices are on a stand-alone basis.

When we are unable to establish the selling price of an element using VSOE or TPE, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine BESP for a product or service by considering multiple factors including, but not limited to, historical pricing practices by geography, customer class and distribution channel, and gross margin objectives.

For our hardware and software elements, we allocate the arrangement consideration based on the relative selling price of the element. For these elements, we use BESP as our selling price. For our hardware and software maintenance and professional services, we generally use VSOE as our selling price. When we are unable to establish selling price using VSOE for our hardware and software maintenance and professional services, we use BESP in our allocation of arrangement consideration.

We regularly review VSOE and BESP and maintain internal controls over the establishment and updates of these estimates. There was no material impact during the quarter from changes in either VSOE or BESP.

The impact from the adoption of the amended revenue recognition rules to total revenue, net income, and deferred revenue was not material for the three and six months ended October 31, 2010. The new accounting guidance for revenue recognition is not expected to have a significant effect on total net revenue in periods after initial adoption, although the impact on the timing and pattern of revenue will vary depending on the nature and volume of new or materially modified contracts in any given period.

Maintenance and subscription revenue is initially deferred and recognized ratably over the life of the contract, with the related expenses recognized as incurred. Maintenance and subscription contracts usually have a term of one to three years. Unearned maintenance and subscription revenue is included in deferred revenue.

We recognize revenue from the sale of third party AntiVirus software net of royalties paid and classify this revenue as net service revenue in our condensed consolidated statements of operations.

Note 2. Per Share Amounts

Our convertible senior notes, discussed in Note 6, are participating securities whereby the holder would participate equally in any future dividends and in undistributed earnings with common stockholders; therefore, we calculated basic and diluted net income per share using the two-class method. Certain of our unvested restricted stock awards and the warrants, discussed in Note 6, are also considered participating securities; however, the number of unvested restricted stock awards and the number of shares covered by the warrants are immaterial and, therefore, are not included in our calculation under the two-class method. See Note 6 for further information regarding the convertible senior notes and warrants.

Under the two-class method, basic net income per share is computed by dividing the net income available to common stockholders by the weighted-average number of common shares outstanding for the period. Net income available to common stockholders is determined after allocating undistributed earnings to the convertible senior note holders. Diluted net income per share is computed using the weighted-average number of shares of common

stock outstanding, including dilutive common shares subject to repurchase and potential shares issuable assuming the (i) dilutive effect of outstanding restricted stock awards and restricted stock units, warrants and shares issuable under our employee stock purchase plan using the treasury stock method, and (ii) conversion of convertible senior notes.

The following table presents the calculation of weighted average common shares used in the computations of basic and diluted per share amounts presented in the accompanying condensed consolidated statements of operations reconciled to basic and diluted per share amounts available to common stockholders:


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
	(in thousands, except per share amounts)
Basic net income per share
Numerator:
Net income	$	12,033		$	8,367		$	25,958		$	12,363
Less: undistributed earnings allocated to convertible senior note holders		(992	)		(737	)		(2,159	)		(1,096	)

Net income available to common stockholders	$	11,041		$	7,630		$	23,799		$	11,267
Denominator:
Basic weighted average common shares used in computing basic net income per share		46,712			43,777			46,520			43,485
Effect of participating convertible senior notes		(3,854	)		(3,854	)		(3,854	)		(3,854	)

Weighted average common shares outstanding using the two-class method		42,858			39,923			42,666			39,631

Basic income per share available to common stockholders	$	0.26		$	0.19		$	0.56		$	0.28

Diluted net income per share
Numerator:
Net income	$	12,033		$	8,367		$	25,958		$	12,363
Less: undistributed earnings allocated to convertible senior note holders		(973	)		(713	)		(2,102	)		(1,064	)

Net income available to common stockholders	$	11,060		$	7,654		$	23,856		$	11,299
Denominator:
Basic weighted average common shares used in computing basic net income per share		46,712			43,777			46,520			43,485
Add: Weighted average employee stock options		705			1,155			780			1,006
Add: Other weighted average dilutive potential common stock		221			270			294			286

Weighted average common shares used in computing diluted net income per share		47,638			45,202			47,594			44,777
Effect of participating convertible senior notes		(3,854	)		(3,854	)		(3,854	)		(3,854	)

Weighted average common share outstanding using the two-class method		43,784			41,348			43,740			40,923

Diluted income per share available to common stockholders	$	0.25		$	0.19		$	0.55		$	0.28

For the three and six months ended October 31, 2010, outstanding stock options and restricted stock awards and units covering an aggregate of 2.6 million shares and 2.2 million shares, respectively, were excluded from the calculation of diluted net income per share as their inclusion would have been anti-dilutive under the treasury stock method.

For the three and six months ended October 31, 2009, outstanding stock options and restricted stock awards and units covering an aggregate of 4.5 million and 5.0 million shares, respectively were excluded from the calculation of diluted net income per share as their inclusion would have been anti-dilutive under the treasury stock method.

Warrants to purchase 385,356 shares of our common stock were outstanding at October 31, 2010 and 2009. The warrants were included in the computation of the diluted net income per share for the three months ended October 31, 2010 and 2009, respectively, and for the six months ended October 31, 2010 because the exercise price of the warrants was less than the average market price of our common stock during the period. The warrants were not included in the computation of diluted net income per share for the six months ended October 31, 2009 because the exercise price of the warrants was greater than the average market price of our common stock during the period; therefore, their inclusion would have been anti-dilutive.

Note 3. Acquisitions

Fiscal 2010 Acquisition

The total purchase price was $6.4 million in cash, consisting of $4.7 million for the shares acquired and $0.4 million of payable for the noncontrolling interest (which amounts include an allocation of $1.1 million for excess working capital remaining as of the closing date), and $1.3 million payable over the 30 months subsequent to the initial closing date. Under the stock purchase agreement, the selling shareholders will indemnify us for up to $1.3 million for damages caused by inaccuracies in, breaches or violations of or defaults under representations, warranties, covenants or agreements. Any such amounts may be withheld from the $1.3 million in remaining payments due under the purchase agreement. In allocating the purchase price based on estimated fair values, we recorded approximately $4.5 million of goodwill, $0.7 million of identifiable intangible assets for customer relationships and $1.2 million of net tangible assets. In connection with the acquisition, we recognized $0.1 million of transaction costs which were included in general and administrative expenses in our condensed consolidated statement of operations in the third quarter of fiscal 2010. In addition, we agreed to pay potential retention bonuses up to an aggregate amount of $2.0 million to certain S7 shareholders who were also employees. Payment of these bonuses is contingent upon the performance of post-acquisition services by those shareholders over the 30 months subsequent to the initial closing date. Accordingly, the potential bonus amounts are accrued as compensation expense over the assumed retention period. Our acquisition of S7 did not result in the creation of a new business segment.

In November 2010, we obtained approval from the Reserve Bank of India to acquire the remaining 7.1% of the outstanding shares of S7, and the final share purchase was concluded on November 22, 2010.

Acquisition-related Intangible Assets

The fair value of the acquisition-related intangible assets was calculated considering market participant expectations and using an income approach with estimates and assumptions provided by S7 and our management. We used a discount rate reflective of the risk of the respective cash flows. The acquisition-related

intangible assets consist of assumed customer contracts, which represent S7’s underlying relationships with its customers. The fair value assigned to customer relationships was $0.7 million, which is amortized on a straight-line basis over the expected useful life of 4 years, consistent with the number of periods of prospective cash flow and other benefits utilized to estimate the fair values of the assets.

Noncontrolling Interest

The Company classified the noncontrolling interest in S7 as a component of equity within the condensed consolidated balance sheet. Given the Company’s majority ownership interest in S7, the fair value of the noncontrolling interest has been recorded as the interest of the stockholders holding the noncontrolling interest in the fair value of the net assets and operations of S7 at October 31, 2010.

Note 4. Goodwill and Identifiable Acquisition-Related Intangible Assets

Goodwill

There were no changes in the carrying amount of goodwill, which generally is not deductible for tax purposes, for the six months ended October 31, 2010.

Identifiable Acquisition-Related Intangible Assets

Our identifiable acquisition-related intangible assets are as follows (in thousands):


October 31, 2010	Amortization period		Gross Amount		Accumulated Amortization			Net Carrying Value
Developed technology and patents		3-7 years	$	26,031	$	(14,066	)	$	11,965
Core technology		5 years		2,929		(2,929	)		—
Customer relationships		4-7 years		37,723		(18,697	)		19,026
Trade name		2 years		400		(400	)		—

Total			$	67,083	$	(36,092	)	$	30,991


April 30, 2010	Amortization period		Gross Amount		Accumulated Amortization			Net Carrying Value
Developed technology and patents		3-7 years	$	26,031	$	(11,730	)	$	14,301
Core technology		5 years		2,929		(2,929	)		—
Customer relationships		4-7 years		37,723		(15,011	)		22,712
Trade name		2 years		400		(380	)		20

Total			$	67,083	$	(30,050	)	$	37,033

Amortization expense for our identifiable acquisition-related intangible assets for the three and six months ended October 31, 2010 and 2009 was allocated as follows:


	Three Months Ended October 31,				Six Months Ended October 31,
	2010		2009		2010		2009
	(in thousands)
Included in cost of net revenue	$	1,168	$	1,347	$	2,356	$	2,695
Included in operating expenses		1,843		1,822		3,686		3,643

Total	$	3,011	$	3,169	$	6,042	$	6,338

As of October 31, 2010, we had no identifiable acquisition-related intangible assets with indefinite lives. The weighted average remaining life of identifiable acquisition-related intangible assets was 2.6 years and 3.1 years as of October 31, 2010 and April 30, 2010, respectively.

Estimated amortization expense related to our identifiable acquisition-related intangible assets in future periods is as follows:


Year Ended April 30,	Amortization
	(in thousands)
Remainder of 2011	$	6,022
2012		11,956
2013		11,782
2014		1,231

	$	30,991

Note 5. Restructuring Activities

Fiscal 2010 Restructuring Plan

On November 3, 2009, we committed to a restructuring plan, which included a planned net reduction of approximately 10% of our headcount through the first quarter of fiscal 2011 and the closure of three facilities, including two research and development facilities located in Riga, Latvia, and South Plainfield, New Jersey (the “2010 Plan”). We consolidated our research and development work at three existing locations—Sunnyvale, California, Draper, Utah and Waterloo, Ontario, Canada—and opened a new location in Bangalore, India. The restructuring activities commenced on November 3, 2009, and were substantially complete by the end of the first quarter of fiscal 2011.

These actions were approved as part of our continuing effort to improve our profitability, to realign our research and development activity and resources, and to drive greater productivity throughout our organization.

Restructuring charges consist primarily of personnel-related severance costs, contract termination costs and stock-based compensation expenses. Stock-based compensation included in restructuring charges resulted primarily from the additional vesting of unvested option shares and restricted shares upon termination of the employment of employees under the 2010 Plan and pursuant to the terms of their separation agreements. The total estimated restructuring costs associated with the 2010 Plan are $12.7 million. Of the total restructuring charges, $10.8 million in charges relates to severance and related benefits for 265 employees and $1.9 million in charges relates to facility closures and consolidations. We have recorded $12.7 million of restructuring charges through the second quarter of fiscal 2011, including $0.1 million of stock-based compensation, and do not expect to incur any material charges in the future.

Summary of Restructuring Plan

The following table summarizes the activity related to the 2010 Plan for the six months ended October 31, 2010:


(in thousands)	Balance, April 30, 2010		Charges to Expense		Cash Payments			Non-cash settlements and other adjustments		Balance, October 31, 2010
Fiscal 2010 Restructuring Plan
Severance	$	989	$	103	$	(1,077	)	$	—	$	15
Facilities		1,255		75		(1,271	)		—		59

Total Restructuring Plan	$	2,244	$	178	$	(2,348	)	$	—	$	74

At October 31, 2010 and April 30, 2010, accrued restructuring was included in other current liabilities in our condensed consolidated balance sheets.

Note 6. Convertible Senior Notes

On June 2, 2008, we issued $80.0 million aggregate principal amount of Zero Coupon Convertible Senior Notes due June 2, 2013 (the “Convertible Senior Notes”) and warrants (the “Warrants”) to purchase an aggregate of 385,356 shares of our common stock at an exercise price of $20.76 to Manchester Securities Corp., an affiliate of Elliott Associates, L.L.P. (“Manchester”) and Francisco Partners II, L.P. and Francisco Partners Parallel Fund II, L.P. (together, the “FP Entities”) in a private placement. As of October 31, 2010, the Convertible Senior Notes were reported on our condensed consolidated balance sheet at $77.7 million, net of a discount of $2.3 million primarily related to the value assigned to the Warrants, which is being amortized to interest expense over the life of the Convertible Senior Notes.

The Convertible Senior Notes rank equal in right of payment to any of our other existing and future senior unsecured indebtedness. The Convertible Senior Notes are initially convertible into 3,853,564 shares of our common stock at the holders’ option at any time prior to maturity at the initial conversion price of $20.76. The Convertible Senior Notes do not bear interest. The conversion price of the Convertible Senior Notes and the exercise price of the Warrants are subject to adjustment, if we:

•

issue shares of our common stock as a dividend or distribution on our shares of common stock;

•

effect a stock split or stock combination;

•

issue shares of capital stock in the event of a reclassification; or

•

purchase shares of our common stock pursuant to a tender offer or exchange offer at a premium to market.

If we issue rights, options, warrants or pay a cash dividend or otherwise make a distribution of cash or other assets to all holders of our common stock, such right, option, warrant, dividend or distribution shall also be issued to the holders of the Convertible Senior Notes and the Warrants on an as-converted or as-exercised basis.

Subject to certain exceptions, the holders of the Convertible Senior Notes, at their option, may require us to repurchase for cash all or a portion of the Convertible Senior Notes at a purchase price equal to 100% of the outstanding principal amount of the Convertible Senior Notes if our common stock is suspended from trading or ceases to be listed on an eligible market for a period of 5 consecutive trading days or for more than 15 trading days in any 365-day period.

On June 2, 2008, we and the FP Entities entered into a Registration Rights Agreement, (the “Registration Rights Agreement”) containing customary terms and conditions providing for the registration of our common stock underlying the Convertible Senior Notes and the Warrants issued to the FP Entities. Pursuant to the Registration Rights Agreement, we filed an automatically effective resale shelf registration statement on August 4, 2008. We filed amendments to that registration statement on June 23, 2009 and October 2, 2009.

Keith Geeslin, a partner of Francisco Partners II, L.P., has served as a member of our Board of Directors since June 2006.

Note 7. Consolidated Balance Sheet Data

Inventory

Inventory consisted of the following:


	October 31, 2010		April 30, 2010
	(in thousands)
Raw materials	$	7,399	$	3,573
Finished goods		3,399		2,437

Total	$	10,798	$	6,010

Other Current Liabilities

Other current liabilities consisted of the following:


	As of
	October 31, 2010		April 30, 2010
	(in thousands)
Professional and consulting fees	$	440	$	541
Accrued royalty		2,185		1,771
Warranty obligations		610		648
Sales and marketing costs		698		388
Supply chain liability		459		288
Accrued restructuring costs		74		2,244
Foreign income taxes payable		3,450		3,258
Other		4,399		3,783

Total other current liabilities	$	12,315	$	12,921

Deferred Revenue

Deferred revenue consisted of the following:


	As of
	October 31, 2010		April 30, 2010
	(in thousands)
Deferred product revenue, current	$	2,187	$	2,025
Deferred service revenue, current		107,101		102,025

Total deferred revenue, current		109,288		104,050
Deferred service revenue, non-current		53,600		50,172

Total deferred revenue	$	162,888	$	154,222

Note 8. Fair Value of Assets and Liabilities

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Cash Equivalents and Restricted Cash

Our cash historically has been invested in highly liquid investments such as time deposits held at major banks, commercial paper, U.S. government agency discount notes, money market mutual funds and other money market securities with maturities at the date of purchase of 90 days or less. Our restricted cash is invested in time deposits with maturity dates consistent with the maturity dates of the letters of credit they collateralize. At October 31, 2010, our cash was invested in money market mutual funds and a money market savings account. The carrying amount of cash and cash equivalents and restricted cash reported on the balance sheet approximates its fair value. The fair values of cash equivalents are based upon quoted market prices.

Convertible Senior Notes

The carrying amount of the Convertible Senior Notes is net of discounts, primarily related to the associated Warrants. The fair value of the Convertible Senior Notes as of October 31, 2010 was determined based on an internal valuation model that utilized quoted market prices and interest rates for similar instruments, and is approximately $108.8 million. See Note 6 for further information regarding the Convertible Senior Notes and Warrants.

The estimated fair values of our financial instruments are as follows:


	As of
	October 31, 2010				April 30, 2010
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Assets:
Cash	$	45,777	$	45,777	$	38,609	$	38,609
Money market funds		244,028		244,028		198,724		198,724

	$	289,805	$	289,805	$	237,333	$	237,333

Reported as:
Assets:
Cash and cash equivalents			$	288,774			$	236,347
Long-term restricted cash				1,031				986

			$	289,805			$	237,333

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts business. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy is based on three levels of inputs that may be used to measure fair value, of which the first two are considered observable and the last is considered unobservable. These levels of inputs are the following:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Fair Value Measurements

Our financial instruments are valued using quoted prices in active markets. The following table sets forth the fair value of our financial assets and liabilities that were measured on a recurring basis as of October 31, 2010 and April 30, 2010 (in thousands):


	Level 1		Level 2		Level 3		Total
October 31, 2010:
Money market funds (1)	$	244,028	$	—	$	—	$	244,028
April 30, 2010:
Money market funds (1)	$	198,724	$	—	$	—	$	198,724

(1)	Included in cash and cash equivalents on our condensed consolidated balance sheets as of October 31, 2010 and April 30, 2010.

Our investments in money market funds are measured at fair value on a recurring basis. Our money market funds comply with Rule 2a-7 of the Investment Company Act of 1940 and are targeted to be priced and have a value of $1 net asset value per share. These money market funds are actively traded and reported daily through a variety of sources. Due to the structure and valuation required by the Investment Company Act of 1940 regarding Rule 2a-7 funds, the fair value of the money market fund investments are classified as Level 1.

During the quarter ended October 31, 2010, we did not remeasure any nonfinancial assets and liabilities measured at fair value on a nonrecurring basis, such as goodwill, intangible assets, property and equipment and nonfinancial assets and liabilities initially measured at fair value in a business combination.

Note 9. Stock-based Compensation

The following table summarizes the stock-based compensation expense for stock options, our Employee Stock Purchase Plan (“ESPP”), restricted stock awards and restricted stock unit awards that we recorded in our condensed consolidated statements of operations for the three and six months ended October 31, 2010 and 2009:


	Three Months Ended October 31,				Six Months Ended October 31,
	2010		2009		2010		2009
	(in thousands)
Stock-based compensation expense:
Cost of net revenue: product	$	153	$	248	$	287	$	463
Cost of net revenue: service		269		567		489		942
Sales and marketing		1,462		2,070		2,794		3,757
Research and development		1,579		1,457		2,810		2,989
General and administrative		1,450		1,185		2,605		2,187

Total	$	4,913	$	5,527	$	8,985	$	10,338

We use the Black-Scholes option valuation model to calculate compensation expense. We estimate the expected term based on our historical experience of grants, exercise pattern and post-vesting cancellations. We considered our historical volatility over the expected term and implied volatility of traded stock options in developing our estimate of volatility.

For the three and six months ended October 31, 2010 and 2009, we used the following assumptions to estimate the fair value of options granted:


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
Risk-free interest rate		1.1	%		2.4	%		1.4	%		2.6	%
Dividend yield		—			—			—			—
Expected term (in years)		4.3			4.8			4.3			4.8
Volatility		59	%		65	%		56	%		66	%
Expected forfeitures		18.0	%		14.0	%		18.0	%		14.0	%

For the three and six months ended October 31, 2010 and 2009, we used the following assumptions to estimate the fair value of shares purchased under our ESPP:


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
Risk-free interest rate		0.2	%		0.2	%		0.2	%		0.4	%
Dividend yield		—			—			—			—
Expected term (in years)		0.5			0.5			0.5			0.5
Volatility		58	%		59	%		52	%		72	%

During the three and six months ended October 31, 2010, options to purchase 200,920 shares and 310,453 shares, respectively, were exercised. As of October 31, 2010, there was approximately $18.6 million and $1.0

million of unrecognized stock-based compensation expense related to stock option grants and ESPP awards, respectively, which will be recognized over the remaining weighted average vesting period of approximately 2.7 years and 0.3 years, respectively.

The cost of awards of restricted stock and restricted stock units is determined using the fair value of our common stock on the date of the grant, and compensation expense is recognized over the vesting period, which generally is four years. During the second quarter of fiscal 2011, we awarded 197,574 restricted stock units and canceled 8,457 shares of restricted stock and 18,854 restricted stock units. As of October 31, 2010, we had approximately $1.6 million and $10.0 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to awards of restricted stock and restricted stock units, respectively, which we will recognize over the remaining weighted average vesting period of approximately 1.5 years and 3.5 years, respectively.

Note 10. Income Taxes

The provision for income taxes for the three and six months ended October 31, 2010 was $4.7 million and $9.7 million, respectively, compared with $1.7 million and $2.1 million for the three and six months ended October 31, 2009, respectively. The provision primarily reflects current U.S. federal and state taxes and foreign income taxes in taxable foreign jurisdictions. The primary difference between the effective tax rate and the federal statutory tax rate relates to taxes in foreign jurisdictions with a tax rate different than the U.S. federal statutory rate and non-deductible stock-based compensation expense.

Our total gross unrecognized tax benefits as of October 31, 2010 and April 30, 2010 were $38.5 million and $33.9 million, respectively. The increase was primarily related to uncertainties with respect to the taxation of cross-border arrangements within the group that were recorded in the period. Included in our gross unrecognized tax benefits as of October 31, 2010 are approximately $36.3 million of tax benefits that, if recognized, would result in an adjustment to our effective tax rate.

We have elected to classify interest and penalties related to uncertain tax positions as a component of our provision for income taxes. Accrued interest and penalties relating to our unrecognized tax benefits was approximately $1.7 million as of October 31, 2010, including approximately $0.3 million and $0.4 million charged to provision for income taxes for the three and six months ended October 31, 2010, respectively.

Due to our taxable loss position from inception through fiscal year 2007, all tax years are subject to examination in U.S. federal and state jurisdictions. We are also subject to examination in various foreign jurisdictions for tax years 2004 forward, none of which are individually material. We are unable to anticipate the change to the balance of our unrecognized tax benefits in the next twelve months due to the possibility of tax examinations and our continued assessment of potential contingencies.

Note 11. Commitments and Contingencies

Guarantees, Indemnifications and Warranty Obligations

Our customer agreements generally include provisions for indemnifying such customers against certain liabilities, including if our products infringe a third party’s intellectual property rights. We have also agreed in certain circumstances to indemnify for customer costs that would be incurred in connection with a product recall. To date, we have not incurred any material costs as a result of such indemnification provisions and we have not accrued any liabilities related to such obligations in the accompanying condensed consolidated financial statements.

Our Bylaws provide that we shall indemnify our directors and officers to the fullest extent permitted by Delaware law, including in circumstances in which indemnification is otherwise discretionary under Delaware law. We have also entered into indemnification agreements or other contractual arrangements with current and

former executive officers and directors of our company and of certain of our subsidiaries, which contain provisions that may require us, among other things, to indemnify such officers and directors against certain liabilities that may arise by reason of their status or service as directors or officers and to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified. We were required to indemnify certain current and former officers and directors and other employees for their attorneys’ fees and related expenses incurred in connection with the regulatory investigations relating to our historical stock option granting practices, and expect to have indemnification obligations to certain current and former officers and directors and other employees in connection with the derivative litigation and internal investigations relating to our historical stock option granting practices.

We maintain a warranty accrual for estimated future warranty obligations based on our historical warranty costs and revenue volumes together with anticipated future warranty costs. If actual warranty expenses are greater than those projected, additional charges against earnings would be required. If actual warranty expenses are less than projected, our obligations would be reduced, which would positively impact our reported results. We generally provide a one-year warranty on hardware products.

Changes in our warranty obligations, which are included in other current liabilities in our condensed consolidated balance sheet for the six months ended October 31, 2010, were as follows (in thousands):


Warranty obligation at April 30, 2010	$	648
Warranties issued during the period		1,224
Warranty costs incurred during the period		(1,262	)

Warranty obligation at October 31, 2010	$	610

Leases

We lease certain office facilities and office equipment under non-cancelable operating leases that expire at various dates through fiscal 2020. The facility leases generally require us to pay operating costs, including property taxes, insurance and maintenance, and may contain scheduled rent increases and certain other rent escalation clauses. Rent expense is recognized in our condensed consolidated financial statements on a straight-line basis over the terms of the respective leases after consideration of rent holidays and improvement allowances, if applicable, with any assets purchased using a lessee improvement allowance capitalized as fixed assets and depreciated over the shorter of their useful lives or the lease term.

Rent expense was $2.4 million and $4.8 million for the three and six months ended October 31, 2010, respectively, and $2.5 million and $5.0 million for the three and six months ended October 31, 2009, respectively.

As of October 31, 2010, future minimum lease payments under non-cancelable operating leases with initial or remaining terms in excess of one year are as follows:


Year ending April 30,	Total
	(in thousands)
Remainder of 2011	$	5,348
2012		9,812
2013		9,501
2014		8,291
2015		7,574
Thereafter		5,776

Total future minimum lease payments, net	$	46,302

Purchase Commitments and Other

We purchase components from a variety of suppliers and use several contract manufacturers to provide manufacturing services for our products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, we enter into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by us or that establish the parameters defining our requirements. A significant portion of our reported purchase commitments arising from these agreements consists of firm, noncancelable, and unconditional commitments. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. These agreements are enforceable and legally binding against us in the short term and all amounts under these arrangements are due to be paid by the end of fiscal 2011. As of October 31, 2010 our total purchase commitments for inventory were $6.2 million.

Note 12. Litigation

IPO Allocation Litigation

Beginning on May 16, 2001, a series of putative securities class actions were filed in the United States District Court for the Southern District of New York against the firms that underwrote our initial public offering, us, and some of our officers and directors. These cases have been consolidated under the case captioned In re CacheFlow, Inc. Initial Public Offering Securities Litigation, Civil Action No. 1-01-CV-5143. In November 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against the firms that underwrote Packeteer’s initial public offering, Packeteer, and some of its officers and directors. An amended complaint, captioned In re Packeteer, Inc. Initial Public Offering Securities Litigation, Civil Action No. 01-CV-10185, was filed on April 20, 2002.

These are two of a number of actions coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, 21 MC 92, with the first action filed on January 12, 2001. Plaintiffs in the coordinated proceeding are bringing claims under the federal securities laws against numerous underwriters, companies, and individuals, alleging generally that defendant underwriters engaged in improper and undisclosed activities concerning the allocation of shares in the IPOs of more than 300 companies during late 1998 through 2000. Among other things, the plaintiffs allege that the underwriters’ customers had to pay excessive brokerage commissions and purchase additional shares of stock in the aftermarket in order to receive favorable allocations of shares in an IPO.

The consolidated amended complaint in our case seeks unspecified damages on behalf of a purported class of purchasers of our common stock between December 9, 1999 and December 6, 2000. Pursuant to a tolling agreement, the individual defendants were dismissed without prejudice. On February 19, 2003, the Court denied our motion to dismiss the claims against us.

The amended complaint in the Packeteer case seeks unspecified damages on behalf of a purported class of purchaser’s of Packeteer’s common stock between July 27, 1999 and December 6, 2000.

In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us and Packeteer, was submitted to the Court for approval. On August 31, 2005, the Court preliminarily approved the settlement. In December 2006, the appellate court overturned the certification of classes in six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceedings. Because class certification was a condition of the settlement, it was deemed unlikely that the settlement would receive final Court approval. On June 25, 2007, the Court entered an order terminating the proposed settlement based upon a stipulation among the parties to the settlement. Plaintiffs have filed amended master allegations and amended complaints in the six focus cases. On March 26, 2008, the Court denied the defendants’ motion to dismiss the amended complaints.

The parties reached a global settlement of the litigation and the plaintiffs filed a motion for preliminary settlement approval with the Court on April 2, 2009. Under the settlement, the insurers will pay the full amount of settlement share allocated to the Company and Packeteer, and the Company and Packeteer would not bear any financial liability. On October 5, 2009, the Court entered an order granting final approval of the settlement. Certain objectors have appealed that order to the Court of Appeals for the Second Circuit.

Derivative Litigations

Actions Pending Against Us

On May 18, 2005, a purported shareholder derivative action was filed in the Superior Court of California, Santa Clara County, alleging that certain of our officers and directors violated their fiduciary duties to the Company by making false or misleading statements about our prospects between February 20, 2004 and May 27, 2004. On July 17, 2006, plaintiffs filed a consolidated amended complaint, adding allegations that certain current and former officers and directors violated their fiduciary duties to us since our initial public offering by granting and failing to account correctly for stock options. That amended complaint sought various types of relief on our behalf from the individual defendants. On September 8, 2006, another and substantively identical purported shareholder derivative action was filed against certain of our current and former officers and directors. These state derivative cases have been consolidated.

On August 8 and September 5, 2006, two purported shareholder derivative actions were filed in the United States District Court for the Northern District of California against certain of our current and former officers and directors. Like the state derivative actions, the federal derivative actions allege that certain of our current and former officers and directors violated their fiduciary duties since our initial public offering by granting and failing to account correctly for stock options and seek various relief on our behalf from the individual defendants. These federal cases have been consolidated.

On November 30, 2007, the federal and state plaintiffs each filed consolidated amended complaints in their respective actions, which focus on our historical stock option granting practices and assert claims for breach of fiduciary duty and other state and federal law claims against certain of our current and former officers and directors.

The plaintiffs in the federal action, by letter dated June 20, 2008, demanded our Board of Directors take action to remedy the conduct complained of. The demand followed our filing of a motion to dismiss on the grounds that plaintiffs had failed to make a pre-suit demand. The demand letter largely repeats the allegations and requested relief in the federal and state derivative actions. In response to the demand letter, our Board of Directors formed a special committee, composed of directors James R. Tolonen and Keith Geeslin, on June 25, 2008. The special committee was granted plenary authority to decide whether it is in the best interests of the Company and its shareholders to pursue or otherwise resolve the claims raised in the demand letter and in the federal and state derivative actions and any other claims of the Company that the special committee deems necessary or appropriate to consider concerning our historical stock option practices.

The parties to the derivative actions entered into a stipulation of settlement, and the court entered an order preliminarily approving that settlement on November 15, 2010 and set a hearing on January 14, 2011, for final determination with respect to the settlement. Should final court approval not be obtained the MOU will be of no force and effect. As part of the settlement, the Company agrees that it has adopted or will adopt certain corporate governance practices within 60 days of final court approval of the settlement. As part of the settlement, certain individual named defendants (none of whom are current directors or officers of the Company) and the insurance carriers for all of the individual named defendants will pay the Company a total of $4,164,208. In addition, in connection with the settlement, the Company will issue shares of the Company’s common stock valued at $1.775 million to plaintiffs’ counsel and Ernst & Young LLP will pay $225,000 in cash to plaintiffs’ counsel to compensate for attorneys’ fees and expenses incurred in connection with the actions.

The Court in the state action has stayed that action pending a case management conference presently scheduled for February 2011.

Action Pending Against Packeteer

On or about October 10, 2007, Vanessa Simmonds, a purported shareholder of Packeteer, filed a complaint in the United States District Court, Western District of Washington, against the underwriters of Packeteer’s 1999 initial public offering of its common stock, seeking recovery in the name of Packeteer for alleged violation by those underwriters of Section 16(b) of the Securities Exchange Act of 1934, as amended. The complaint seeks to recover from the underwriters any “short-swing profits” obtained by them in violation of Section 16(b). Packeteer is named as a nominal defendant. On February 28, 2008, the plaintiff filed an amended complaint asserting substantially similar claims as those set forth in the initial complaint and naming three additional underwriters as defendants.

This is one of 54 actions that were coordinated for pretrial purposes as In re Section 16(b) Litigation, Master Case No. 07-1549 JLR, with the first action filed on October 2, 2007. In July 2008, Packeteer and 29 other nominal defendants moved to dismiss the amended complaint. Packeteer also separately moved to dismiss the action brought against it on the ground that the plaintiff lacks standing to pursue the action because her interest was extinguished when Packeteer merged into our wholly-owned subsidiary on June 6, 2008. The Court heard the motions to dismiss in January 2009. On March 12, 2009, as a consequence of those motions, the Court issued an Order Dismissing Cases and entered judgment dismissing the actions, including the action brought against Packeteer. The Court denied as moot, Packeteer’s separate motion to dismiss.

On March 31, 2009, Simmonds appealed the judgment to the Court of Appeals for the Ninth Circuit, and thereafter filed an amended notice of appeal on April 10, 2009 at the Court’s request. The underwriter defendants filed a cross-appeal in each of the cases wherein the issuers moved for dismissal (including the appeal relating to Packeteer’s IPO). The Court heard oral argument on October 5, 2010, but has not yet ruled on the appeal.

Although we cannot predict the outcome of the IPO allocation cases or the derivative litigation discussed above, the costs of defending these matters (including, as applicable, our obligations to indemnify current or former officers, directors, employees or customers) could have a material adverse effect on our results of operations and financial condition.

From time to time and in the ordinary course of business, we may be subject to various other claims and litigation. Such claims could result in the expenditure of significant financial and other resources.

Note 13. Geographic and Product Category Information Reporting

We conduct business in one operating segment that designs, develops and sells products and services that optimize and secure the delivery of business applications and other information to distributed users over a WAN. Our chief operating decision maker, our chief executive officer, allocates resources and makes operating decisions based on financial data consistent with the presentation in the accompanying condensed consolidated financial statements. Our revenue consists of two categories: product and service.

Net revenue is attributed to three geographic areas based on the location of the customers. The following is a summary of net revenue by geographic area:


	Three months ended October 31,
	2010				2009
	(dollars in thousands)
Americas (1)	$	56,937	47.0	%	$	55,255	45.9	%
EMEA (2)		40,889	33.8			44,952	37.3
APAC (3)		23,221	19.2			20,229	16.8

Total net revenue	$	121,047	100	%	$	120,436	100.0	%


	Six months ended October 31,
	2010				2009
	(dollars in thousands)
Americas (1)	$	111,549	45.8	%	$	108,560	45.9	%
EMEA (2)		83,096	34.1			86,705	36.7
APAC (3)		48,882	20.1			41,160	17.4

Total net revenue	$	243,527	100	%	$	236,425	100.0	%

(1)	North America, Central America and Latin America (“Americas”)

(2)	Europe, Middle East and Africa (“EMEA”)

(3)	Asia and Pacific regions (“APAC”)

The following is a summary of net revenue by product category:


	Three months ended October 31,
	2010				2009
	(dollars in thousands)
Product	$	73,127	60.4	%	$	76,502	63.5	%
Service		47,920	39.6			43,934	36.5

Total net revenue	$	121,047	100.0	%	$	120,436	100.0	%


	Six months ended October 31,
	2010				2009
	(dollars in thousands)
Product	$	148,695	61.1	%	$	150,194	63.5	%
Service		94,832	38.9			86,231	36.5

Total net revenue	$	243,527	100.0	%	$	236,425	100.0	%

At October 31, 2010, substantially all of our long-lived assets were located in the United States.

Certain of our global distributors, including their various affiliates, may account for more than 10% of our net revenue in certain periods. In the second quarter of fiscal 2011, ComputerLinks, Westcon Group, Inc. and Arrow Enterprise Computing Solutions, Inc. accounted for 27.4%, 14.1% and 18.0% of our total net revenue, respectively. In the second quarter of fiscal 2010, ComputerLinks, Westcon Group, Inc. and Arrow Enterprise Computing Solutions, Inc. accounted for 23.9%, 17.1% and 13.9% of our total net revenue, respectively. In the first six months of fiscal 2011, ComputerLinks, Westcon Group, Inc. and Arrow Enterprise Computing Solutions, Inc. accounted for 25.3%, 16.0% and 14.9% of our total net revenue, respectively. In the first six months of fiscal 2010, ComputerLinks, Westcon Group, Inc. and Arrow Enterprise Computing Solutions, Inc. accounted for 19.9%, 15.2% and 10.7% of our total net revenue, respectively.

Note 14. Subsequent Event

On November 16, 2010, our Board of Directors approved a program to repurchase up to $50 million of our common stock. Repurchases may be made from time to time in the open market or in negotiated transactions and are expected to comply with Rule 10b-18 under the Securities Exchange Act of 1934 and other legal requirements. The timing and amount of the repurchase transactions will be determined by management and may depend on a variety of factors, including the trading price of the stock, market conditions, alternative investment opportunities, and other corporate and regulatory considerations. The program does not obligate us to acquire any particular amount of common stock and the program may be modified or discontinued at any time. The repurchases will be funded from available working capital.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We sell a family of proxy and other appliances, and related software and services. Our appliances, together with our software, secure, accelerate and optimize the delivery of business applications, Web content and other information over a Wide Area Network (“WAN”) or across an enterprise’s Internet gateway. Our products are based on three core functionalities: 1) security of the delivery of applications and content; 2) acceleration and optimization of the delivery of applications and content; and 3) visibility of the applications, content and users on the network. While our products are frequently sold and used individually, many of our product and service offerings share a common architecture and work together as part of an Application Delivery Network infrastructure. The combined offering enables distributed enterprises with multiple offices and geographically decentralized employees to more efficiently and effectively use and secure their critical business applications and networks.

Effective September 1, 2010, Michael J. Borman was appointed as President and Chief Executive Officer of the Company. Brian M. NeSmith, who has served as President and Chief Executive Officer since 1999, was appointed to the newly created role of Chief Product Officer, and is now directly responsible for overseeing our product strategy and development. Mr. NeSmith also currently serves as our acting Chief Marketing Officer and we are actively engaged in recruiting a new Chief Marketing Officer.

In fiscal 2010 and the first half of fiscal 2011, we evolved our business strategy to include offering the core functionality of our products to new markets and through new delivery models and strategic relationships. We reorganized our product-oriented and development resources into product groups to support this strategy and to better address specific markets, such as the telecommunications carrier market and the mid-market for Secure Web Gateway.

During fiscal 2010 and the first half of fiscal 2011, we also focused on improving our operational efficiency and cost structure. We measure the success of these efforts in substantial part by our operating margin and cash flow from operations. While we were successful in maintaining operating profitability at our projected levels in the first half of fiscal 2011, many factors can impact our future performance and profitability, including the global economic environment, seasonality and actions we take that we believe are necessary to drive future growth, including investments in research and development and in sales and marketing programs.

We believe that continued growth of our net revenue will be a key driver of future increases in our profitability and improvement in our financial condition. In recent quarters, the seasonally adjusted growth rate of our product revenue has slowed and we experienced a decline in product revenue in the second quarter of fiscal 2011 compared with the same quarter a year ago. While we believe that in large part this was due to the timing of our new product introductions, we believe that it also resulted from our need to improve our sales and marketing programs and focus. We are taking steps to address these issues and to reinvigorate our net revenue growth through sales of our products and new services, and this will be a significant priority for us in the second half of fiscal 2011.

We presently are taking steps to grow our net revenue through a number of sales, marketing and development efforts. These include steps designed to increase sales of our Secure Web Gateway products to our traditional large enterprise customers through adding new functionality, such as functionality to control and manage Web 2.0 and social networking traffic, and by expanding that customer base and engaging in cross-selling. Later this fiscal year, we will release our new Secure Web Gateway products, including a cloud-based services offering and a Secure Web Gateway appliance with functionality tailored for the mid-market enterprise. We also are taking steps to increase sales of our WAN acceleration products through targeted marketing and channel programs; assignment of dedicated officer level and sales resources; and increased sales incentives. We recently released a new version of our PacketShaper product and are investing in sales and marketing programs to promote that product line.

In addition to addressing revenue growth of specific products and in specific markets, we are focusing on addressing sales coverage and strategies in specific geographies outside the United States. We have taken steps to address problems that we identified in our EMEA region after the fourth quarter of fiscal 2010, including realigning our sales practices in Europe to better implement mixed sales strategies that address the needs of our diverse customer base and the variety of our product offerings, and have taken steps to address the structure and leadership of our EMEA sales organization. While we are seeing improvement in our EMEA bookings and sales closure rates, we believe that it may take several quarters to effect the changes we believe are necessary to materially improve performance in that region.

Although we intend to continue to focus on our operational efficiency, cost structure and profitability during the remainder of this fiscal year, we also will be making significant investments designed to drive increased net revenue and market penetration, including making expenditures on sales, marketing and research and development. Revenue from certain of our new products will be recognized ratably over a period of a year or more and accordingly will have a lessened impact on current revenue when sales commence. Finally, certain of our product lines, including our telecommunications carrier product that uses our CacheFlow platform, may have longer sales cycles than those we traditionally have experienced. Any of the foregoing may impact our ability to achieve our desired level of profitability during the remainder of this fiscal year.

We track many financial metrics as key measures of our business performance, including net revenue, operating margin, deferred revenue, cash flow from operations and cash position.

Net Revenue

Net revenue, which includes product and service revenue, increased to $121.0 million in the second quarter of fiscal 2011 from $120.4 million in the second quarter of fiscal 2010. Net product revenue in the second quarter of fiscal 2011 was $73.1 million, a $3.4 million decrease compared with the second quarter of fiscal 2010.

During the second quarter of fiscal 2011, we experienced a slowdown in the growth rates of sales of certain of our existing products, which contributed to the decrease in our net product revenue. This decrease included a $6.8 million decline in our product revenue in EMEA, partially offset by increased sales of our products in APAC and the Americas. Net product revenue primarily consists of revenue from sales of our ProxySG and PacketShaper appliances and licenses to our WebFilter product. We recognized $47.9 million in service revenue in the second quarter of fiscal 2011, a $4.0 million increase compared with the second quarter of fiscal 2010. The increase in service revenue was a result of sales of new service contracts sold with our appliances, continued growth in our installed base and the resulting increase in revenue from renewal service contracts.

Operating Margin

Our operating income increased by $6.6 million to $16.7 million in the second quarter of fiscal 2011 compared with the second quarter of fiscal 2010. This increase was attributable to an increase in our gross profit margin from 73.3% in the second quarter of fiscal 2010 to 78.5% in the second quarter of fiscal 2011. The year-over-year gross margin increase resulted from a favorable impact of our product mix and a decreased impact from the application of fair value purchase accounting on Packeteer inventory and deferred revenue, which negatively impacted the cost of net revenue and service revenue by $1.6 million in total in the second quarter of fiscal 2010 compared with a negative impact of $0.2 million in total in the second quarter of fiscal 2011. Excluding the fair value purchase accounting impact on gross profit in these two fiscal periods, our gross profit margin in fiscal 2011 would have been approximately 471 basis points higher than that in fiscal 2010, primarily as a result of higher gross margins associated with our high-end ProxySG appliance and higher service gross margins associated with the improved efficiency of our worldwide support delivery model.

Operating expenses consist of sales and marketing expenses, research and development expenses, general and administrative expenses, amortization of acquisition-related intangible assets and restructuring charges. Personnel-related costs, including stock-based compensation, are the primary driver of our operating expenses in each functional area. As of October 31, 2010 and 2009 we had 1,294 and 1,481 full-time equivalent employees, respectively.

Deferred Revenue

Net deferred revenue was $162.9 million at October 31, 2010 compared with $154.2 million at April 30, 2010. The increase was primarily due to an increase in the sales of renewal service contracts to our customers.

Cash Flow from Operations and Cash Position

During first six months of fiscal 2011, we generated cash flow from operations of $51.4 million compared with $28.7 million generated in the same period in fiscal 2010. The increase in operating cash flow in fiscal 2011 was primarily driven by higher net income after excluding the impact of non-cash charges such as stock-based compensation, depreciation and amortization expense, as well as an increase in working capital sources of cash from higher accounts payable, accrued expenses and deferred revenue balances, partially offset by working capital uses of cash from higher accounts receivable and inventory balances at October 31, 2010. Our cash and cash equivalents and restricted cash were $289.8 million at October 31, 2010 compared with $237.3 million at April 30, 2010.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, net revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates,

including those related to Revenue Recognition, Allowance for Doubtful Accounts, Stock-Based Compensation, Supply Chain Liabilities and Valuation of Inventory, Acquisitions, Goodwill and Identifiable Intangible Assets, Income Taxes, and Legal and Other Contingencies. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and such differences could be material.

We have discussed the development and selection of critical accounting policies and estimates with the audit committee of our board of directors. We believe the accounting policies described below are those that most frequently require us to make estimates and judgments that materially affect our financial statements and that are critical to the understanding of our financial condition and results of operations:

•

Revenue Recognition

•

Allowance for Doubtful Accounts

•

Stock-Based Compensation

•

Supply Chain Liabilities and Valuation of Inventory

•

Acquisitions, Goodwill and Identifiable Intangible Assets

•

Income Taxes

•

Legal and Other Contingencies

Revenue Recognition

In October 2009, the Financial Accounting Standards Board (“FASB”) amended the accounting standards for revenue recognition to remove from the scope of industry-specific software revenue recognition guidance any tangible products containing software components and non-software components that operate together to deliver the product’s essential functionality. In addition, the FASB amended the accounting standards for certain multiple element revenue arrangements to:

•

eliminate the use of the residual method and require an entity to allocate arrangement consideration using the selling price hierarchy.

the use of the residual method. Certain of our stand-alone software when sold with our appliances is considered essential to its functionality and as a result is no longer accounted for under industry-specific software revenue recognition guidance; however, this same software when sold separately is accounted for under the industry-specific software revenue recognition guidance.

The sales price is fixed or determinable. We assess whether the sales price is fixed or determinable based on payment terms and whether the sales price is subject to refund or adjustment.

For transactions entered into prior to our adoption of the amended revenue standards in the first quarter of fiscal 2011, we allocated revenues for arrangements with multiple elements, such as appliances, maintenance or software, to each element using the residual method. Under the residual method, the amount of revenue allocated

to delivered elements equals the total arrangement consideration less the aggregate fair value of any undelivered elements, provided VSOE of fair value exists for all undelivered elements. If evidence of the fair value of one or more undelivered elements does not exist, all revenue generally is deferred and recognized at the earlier of delivery of those elements or establishment of fair value for the remaining undelivered elements. When VSOE of fair value cannot be determined for any undelivered maintenance, subscription or service element, revenue for the entire arrangement is recognized ratably over the maintenance, subscription or service period.

Consistent with our methodology under previous accounting guidance, we determine VSOE for each element based on historical stand-alone sales to third parties.

VSOE of fair value is based on the price charged when the element is sold separately. We analyze our stand-alone hardware and software maintenance renewals by stratification of sales channel and service offering. We determine the VSOE of fair value for hardware and software maintenance by analyzing our stand-alone maintenance renewals and noting that a substantial majority of transactions fall within a narrow range for each stratum. In limited cases, VSOE of fair value has been based on management determined prices.

We typically are not able to determine TPE for our products maintenance or professional services. TPE is determined based on competitor prices for similar elements when sold separately. Generally, our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, our go-to-market strategy differs from that of our peers and we are unable to reliably determine what similar competitor products’ selling prices are on a stand-alone basis.

initial adoption, although the impact on the timing and pattern of revenue will vary depending on the nature and volume of new or materially modified contracts in any given period. However, we expect that this new accounting guidance will facilitate our efforts to optimize the sales and marketing of our offerings due to better alignment between the economics of an arrangement and the accounting for that arrangement. This may lead us to engage in new go-to-market practices. In particular, we expect that the new accounting standards will enable us to better combine products and services for which VSOE does not exist with other offerings and solutions. As these go-to-market strategies evolve, we may modify our pricing practices, which could result in changes in the relative selling prices of our elements, including both VSOE and BESP. As a result, the timing of revenue recognition on our future multiple element arrangements could differ materially from the recognition in the current period. Changes in the allocation of the sales price between elements may impact the timing of revenue recognition, but will not change the total revenue recognized with respect to the arrangement. We currently are unable to determine the impact that the newly adopted accounting principles could have on the timing of our revenue as these go-to-market strategies evolve.

We recognize revenue from the sale of third party Anti-Virus software net of royalties paid and classify this revenue as net service revenue in our condensed consolidated statements of operations.

Allowance for Doubtful Accounts

We perform ongoing credit evaluations of our customers’ financial condition and maintain an allowance for doubtful accounts. We analyze accounts receivable and historical bad debts, customer geographic concentrations, customer solvency, current economic and geographic trends, and changes in customer payment terms and practices when evaluating the adequacy of such allowance, and record any required changes in the allowance account to general and administrative expense. We write off accounts receivable when they are deemed to be uncollectible.

Stock-Based Compensation

Effective May 1, 2006, we adopted the fair value recognition provisions of Accounting Standards Codification (“ASC”) No. 718, Compensation—Stock Compensation, (“ASC 718,” formerly FASB Statement No. 123(R)) using the modified prospective transition method. Under that transition method, compensation expense recognized beginning on that date include: (a) compensation expense for all unvested share-based payments granted prior to May 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of FASB Statement 123; and (b) compensation expense for all share-based payments granted on or after May 1, 2006, based on the grant date fair value estimated in accordance with the provisions of ASC 718. We use the Black-Scholes option valuation model to calculate compensation expense.

The Black-Scholes option valuation model requires the input of highly subjective assumptions, including the expected term of options, the price volatility of the stock underlying such options, the risk-free interest rate, and the dividend yield. We are required to estimate the stock awards that we ultimately expect to vest and to reduce compensation expense for the effects of estimated forfeitures of awards over the expense recognition period. To the extent our actual forfeitures are different than our estimates, we record a true-up for the difference in the period that the awards vest.

Supply Chain Liabilities and Valuation of Inventory

We outsource our manufacturing, product fulfillment and repair operations to contract manufacturers and third party logistics providers, and a significant portion of our cost of net revenue results from these activities. We currently purchase several key parts and components used in the manufacture of our products from a limited

number of suppliers. Our contract manufacturers procure components and manufacture our products based on demand forecasts that we prepare. These forecasts are based on estimates of future product demand and are adjusted for overall market conditions. If the actual product demand is significantly lower than forecasted, we may be required to write down our inventory or accrue for excess supply chain liability, which could have an adverse impact on our gross margins and profitability.

Inventory consists of raw materials and finished goods. Inventory is recorded at the lower of cost (using the first-in, first-out method) or market, after obsolescence and inventory in excess of anticipated future demand is considered. In assessing the ultimate recoverability of inventory, we are required to make estimates regarding future customer demand, last time buy decisions, the timing of new product introductions, economic trends and market conditions.

Acquisitions, Goodwill and Identifiable Intangible Assets

We account for acquired businesses using the purchase method of accounting, which requires that the assets acquired, liabilities assumed, contractual contingencies and contingent consideration be recorded at the date of acquisition at their respective fair values. Goodwill is measured as a residual as of the acquisition date, which in most cases, results in measuring goodwill as an excess of the purchase consideration transferred plus the fair value of any noncontrolling interest in the acquiree over the fair value of the net assets acquired, including any contingent consideration. It further requires acquisition-related costs to be recognized separately from the acquisition and expensed as incurred, restructuring costs to be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period to impact the provision for income taxes. In addition, acquired in-process research and development is capitalized as an intangible asset and amortized over its estimated useful life.

The fair value of identifiable intangible assets is based on significant judgments made by management. We typically engage third party valuation appraisal firms to assist us in determining the fair values and useful lives of the assets acquired. Such valuations and useful life determinations require us to make significant estimates and assumptions. These estimates and assumptions are based on historical experience and information obtained from the management of the acquired companies, and also include, but are not limited to, future expected cash flows to be earned from the product-related technology and discount rates applied in determining the present value of those cash flows. Unanticipated events and circumstances may occur that could affect the accuracy or validity of such assumptions, estimates or actual results. Acquisition-related identifiable intangible assets are amortized on a straight-line basis over their estimated economic lives, which are three to seven years for developed technology and patents, five years for core technology, four to seven years for customer relationships and two years for trade name.

We perform goodwill impairment tests annually during our fourth fiscal quarter, and whenever events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. The first step of the test identifies whether potential impairment may have occurred, and the second step of the test measures the amount of the impairment, if any. An impairment of goodwill is recognized when the carrying amount of the assets exceeds their fair value. The process of evaluating the potential impairment of goodwill is highly subjective and requires the application of significant judgment. For purposes of the annual impairment test, we consider our market capitalization compared with the carrying amount of our net assets on the date of the test, since we have only one reporting unit. We performed our annual review of goodwill in the fourth quarter of fiscal 2010 and concluded that no impairment existed at April 30, 2010. During the first six months of fiscal 2011, there were no significant events or changes in circumstances that affect our valuation of goodwill.

We evaluate long-lived assets, including identifiable intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events or changes in circumstances that could result in an impairment review include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of

use of the acquired assets or the strategy for our overall business, and significant negative industry or economic trends. Impairment is recognized when the carrying amount of an asset exceeds its fair value as calculated on a discounted cash flow basis.

Income Taxes

We use the liability method to account for income taxes. As part of the process of preparing our condensed consolidated financial statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. This process involves determining our income tax expense and calculating the deferred income tax expense related to temporary differences resulting from the differing treatment of items for tax and accounting purposes, such as deferred revenue or deductibility of the amortization of certain intangible assets. These temporary differences result in deferred tax assets or liabilities, which are included within the condensed consolidated balance sheets.

We record a valuation allowance to reduce certain deferred tax assets to an amount that we estimate is more likely than not to be realized. We consider estimated future taxable income and prudent tax planning strategies in determining the need for a valuation allowance. When we determine that it is more likely than not that some or all of our deferred tax assets will be realized by either refundable income taxes or future taxable income, the valuation allowance will be reduced and the related tax impact will be recorded as a reduction to the tax provision in that period. Likewise, should we determine that we are not likely to realize all or part of our deferred tax assets in the future, an increase to the valuation allowance would be recorded as an increase to the tax provision in the period in which such determination was made.

As a multinational corporation, we conduct our business in many countries and are subject to taxation in many jurisdictions. The taxation of our business is subject to the application of multiple and conflicting tax laws and regulations, as well as multinational tax conventions. Our effective tax rate is highly dependent upon the geographic distribution of our worldwide earnings or losses, the tax regulations and tax holidays in each geographic region, the availability of tax credits and carryforwards, and the effectiveness of our tax planning strategies. The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws themselves are subject to change as a result of changes in fiscal policy, changes in legislation, and the evolution of regulations and court rulings. Consequently, tax authorities may impose tax assessments or judgments against us that could materially impact our tax liability and/or our effective income tax rate.

We use a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation, if any. The second step is to measure the tax benefit as the largest amount that is more likely than not to be realized upon settlement. We review our uncertain tax benefits quarterly, and we may adjust such uncertain tax benefits as a consequence of: proposed assessments by tax authorities; changes in facts and circumstances; issuance of new regulations or new case law; previously unavailable information obtained during the course of an examination; negotiations with tax authorities of different countries concerning our transfer pricing; resolution with respect to individual audit issues/audit years; or the expiration of statutes of limitations. In addition, our tax contingency reserve includes certain amounts for potential tax assessments for pre-acquisition tax years of acquired companies, which, if recognized, will be recorded to our provision for income taxes.

Legal and Other Contingencies

We are currently involved in various claims and legal proceedings. We review the status of each significant matter and assess our potential financial exposure on a quarterly basis. We record a charge equal to at least the minimum estimated liability for damages arising from litigation or other loss contingencies only when both of the following conditions are met: (i) information available prior to issuance of our condensed consolidated financial

statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements and (ii) the range of loss can be reasonably estimated. As additional information becomes available, we reassess the potential liability related to pending loss contingencies and may revise our estimates. Such revisions in the estimates of the potential liabilities could have a material impact on our results of operations and financial position.

Results of Operations

The following table sets forth, as a percentage of net revenue, condensed consolidated statements of operations data for the periods indicated:


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
Net revenue:
Product		60.4	%		63.5	%		61.1	%		63.5	%
Service		39.6	%		36.5	%		38.9	%		36.5	%

Total net revenue		100.0	%		100.0	%		100.0	%		100.0	%
Cost of net revenue:
Product		12.6	%		16.0	%		12.8	%		16.4	%
Service		8.9	%		10.7	%		8.7	%		10.6	%

Total cost of net revenue		21.5	%		26.7	%		21.5	%		27.0	%
Gross profit		78.5	%		73.3	%		78.5	%		73.0	%
Operating expenses:
Sales and marketing		37.0	%		37.9	%		36.7	%		38.6	%
Research and development		17.3	%		16.2	%		16.8	%		16.7	%
General and administrative		8.9	%		9.3	%		8.6	%		10.1	%
Amortization of intangible assets		1.5	%		1.5	%		1.5	%		1.5	%
Restructuring		—			—			0.1	%		—

Total operating expenses		64.7	%		64.9	%		63.7	%		66.9	%

Operating income		13.8	%		8.4	%		14.8	%		6.1	%
Interest income		0.1	%		0.1	%		0.1	%		0.1	%
Interest expense		(0.2	)%		(0.2	)%		(0.2	)%		(0.2	)%
Other income (expense), net		0.1	%		0.1	%		(0.1	)%		0.1	%

Income before income taxes		13.8	%		8.4	%		14.6	%		6.1	%
Provision for income taxes		3.9	%		1.4	%		4.0	%		0.9	%

Net income		9.9	%		7.0	%		10.6	%		5.2	%

Net Revenue

Net revenue consists of product and service revenue. Net product revenue primarily consists of revenue from sales of our ProxySG and PacketShaper appliances and licenses to our WebFilter product. Net service revenue primarily consists of sales of new and renewal service contracts and sales of third party software. Although it is generally our practice to promptly ship products upon receipt of properly finalized purchase orders based on our published shipping lead times, we occasionally have orders that have not shipped or have otherwise not met all the required criteria for revenue recognition at the end of the quarter. In some of these cases, we may exercise discretion over the timing of shipments, which affects the timing of revenue recognition for those orders. In such cases, we consider a number of factors, including: our operational capacity to fulfill orders at the end of the quarter; our published shipment lead times; the delivery dates requested by customers and resellers; the amount of orders shipped in the quarter; and the concentration of orders received at the end of the quarter.

The following is a summary of net revenue and the changes in net revenue:


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
	(dollars in thousands)
Total net revenue	$	121,047		$	120,436		$	243,527		$	236,425
Change from same period prior year ($)	$	611		$	1,412		$	7,102		$	14,898
Change from same period prior year (%)		0.5	%		1.2	%		3.0	%		6.7	%

Quarter Ended October 31, 2010 compared with Quarter Ended October 31, 2009: Net revenue, which includes product and service revenue, increased $0.6 million, or 0.5%, in the second quarter of fiscal 2011 compared with the same period in fiscal 2010. Net product revenue in the second quarter of fiscal 2011 was $73.1 million, a $3.4 million decrease compared with the same period in fiscal 2010. During the second quarter of fiscal 2011, we experienced a slowdown in the growth rates of sales of certain of our existing products, which contributed to the decrease in our net product revenue. This decrease included a $6.8 million decline in our product revenue in EMEA, partially offset by increased sales of our products in APAC and the Americas. Net service revenue in the second quarter of fiscal 2011 was $47.9 million, a $4.0 million increase compared with the same period in fiscal 2010. The increase in service revenue was the result of sales of new service contracts sold with our appliance, continued growth in our installed base and the resulting increase in revenue from renewal service contracts.

Six Months Ended October 31, 2010 compared with Six Months Ended October 31, 2009: Net revenue, which includes product and service revenue, increased $7.1 million, or 3.0%, in the first six months of fiscal 2011 compared with the same period in fiscal 2010. Net product revenue in the first six months of fiscal 2011 was $148.7 million, a $1.5 million decrease compared with the same period in fiscal 2010. During the first six months of fiscal 2011, we experienced a slowdown in the growth rates of sales of certain of our existing products, which contributed to the decrease in our net product revenue. This decrease resulted from decreased sales of our products in EMEA, partially offset by increased sales of our products in APAC and the Americas. Net service revenue in the first six months of fiscal 2011 was $94.8 million, an $8.6 million increase compared with the same period in fiscal 2010. The increase in service revenue was the result of sales of new service contracts sold with our appliance, continued growth in our installed base and the resulting increase in revenue from renewal service contracts, and an increase in consulting revenue. The increase in consulting revenue was driven by an arrangement that was completed at the end of the second quarter of fiscal 2011.

The following is a summary of net revenue by geographic area:


	Three months ended October 31,
	2010				2009
	(dollars in thousands)
Americas (1)	$	56,937	47.0	%	$	55,255	45.9	%
EMEA (2)		40,889	33.8			44,952	37.3
APAC (3)		23,221	19.2			20,229	16.8

Total net revenue	$	121,047	100.0	%	$	120,436	100.0	%


	Six months ended October 31,
	2010				2009
	(dollars in thousands)
Americas (1)	$	111,549	45.8	%	$	108,560	45.9	%
EMEA (2)		83,096	34.1			86,705	36.7
APAC (3)		48,882	20.1			41,160	17.4

Total net revenue	$	243,527	100.0	%	$	236,425	100.0	%

(1)	North America, Central America and Latin America (“Americas”)

(2)	Europe, Middle East and Africa (“EMEA”)

(3)	Asia and Pacific regions (“APAC”)

Revenues from sales to customers outside of the Americas are a significant part of our revenue mix. Since all of our sales are currently invoiced in U.S. dollars, a change in the value of the dollar relative to foreign currencies could affect the demand for our products and therefore impact our revenues in foreign markets. For the three and six months ended October 31, 2010, approximately 53.0% and 54.2% of our total net revenue, respectively, was derived from customers outside of the Americas compared with 54.1% for each of the three and six months ended October 31, 2009.

Net revenue in the Americas increased $1.7 million in the second quarter of fiscal 2011, up 3.0% from the same period in fiscal 2010. This increase was partially driven by a $1.0 million increase in product revenue from an increase in sales of our proxy appliances, partially offset by a decrease in sales of our PacketShaper appliances. Service revenue also increased by $0.7 million, driven primarily by an increase in revenue from both new and renewal service contracts. Net revenues in the Americas for the six months ended October 31, 2010 increased $3.0 million, up 2.8% compared with the same period in fiscal 2010, driven primarily by an increase in revenue from both new and renewal service contracts and an increase in consulting revenue. The increase in consulting revenue was driven by an arrangement that was completed at the end of the second quarter of fiscal 2011.

Net revenue in EMEA decreased $4.1 million in the second quarter of fiscal 2011, down 9.0% from the same period in fiscal 2010. This decrease was driven by a $6.8 million decrease in product revenue resulting from a decrease in sales of our proxy appliances, partially offset by a $2.7 million increase in service revenue from both new and renewal service contracts. Net revenue in EMEA for the six months ended October 31, 2010 decreased $3.6 million, down 4.2% compared with the same period in fiscal 2010, driven primarily by a decrease in sales of our proxy appliances partially offset by an increase in service revenue from both new and renewal service contracts.

Net revenue in APAC increased $3.0 million in the second quarter of fiscal 2011, up 14.8% from the same period in fiscal 2010. This increase was primarily driven by a $2.4 million increase in product revenue resulting from an increase in sales of our proxy appliances and a $0.6 million increase in service revenue due to an increase in revenue from both new and renewal service contracts. Net revenue in APAC for the six months ended October 31, 2010 increased $7.7 million, up 18.8% compared with the same period in fiscal 2010, driven by an increase in sales of our proxy appliances and an increase in service revenue from both new and renewal service contracts.

Gross Profit

The following is a summary of gross profit:


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
	(dollars in thousands)
Gross profit	$	95,040		$	88,228		$	191,168		$	172,697
Gross profit margin		78.5	%		73.3	%		78.5	%		73.0	%

Quarter Ended October 31, 2010 compared with Quarter Ended October 31, 2009: Gross profit increased $6.8 million, or 7.7%, in the second quarter of fiscal 2011 compared with the same period of fiscal 2010, as a result of an increase in net revenue and related gross profit margin. Gross profit margin in the second quarter of fiscal 2011 increased to 78.5% from 73.3% in the second quarter of fiscal 2010, primarily as a result of higher gross margins associated with our high-end ProxySG appliance, higher service gross margins associated with the improved efficiency of our worldwide support delivery model and a decreased impact from the application of fair value purchase accounting on Packeteer inventory and deferred revenue, which negatively impacted the cost of product revenue and net service revenue by $1.6 million for the second quarter of fiscal 2010 compared with a negative impact of $0.2 million for the same period in fiscal 2011. Excluding the fair value purchase accounting

impact on gross profit in these two fiscal periods, gross profit margin in the second quarter of fiscal 2011 would have been approximately 471 basis points higher than that of the same period in fiscal 2010.

Six Months Ended October 31, 2010 compared with Six Months Ended October 31, 2009: Gross profit increased $18.5 million, or 10.7%, in the first six months of fiscal 2011 compared with the same period of fiscal 2010, as a result of an increase in net revenue and related gross profit margin. Gross profit margin in the first six months of fiscal 2011 increased to 78.5% from 73.0% in the first six months of fiscal 2010, primarily as a result of higher gross margins associated with our high-end ProxySG appliance, higher service gross margins associated with the improved efficiency of our worldwide support delivery model and a decreased impact from the application of fair value purchase accounting on Packeteer inventory and deferred revenue, which negatively impacted the cost of net revenue and service revenue by $3.9 million in total for the first six months of fiscal 2010 compared with a negative impact of $0.5 million in total for the same period in fiscal 2011.

Sales and Marketing

Sales and marketing expense consists primarily of salaries and benefits, commissions, travel, advertising and promotional expenses. The following is a summary of sales and marketing expense:


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
	(dollars in thousands)
Sales and marketing	$	44,821		$	45,608		$	89,476		$	91,184
Sales and marketing as a percentage of net revenue		37.0	%		37.9	%		36.7	%		38.6	%

Quarter Ended October 31, 2010 compared with Quarter Ended October 31, 2009: Sales and marketing expense decreased $0.8 million, or 1.7%, in the second quarter of fiscal 2011 compared with the same period in fiscal 2010. The decrease in sales and marketing expense was primarily attributable to a $1.4 million decrease in salaries and benefits as a result of lower headcount during the current fiscal year compared with the same period in fiscal 2010, including commission payments and lower marketing program costs, partially offset by an increase in various other sales expenses, including travel and sales events. Sales and marketing headcount was 492 at October 31, 2010 compared with 546 at October 31, 2009.

Six Months Ended October 31, 2010 compared with Six Months Ended October 31, 2009: Sales and marketing expense decreased $1.7 million, or 1.9%, in the first six months of fiscal 2011 compared with the first six months of fiscal 2010. The decrease in sales and marketing expense was primarily attributable to a $2.8 million decrease in salaries and benefits as a result of lower headcount during the current fiscal year compared with the prior fiscal year, including commission payments and lower marketing program costs, partially offset by an increase in various other sales expenses, including travel and sales events.

We currently expect sales and marketing expense during the remainder of fiscal 2011 to increase in absolute dollars, as a consequence of increases in our quota-carrying sales force and marketing personnel, and increases in programmatic spending.

Research and Development

Research and development expense consists primarily of salaries and benefits, prototype costs, and testing equipment costs. The following is a summary of research and development expense:


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
	(dollars in thousands)
Research and development	$	20,948		$	19,568		$	40,803		$	39,404
Research and development as a percentage of net revenue		17.3	%		16.2	%		16.8	%		16.7	%

Quarter Ended October 31, 2010 compared with Quarter Ended October 31, 2009: Research and development expense increased $1.4 million, or 7.1%, in the second quarter of fiscal 2011 compared with the same period in fiscal 2010 primarily due to increases in investments in new and ongoing research and development projects and increased profit sharing expense, partially offset by decreased personnel-related charges as a result of lower headcount during the current fiscal year compared with the prior fiscal year related to the departure of transition employees associated with the Fiscal 2010 Restructuring Plan (the “2010 Plan”). Research and development headcount was 367 at October 31, 2010 compared with 425 at October 31, 2009.

Six Months Ended October 31, 2010 compared with Six Months Ended October 31, 2009: Research and development expense increased $1.4 million, or 3.6%, in the first six months of fiscal 2011 compared with the same period in fiscal 2010. The increase in research and development expense for the first six months of fiscal 2011 was largely attributable to increases in investments in new and ongoing research and development projects and increased profit sharing expense, partially offset by decreased personnel-related charges as a result of lower headcount during the current fiscal year compared with the prior fiscal year related to the departure of transition employees associated with the 2010 Plan.

We believe that continued investment in product enhancements and new product development is critical to achieving our strategic objectives in fiscal 2011 and beyond. We currently expect research and development expense to increase in absolute dollars and increase slightly as a percentage of net revenue due to our continued investment in the development of new products and services and enhancement of existing products.

General and Administrative

General and administrative expense consists primarily of salaries and benefits, legal services, accounting and audit services, and other general corporate expenses. The following is a summary of general and administrative expense:


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
	(dollars in thousands)
General and administrative	$	10,715		$	11,176		$	21,058		$	23,892
General and administrative as a percentage of net revenue		8.9	%		9.3	%		8.6	%		10.1	%

Quarter Ended October 31, 2010 compared with Quarter Ended October 31, 2009: General and administrative expense decreased $0.5 million, or 4.1%, in the second quarter of fiscal 2011 compared with the same period in fiscal 2010. The decrease was primarily due to a decrease in legal expenses and professional services fees, partially offset by an increase in profit sharing expense. General and administrative headcount was 181 at October 31, 2010 compared with 198 at October 31, 2009.

Six Months Ended October 31, 2010 compared with Six Months Ended October 31, 2009: General and administrative expense decreased $2.8 million, or 11.9%, in the first six months of fiscal 2011 compared with the first six months of fiscal 2010. The decrease was primarily due to a decrease in legal expenses and professional services fees and a decrease in salaries and benefits as a result of lower headcount, partially offset by an increase in profit sharing expense.

Amortization of Intangible Assets

Amortization expense for our intangible assets for the three and six months ended October 31, 2010 and 2009 was allocated as follows:


	Three Months Ended October 31,				Six Months Ended October 31,
	2010		2009		2010		2009
	(in thousands)
Included in cost of net revenue	$	1,168	$	1,347	$	2,356	$	2,695
Included in operating expenses		1,843		1,822		3,686		3,643

Total	$	3,011	$	3,169	$	6,042	$	6,338

The acquisition-related intangible assets associated with our acquisition of S7 consist of assumed customer contracts, which represent S7’s underlying relationships with its customers. The fair value assigned to customer relationships was $0.7 million, which is amortized on a straight-line basis over the expected useful life of 4 years, consistent with the number of periods of prospective cash flow utilized to estimate the fair value of the assets.

For the three and six months ended October 31, 2010 and 2009, the amortization of intangible assets was related to our acquisitions of S7, Packeteer, Inc., certain assets of the NetCache business from Network Appliance, Permeo, Inc., Cerberian, Inc. and Ositis Software, Inc. The amortization of developed technology and trade name is charged to cost of net revenue, while the amortization of customer relationships is charged to operating expense. Our core technology intangible assets prior to being fully amortized were also charged to cost of net revenue. We amortize customer relationships, developed technology and trade name on a straight-line basis over their weighted average expected useful lives of 5, 5, and 2 years, respectively. Total amortization expense for our identifiable intangible assets for the three and six months ended October 31, 2010 was $3.0 million and $6.0 million, respectively, and $3.2 million and $6.3 million for the three and six months ended October 31, 2009, respectively. Amortization expense related to our identifiable intangible assets for the remainder of fiscal 2011 is expected to be $6.0 million.

Restructuring Charges

Restructuring charges consist primarily of personnel-related severance costs, contract termination costs and stock-based compensation expense. Stock-based compensation expense included in restructuring charges resulted primarily from the additional vesting of unvested option shares and restricted shares upon termination of the employment of those employees pursuant to the terms of their separation agreements. The following is a summary of restructuring charges:


	Three Months Ended October 31,				Six Months Ended October 31,
	2010		2009		2010			2009
	(dollars in thousands)
Restructuring charges	$	38	$	—	$	178		$	—
Restructuring charges as a percentage of net revenue		—		—		0.1	%		—

Restructuring charges in the first six months of fiscal 2011 consisted of expenses associated with the 2010 Plan. The total estimated restructuring charges associated with the 2010 Plan are $12.7 million. Of the total restructuring charges, $10.8 million in charges relates to severance and related benefits for 265 employees and $1.9 million in charges relates to facility closures and consolidations. We have recorded $12.7 million of restructuring charges through the second quarter of fiscal 2011, including $0.1 million of stock-based compensation, and do not expect to incur any material charges in the future. Restructuring activities were substantially complete by the end of the first quarter of fiscal 2011.

Interest Income, Interest Expense and Other Income (Expense), Net

Interest income consists of interest income earned on our cash and marketable securities. Our cash historically has been invested in highly liquid investments such as time deposits held at major banks, commercial paper, U.S. government agency discount notes, money market mutual funds and other money market securities with maturities at the date of purchase of 90 days or less. At October 31, 2010, our cash was invested in money market mutual funds and a money market savings account. Interest expense primarily relates to amortization of the fair value of warrants and a beneficial conversion feature associated with our convertible senior notes. Other income (expense), net, consists primarily of foreign currency exchange gains or losses, and non-recurring gains or losses realized outside our normal course of business. The following is a summary of interest income, interest expense and other income (expense), net:


	Three Months Ended October 31,						Six Months Ended October 31,
	2010			2009			2010			2009
	(in thousands)
Interest income	$	126		$	72		$	290		$	173
Interest expense	$	(223	)	$	(227	)	$	(447	)	$	(455	)
Other income (expense), net	$	158		$	155		$	(165	)	$	139

Quarter Ended October 31, 2010 compared with Quarter Ended October 31, 2009: Interest income increased in the second quarter of fiscal 2011 compared with the same period of fiscal 2010 as a result of interest paid on our higher cash balances. Interest expense was essentially flat in the second quarter of fiscal 2011 compared with the same period in fiscal 2010 and during both periods related to the amortization of the fair value of warrants and a beneficial conversion feature associated with our Convertible Senior Notes (as defined in “Liquidity and Capital Resources”).

Six Months Ended October 31, 2010 compared with Six Months Ended October 31, 2009: Interest income increased for the first six months of fiscal 2011 compared with the same period of fiscal 2010 as a result of interest paid on our higher cash balances. Interest expense was flat in the first six months of fiscal 2011 compared with the same period in fiscal 2010 and during both periods related to the amortization of the fair value of warrants and a beneficial conversion feature associated with our Convertible Senior Notes. Other income (expense), net increased during the first six months of fiscal 2011 compared with the same period in fiscal 2010 due to an increase in foreign exchange losses incurred during the first six months of fiscal 2011.

Provision for Income Taxes

The following is a summary of provision for income taxes:


	Three Months Ended October 31,				Six Months Ended October 31,
	2010		2009		2010		2009
	(in thousands)
Provision for income taxes	$	4,703	$	1,687	$	9,687	$	2,068

The provision for income taxes primarily reflects current and deferred U.S. federal and state taxes and foreign income taxes in taxable foreign jurisdictions. The provision for income taxes for the three and six months ended October 31, 2010 was $4.7 million and $9.7 million, respectively, compared with $1.7 million and $2.1 million for the three and six months ended October 31, 2009.

Our total gross unrecognized tax benefits as of October 31, 2010 and April 30, 2010 were $38.5 million and $33.9 million, respectively. The increase is primarily related to uncertainties with respect to the taxation of cross-border arrangements within the group that were recorded in the period. Included in our gross unrecognized tax benefits as of October 31, 2010 is approximately $36.3 million of tax benefits that, if recognized, would result in an adjustment to our effective tax rate.

We have elected to classify interest and penalties related to uncertain tax positions as a component of our provision for income taxes. Accrued interest and penalties relating to our unrecognized tax benefits were approximately $1.7 million as of October 31, 2010, including approximately $0.3 million and $0.4 million charged to provision for income taxes for the three and six months ended October 31, 2010, respectively.

Acquisitions

On January 25, 2010, we acquired 84.5% of the outstanding shares of S7, an IT research and development outsourcing firm based in Bangalore, India. We acquired an additional 8.4% of the outstanding shares of S7 in July 2010, and held 92.9% of the outstanding shares of S7 at October 31, 2010. We acquired S7 to serve as the Company’s new development center in India and to provide expertise in software development, code migration and network security. The total purchase price was $6.4 million in cash, consisting of $4.7 million for the shares acquired and $0.4 million of payable for the noncontrolling interest (which amounts include an allocation of $1.1 million for excess working capital remaining as of the closing date), and $1.3 million payable over the 30 months subsequent to the initial closing date. Under the stock purchase agreement, the selling shareholders will indemnify us for up to $1.3 million for damages caused by inaccuracies in, breaches or violations of or defaults under representations, warranties, covenants or agreements. Any such amounts may be withheld from the $1.3 million in remaining payments due under the purchase agreement. In allocating the purchase price based on estimated fair values, we recorded approximately $4.5 million of goodwill, $0.7 million of identifiable intangible assets for customer relationships and $1.2 million of net tangible assets. In connection with the acquisition, we recognized $0.1 million of transaction costs which were included in general and administrative expenses in our condensed consolidated statement of operations. In addition, we agreed to pay potential retention bonuses up to an aggregate amount of $2.0 million to certain S7 shareholders who were also employees. Payment of these bonuses is contingent upon the performance of post-acquisition services by those shareholders over the 30 months subsequent to the initial closing date. Accordingly, the potential bonus amounts will be accrued as compensation expense over the assumed retention period. Our acquisition of S7 did not result in the creation of a new business segment.

In November 2010, we obtained approval from the Reserve Bank of India to acquire the remaining 7.1% of the outstanding shares of S7, and the final share purchase was concluded on November 22, 2010.

Liquidity and Capital Resources

Since our inception, we have financed our operations and capital expenditures through cash provided by operating activities, private sales of preferred and common stock, bank loans, equipment leases, private sales of convertible notes and warrants and an initial public offering of our common stock.

Cash and Cash Equivalents and Restricted Cash

We consider all highly liquid investments with insignificant interest rate risk and original maturities of three months or less to be cash equivalents. We determine the appropriate classification of our investments at the time of purchase and evaluate such designation as of each balance sheet date based on our intent and whether it is more likely than not that we will be required to sell the instrument before recovery of its amortized cost basis. To date, all of our short-term investments have been classified as available-for-sale and are carried at fair value, with unrealized gains and losses, excluding the portion relating to credit loss, if any, included in accumulated other comprehensive income (loss) in stockholders’ equity. The fair value of these securities is determined based on quoted market prices in active markets.

As of October 31, 2010, we had cash and cash equivalents of $288.8 million and restricted cash of $1.0 million. We believe our existing cash and cash equivalents and anticipated cash from operations will be sufficient to meet our operating requirements for at least the next twelve months, including working capital requirements and capital expenditures. We may seek to raise additional capital to strengthen our financial condition, facilitate expansion and pursue strategic acquisitions or investments, or to take advantage of other business opportunities as they arise.

The following summarizes cash and cash equivalents and restricted cash:


	As of October 31, 2010			As of April 30, 2010
	(dollars in thousands)
Cash and cash equivalents	$	288,774		$	236,347
Restricted cash		1,031			986

Total cash and cash equivalents and restricted cash	$	289,805		$	237,333

Percentage of total assets		38.3	%		34.0	%

Cash Flows


	Six Months Ended October 31,
	2010			2009
	(in thousands)
Cash provided by operating activities	$	51,437		$	28,743
Cash used in investing activities		(6,425	)		(10,854	)
Cash provided by financing activities		7,415			9,469

Net increase in cash and cash equivalents	$	52,427		$	27,358

Cash Flows from Operating Activities: Our largest source of operating cash is cash collected from our customers who purchase our products and services. Our primary uses of cash from operating activities are for personnel-related costs, product costs, and facility costs.

Net cash provided by operating activities was $51.4 million for the first six months of fiscal 2011 compared with $28.7 million in the same period of fiscal 2010. In the first six months of fiscal 2011, we had significantly higher net income after excluding the impact of non-cash charges such as stock-based compensation, depreciation and amortization expense, as well as an increase in working capital sources of cash from higher accounts payable, accrued expenses and deferred revenue balances, partially offset by working capital uses of cash from higher accounts receivable and inventory balances at October 31, 2010. Accounts payable increased primarily as a result of timing of payments to vendors. The increase in deferred revenue was primarily due to an increase in the sales of renewal service contracts to our customers. Accrued liabilities increased primarily due to an increase in long-term income taxes payable as a result of our significantly higher net income in the current fiscal year, offset by decreases in accrued restructuring. These sources of cash were partially offset by working capital uses of cash, including an increase in the accounts receivable balance as reflected by our increase in days sales outstanding from 44 days at April 30, 2010 to 61 days at October 31, 2010 due to decreased linearity of our shipments during the second quarter of fiscal 2011 and an increase in inventory as a result of increased inventory of certain appliances on hand.

Cash Flows from Investing Activities: The changes in cash flows from investing activities primarily related to acquisitions and purchases of property and equipment, and technology licenses.

Net cash used by investing activities was $6.4 million for the first six months of fiscal 2011 compared with $10.9 million in the same period of fiscal 2010. The net cash used by our investing activities in the first six

months of fiscal 2011 primarily consisted of purchases of property and equipment, and technology licenses and cash used to purchase an additional ownership interest in S7 for $0.4 million.

Cash Flows from Financing Activities: The changes in cash flows from financing activities primarily related to proceeds from issuances of common stock.

Net cash provided by financing activities was $7.4 million the first six months of fiscal 2011 compared with $9.5 million in the same period of fiscal 2010. The net cash provided by our financing activities in the first six months of fiscal 2011 primarily consisted of proceeds from purchases of our stock under our employee stock purchase plan and the proceeds from the exercise of employee stock options, which were significantly lower than in the same period of fiscal 2010. This decrease in option exercises was also coupled with an increase in net issuances of shares to satisfy our tax withholding obligations for vesting of restricted stock awards and restricted stock units compared with the same period in fiscal 2010.

Convertible Senior Notes

Contractual Obligations

Leases

We lease certain office facilities and office equipment under non-cancelable operating leases that expire at various dates through 2020. The facility leases generally require us to pay operating costs, including property taxes, insurance and maintenance, and contain scheduled rent increases and certain other rent escalation clauses. Rent expense is recognized in our condensed consolidated financial statements on a straight-line basis over the terms of the respective leases after consideration of rent holidays and improvement allowances, if applicable. Any assets purchased using a lessee improvement allowance are capitalized as fixed assets and depreciated over the shorter of their useful lives or the lease term.

As of October 31, 2010, future minimum lease payments under non-cancelable operating leases with initial or remaining terms in excess of one year are as follows:


Year ending April 30,	Total
	(in thousands)
Remainder of 2011	$	5,348
2012		9,812
2013		9,501
2014		8,291
2015		7,574
Thereafter		5,776

Total future minimum lease payments, net	$	46,302

Purchase Commitments and Other

Off-Balance Sheet Arrangements

As of October 31, 2010, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. Further, we have not guaranteed any obligations of unconsolidated entities, nor do we have any commitment or intent to provide funding to any such entities. As such, we are not materially exposed to any market, credit, liquidity or financing risk that could arise if we had engaged in such relationships.

As of October 31, 2010, we did not have any off-balance sheet transactions, arrangements, or obligations that are reasonably likely to have a material current or future effect on our financial condition, results of operations, liquidity, or capital resources.

Recent Accounting Pronouncements

For information with respect to recent accounting pronouncements and the impact of these pronouncements on our condensed consolidated financial statements, see Note 1 of Notes to Condensed Consolidated Financial Statements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are subject to certain market risks, including changes in exchange rates and interest rates. We do not undertake any specific actions to cover our exposures to exchange and interest rate risks, and we are not a party to any risk management transactions. We also do not purchase or hold any derivative financial instruments for hedging, speculative or trading purposes.

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. As of October 31, 2010, we had cash and cash equivalents of $288.8 million and restricted cash of $1.0 million. These amounts were primarily held in money market funds. We maintain a conservative investment policy, which is intended to enhance the safety and preservation of our invested funds by limiting default risk, market risk and reinvestment risk. The fair value of our investment portfolio would not be significantly impacted by either a 100 basis point increase or decrease in market interest rates, given the short-term nature of the majority of our investment portfolio.

Foreign Currency Exchange Rate Risk

We primarily develop products in the United States and sell them throughout the world. As a result, our financial results are affected by factors such as changes in foreign currency exchange rates and economic conditions in foreign markets. Since all of our sales are currently invoiced and collected in U.S. dollars, a strengthening of the dollar could potentially make our products less price-competitive in foreign markets. As a

significant portion of our net revenue and earnings are derived from international operations, this could adversely affect our net revenue and earnings. For the three and six months ended October 31, 2010, approximately 53.0% and 54.2%, respectively of our total net revenue was derived from customers outside of the Americas. In contrast, substantially all of the expenses of operating our foreign subsidiaries are incurred in foreign currencies, which to date have constituted an insignificant portion of our total operating expenses. As a result, our U.S. dollar earnings and net cash flows from international operations may be affected by changes in foreign currency exchange rates. The foreign currency translation risk associated with our international operations has been material in the past and could be material in the future.

Item 4. Controls and Procedures

Under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial and Accounting Officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this report (the “Evaluation Date”). Based on this evaluation, our Principal Executive Officer and Principal Financial and Accounting Officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to Blue Coat, including our consolidated subsidiaries, required to be disclosed in the reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to Blue Coat’s management, including our Principal Executive Officer and Principal Financial and Accounting Officer, as appropriate to allow timely decisions regarding required disclosure.

Under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial and Accounting Officer, we conducted an evaluation of any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during our most recently completed fiscal quarter. Based on that evaluation, our Principal Executive Officer and Principal Financial and Accounting Officer concluded that there has not been any change in our internal control over financial reporting during that quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The information set forth above under Note 12 contained in the “Notes to Condensed Consolidated Financial Statements” is incorporated herein by reference.

Item 1A. Risk Factors

In addition to the other information contained in this Quarterly Report on Form 10-Q, the following risk factors should be carefully considered by investors before making an investment decision. We have updated a risk factor relating to personnel from that presented in our Annual Report on Form 10-K, Part I, Item 1A, for the fiscal year ended April 30, 2010. That risk factor is set forth at the end of this section and addresses certain management changes and transitions during the past fiscal quarter.

Our business, financial condition and results of operations could be seriously harmed as a consequence of any of the following risks and uncertainties. The trading price of our common stock could decline due to any of these risks and uncertainties, and investors may lose all or part of their investment. These risks and uncertainties are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem less significant also may impair our business, financial condition and results of operations, or result in a decline in the trading price of our common stock.

Our quarterly operating results fluctuate significantly, are difficult to predict and may not meet our guidance or third party expectations.

Our net revenue and operating results have in the past, and may in the future, vary significantly from quarter to quarter and year over year due to a number of factors, many of which are outside of our control, including the macroeconomic environment. These factors limit our ability to accurately predict our operating results on a quarterly basis and include factors discussed throughout this “Risk Factors” section, including the following:

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Macroeconomic conditions in our market, both domestic and international, as well as the level of discretionary IT spending;

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The timing, size and mix of orders from customers, including the timing of large orders, and nonlinear sales and shipping patterns;

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Fluctuations in demand for our products and services;

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Evolving condition in the markets in which we compete;

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Variability and unpredictability in the rate of growth in the markets in which we compete;

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Our ability to continue to increase our market share consistent with past rates of increase;

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Our variable sales cycles, which may lengthen as the complexity of products and competition in our market increases and in response to macroeconomic conditions;

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The level of competition in our markets, including the effect of new entrants, consolidation, technological innovation and substantial price discounting;

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Market acceptance of our new products and product enhancements and our services;

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Product announcements, introductions, transitions and enhancements by us or our competitors, which could result in deferrals of customer orders;

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Technological changes in our markets;

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The quality and level of our execution of our business strategy and operating plan;

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The level of industry consolidation among our competitors and customers;

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The impact of future acquisitions or divestitures;

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Changes in accounting rules and policies; and

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The need to recognize certain revenue ratably over a defined period or to defer recognition of revenue to a later period.

A high percentage of our expenses, including those related to manufacturing overhead, service and maintenance, research and development, sales and marketing, and general and administrative functions are generally fixed in nature in the short term. As a result, if our net revenue is less than forecasted, such expenses cannot effectively be reduced to compensate for the revenue shortfall and our quarterly operating results will be adversely affected.

We believe that quarter-to-quarter comparisons of our operating results should not necessarily be relied upon as indicators of our future performance. In the past our quarterly results have on occasion failed to meet our quarterly guidance and the expectations of public market analysts or investors, and it is likely that this will occur in the future. If this occurs our stock price likely will decline, and may decline significantly. Such a decline may also occur even when we meet our published guidance, but our results or future guidance fail to meet third party expectations.

The market for our products and services is intensely competitive and certain of our competitors have greater resources and experience.

Our products and services currently focus on the markets for Secure Web Gateway and WAN Optimization products and services, and we recently introduced a product directed to the telecommunications carrier infrastructure provider (“Carrier Infrastructure”) market. We also have announced our intention to deliver the functionality of our Secure Web Gateway products and services on a subscription basis over the Internet, a model frequently referred to as “cloud computing” and typically directed at the enterprises smaller than those that we typically sell to.

Each of these markets is intensely competitive, and the intensity of this competition is expected to increase, particularly given current economic pressures and industry consolidation. As well, the market for cloud computing services is one characterized by extreme competition and one that we have not traditionally sold into. Sales to the service provider markets are especially volatile and typically have longer sales cycles. Competition in these markets may result in price reductions, reduced margins, loss of market share and inability to gain market share, any one of which could seriously impact our business, financial condition and results of operations. We may not be able to compete successfully against current or future competitors, including those resulting from consolidation in our historical and new markets and we cannot be certain that the competitive pressures we face will not seriously impact our business.

Some of our current and potential competitors have longer operating histories; significantly greater financial, technical, sales and marketing resources; significantly greater name recognition; and a larger installed base of customers than we do. Such competitors also may have well-established relationships with our current and potential customers and extensive knowledge of our industry and the markets in which we compete and intend to compete. As a result, those competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, marketing, promotion and sale of their products than we can. They also may make strategic acquisitions or establish cooperative relationships among themselves or with other providers, thereby increasing their ability to provide a broader suite of products, and potentially causing customers to defer purchasing decisions. Finally, they may engage in aggressive pricing strategies or discounting. Any of the foregoing may limit our ability to compete effectively in the market and adversely affect our business, financial condition and results of operations.

Economic uncertainty and adverse macroeconomic conditions may harm our business.

Our revenues and margins are dependent on various economic factors, including rates of inflation, currency fluctuations, energy costs, levels of consumer sentiment and other macroeconomic factors, which may impact levels of business spending. These conditions may adversely affect corporate spending for IT products and services in specific geographies or more broadly, and could result in:

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a significant reduction in our net revenue, gross margin and operating margin;

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increased price competition for our products and services;

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risk of excess and obsolete inventory;

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higher overhead costs as a percentage of net revenue;

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difficulty in accurately forecasting demand for our products and services;

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insolvency or credit difficulties confronting our customers and channel partners, affecting their ability to purchase or pay for our products and services; and

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insolvency or credit difficulties confronting our key suppliers, which could disrupt our supply chain.

In addition, a significant percentage of our operating expenses are generally fixed in nature, particularly in the short term, which could limit our ability to mitigate any negative impact on our profit margins.

We rely significantly on third party sales channel partners to sell our products.

Substantially all of our revenue is generated through sales by our channel partners, which include distributors and value-added resellers. During fiscal 2010, approximately 98% of our revenue was generated through our channel partners, and 54% of our revenue was generated through 3 channel partners. During the first six months of fiscal 2011, approximately 99% of our revenue was generated through our channel partners, and 56% of our revenue was generated through three channel partners. We depend upon these partners to generate sales opportunities and to independently manage the sales process for opportunities with which they are involved. In order to increase our net revenue, we will need to maintain our existing sales channel partners and to add new sales channel partners and effectively train and integrate them with our sales process. As well, our planned entry into new markets, such as cloud computing, potentially will require that we add new channel partners and educate and transition existing channel partners to effectively address these markets. If we are unsuccessful in those efforts, this will limit our ability to grow our business and our business, financial condition and results of operations will be adversely affected.

Our products are complex, and there can be no assurance that the sales training programs that are offered to our sales channel partners will always be effective. In addition, our sales channel partners may be unsuccessful in marketing, selling and supporting our products and services for reasons unrelated to training. Most of our sales channel partners do not have minimum purchase or resale requirements, and they may fail to devote adequate effort to sales of our products or may cease selling our products at any time. They may also market, sell and support products and services that are competitive with ours, and may devote more resources to the marketing, sales and support of products competitive to ours. There is no assurance that we will retain these sales channel partners or that we will be able to secure additional or replacement sales channel partners in the future. The loss of one or more of our key sales channel partners in a given geographic area could harm our operating results within that area, as new sales channel partners typically require extensive training and take several months to achieve acceptable productivity.

We also depend on some of our sales channel partners to deliver first line service and support for our products. Any significant failure on their part to provide such service and support could impact customer satisfaction and future sales of our products.

While we require that our third party sales channel partners comply with applicable regulatory requirements, they could engage in behavior or practices that expose us to legal or reputational risk.

Our gross margin is affected by a number of factors, and we may not be able to sustain it at present levels.

Our gross margin percentage has been and will continue to be affected by a variety of factors, including:

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market acceptance of our products and fluctuations in demand;

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the timing, size and mix of customer orders and product implementations;

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increased price competition and changes in product pricing;

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actions taken by our competitors;

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new product introductions and enhancements;

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manufacturing and component costs;

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availability of sufficient inventory to meet demand;

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purchase of inventory in excess of demand;

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our execution of our strategy and operating plans;

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changes in our sales model;

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geographies in which sales are made; and

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revenue recognition rules.

For example, we have in the past entered into large revenue transactions with certain customers that, because of the product mix and discounting, have decreased our gross margin percentage. We may, in the future, enter into similar transactions. As well, our lower end appliances typically have lower margins than our higher end appliances, and therefore large orders for our lower end appliances could negatively impact our overall gross margin percentage. Macroeconomic and competitive developments could put further pressure on our gross margin.

We expect that our entry into the cloud computing business will put negative pressure on our gross margins, both as a consequence of our need to invest in infrastructure and the ratable recognition of subscription revenue for such services when received.

Even if we achieve our net revenue and operating expense objectives, our net income and operating results may be below our expectations and the expectations of investors and analysts if our gross margins are below expectations.

We must continue to develop market awareness of our company and our products and services.

We have focused our business strategy and investments on the markets for Secure Web Gateway and WAN optimization products and services during the past fiscal year. We are now moving into new markets, including the Carrier Infrastructure market and the market for the delivery of Secure Web Gateway functionality as a service, with our planned cloud computing service.

Market awareness is essential to our continued growth and our success in the markets in which we compete and intend to compete. If our advertising and marketing programs are not successful in creating market awareness of our participation in these markets, the need for our products and services, and the value and capabilities of our specific products and services, we may not be able to achieve sustained growth. Moreover, if the markets for our products and services fail to grow as we anticipate, we may not be able to sell as many of our products and services as we currently project, which would reduce our anticipated net revenue and could result in a decline in our stock price.

We must anticipate market needs, and develop and introduce new products and enhancements to rapidly meet those needs.

To maintain our competitive position in markets characterized by rapid rates of technological advancement, we must correctly anticipate market requirements and invest our research and development resources to meet those requirements. We have recently restructured our product operations into product groups or “business units” and the organic growth of our business is dependent on the success of this new operating model. As well, the introduction of new products by others, market acceptance of products based on new or alternative technologies, or the emergence of new industry standards, could render our existing products obsolete or make it easier for other products to compete with our products. Our future success will depend in part upon our ability to:

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develop and maintain competitive products;

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enhance our products by adding innovative features that differentiate our products from those of our competitors;

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bring products to market on a timely basis at competitive prices;

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identify and respond to emerging technological trends in the market; and

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respond effectively to new technological changes or new product announcements by others.

There is no guarantee that we will accurately predict the direction in which the markets in which we compete or intend to compete will evolve. Failure on our part to anticipate the direction of our markets and to develop products, enhancements and service offerings that meet the needs of those markets will significantly impair our business, financial condition and results of operations.

Our internal investments in research and development may not yield the benefits we anticipate.

The success of our business is predicated on our ability to create new products and technologies and to anticipate future market requirements and applicable industry standards. We presently are investing in several new product groups, including one targeted at carrier infrastructure products, one targeted at providing our Secure Web Gateway functionality as a cloud computing service, and one targeted at providing a Secure Web Gateway appliance for the mid-market enterprise customer. To accomplish these investments, we intend to continue to add personnel and other resources to our research and development function. We will likely recognize costs associated with these investments earlier than the anticipated benefits. If we do not achieve the anticipated benefits from these investments, or if the achievement of these benefits is delayed, our business, financial condition and results of operations may be adversely affected.

The process of developing new technologies is time consuming, complex and uncertain, and requires commitment of significant resources well in advance of being able to fully determine market requirements and industry standards. Furthermore, we may not be able to timely execute new product or technical initiatives because of errors in product planning or timing, technical difficulties that we cannot timely resolve, or a lack of appropriate resources. This could result in competitors bringing products to market before we do and a consequent decrease in our market share and net revenue. Our inability to timely and cost-effectively introduce new products and product enhancements, or the failure of these new products or enhancements to achieve market acceptance and comply with industry standards, could seriously harm our business, financial condition and results of operations. Additionally, our introduction of new products and product enhancements could result in the obsolescence of previously purchased or committed inventory, which would reduce our net income.

Our acquisitions may not provide the benefits we anticipate and may disrupt our existing business.

In the past, we have acquired other businesses, including our acquisitions of S7, Packeteer, Inc. and Permeo Technologies, Inc., and our acquisition of certain assets of the NetCache business from Network Appliance, Inc. It is likely we will acquire additional businesses or assets in the future. There is no guaranty that such

acquisitions will yield the benefits we anticipate. The success of any acquisition is impacted by a number of factors, and may be subject to the following risks:

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inability to successfully integrate the operations, technologies, products and personnel of the acquired companies;

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diversion of management’s attention from normal daily operations of the business;

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loss of key employees; and

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substantial transaction costs.

Acquisitions may also result in risks to our existing business, including:

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dilution of our current stockholders’ percentage ownership to the extent we issue new equity;

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assumption of additional liabilities;

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incurrence of additional debt or a decline in available cash;

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adverse effects to our financial statements, such as the need to make large and immediate write-offs or the incurrence of restructuring and other related expenses;

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liability for intellectual property infringement and other litigation claims, which we may or may not be aware of at the time of acquisition;

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creation of goodwill or other intangible assets that could result in significant amortization expense or impairment charges; and

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incurrence of tax expense related to the effect of acquisitions on our intercompany research and development cost sharing arrangements and legal structure.

The occurrence of any of the above risks could seriously impact our business, financial condition and results of operations.

Third parties may assert that our products or services infringe their intellectual property rights.

Third parties have in the past and may in the future claim that our current or future products or services infringe their intellectual property rights, and these claims, even if without merit, could harm our business by increasing our costs, reducing our net revenue or by creating customer concerns that result in delayed or reduced sales. This is particularly true in the patent area, as an increasing number of U.S. patents covering computer networking and Internet technology have been issued in recent years. Patent owners, including those that do not commercially manufacture or sell products, may claim that one or more of our products infringes a patent they own.

We expect that companies in the Internet and networking industries will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. The defense or settlement of any such claims, even if unmeritorious, could be time-consuming and costly. As well, such claims may require us to enter into royalty or licensing agreements, or to develop non-infringing technology. As well, injunctive relief could be entered against us or trade restrictions could be imposed. Any of the foregoing could seriously harm our business, financial condition and results of operations.

Our international operations expose us to risks.

We currently have operations in a number of foreign countries. In fiscal 2010, 55.5% of our total net revenue was derived from customers outside of the Americas and during the first six months of fiscal 2011, 54.2% of our total revenue was derived from customers outside of the Americas; thus, our business is

substantially dependent on economic conditions and IT spending in markets outside the Americas. As well, in fiscal 2010, we commenced moving certain of our research and development and other operations offshore to lower cost geographies. The expansion of our international operations and entry into additional international markets requires significant management attention and financial resources, and subjects us to certain inherent risks including:

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technical difficulties and costs associated with product localization;

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challenges associated with coordinating product development efforts among geographically dispersed areas;

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potential loss of proprietary information due to piracy, misappropriation or laws that may inadequately protect our intellectual property rights;

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our limited experience in establishing a sales and marketing presence, and research and development operations, together with the appropriate internal systems, processes and controls, in certain geographic markets;

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longer payment cycles for sales in certain foreign countries;

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seasonal reductions in business activity in the summer months in Europe and at other times in various countries;

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the significant presence of some of our competitors in some international markets;

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potentially adverse tax consequences or changes in applicable tax laws;

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import and export restrictions and tariffs and other trade protection initiatives;

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potential failures of our foreign employees to comply with both U.S. and foreign laws, including antitrust laws, trade regulations and the Foreign Corrupt Practices Act;

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compliance with foreign laws and other government controls, such as those affecting trade, privacy, the environment and employment;

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management, staffing, legal and other costs of operating an enterprise spread over various countries;

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fluctuations in foreign exchange rates, which we currently do not hedge against;

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political or economic instability, regulatory changes, and war or terrorism in the countries where we are doing business; and

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fears concerning travel or health risks that may adversely affect our ability to sell our products and services in any country in which the business sales culture encourages face-to-face interactions.

To the extent we are unable to effectively manage our international operations and these risks, our international sales may be adversely affected, we may incur additional and unanticipated costs, and we may be subject to litigation or regulatory action. As a consequence, our business, financial condition and results of operations could be seriously harmed.

If we fail to accurately predict our manufacturing requirements and manage our supply chain we could incur additional costs or experience manufacturing delays that could harm our business.

We provide forecasts of our requirements to our supply chain partners on a rolling 12-month basis. If our forecast exceeds our actual requirements, a supply chain partner may assess additional charges or we may have liability for excess inventory, each of which could negatively affect our gross margin. If our forecast is less than our actual requirements, the applicable supply chain partner may have insufficient time or components to produce or fulfill our product requirements, which could delay or interrupt manufacturing of our products or fulfillment of orders for our products, and result in delays in shipments, customer dissatisfaction, and deferral or

loss of revenue. As well, we may be required to purchase sufficient inventory to satisfy our future needs in situations where a component or product is being discontinued. In fiscal 2010, we eliminated the stocking rights of distributors, so we now must rely on our own inventory of products to satisfy customer orders. If we fail to accurately predict our requirements, we may be unable to fulfill those orders or we may be required to record charges for excess inventory. Any of the foregoing could adversely affect our business, financial condition and results of operations.

We depend on single and, in some cases, limited source suppliers for several key products and components of products.

We have limited sources of supply for certain key components of our products, which exposes us to the risk of component shortages or unavailability. In addition, we are unable to rapidly change quantities and delivery schedules because the procurement of certain components is subject to lengthy lead times and the qualification of additional or alternate sources is time consuming, costly and difficult. In the event our business growth exceeds our projections, or required components are otherwise in scarce supply, we may be subject to shortages, delays or unavailability of such components, or potential price increases, which may be substantial. If we are unable to secure sufficient components at reasonable prices in order to timely build our products, customer shipments may be delayed. This would adversely affect both our relationships with those customers and our net revenue. Alternatively, we may pay increased prices, which would impact our gross margin. Any of the foregoing could adversely affect our business, financial condition and results of operations.

We are dependent on original design manufacturers, contract manufacturers and third party logistics providers to design and manufacture our products and to fulfill orders for our products.

We depend primarily on original design manufacturers (each of which is a third party original design manufacturer for numerous companies) to co-design and co-develop the hardware platform for our products. We also depend on independent contract manufacturers (each of which is a third party manufacturer for numerous companies) to manufacture and fulfill our products. These supply chain partners are not committed to design or manufacture our products, or to fulfill orders for our products, on a long-term basis in any specific quantity or at any specific price. Also, from time to time, we may be required to add new supply chain partner relationships or new manufacturing or fulfillment sites to accommodate growth in orders or the addition of new products. It is time consuming and costly to qualify and implement new supply chain partner relationships and new manufacturing or fulfillment sites, and such additions increase the complexity of our supply chain management. Our ability to ship products to our customers could be delayed if we fail to effectively manage our supply chain partner relationships; if one or more of our design manufacturers does not meet our development schedules; if one or more of our contract manufacturers experiences delays, disruptions or quality control problems in manufacturing our products; or if one or more of our third party logistics providers experiences delays or disruptions or otherwise fails to meet our fulfillment schedules; or if we are required to add or replace design manufacturers, contract manufacturers, third party logistics providers or fulfillment sites. In addition, these supply chain partners have access to certain of our critical confidential information and could wrongly disclose such information. Moreover, an increasing portion of our manufacturing is performed outside the United States, primarily in China, and is, therefore, subject to risks associated with doing business in foreign countries. If manufacturing or logistics in these foreign countries is disrupted for any reason, including natural disasters, information technology system failures, military or government actions or economic, business, labor, environmental, public health, or political issues, our business, financial condition and results of operations could be adversely affected.

If the protection of our proprietary technology is inadequate, our competitors may gain access to our technology.

Our success is heavily dependent on our ability to create proprietary technology and to protect and enforce our intellectual property rights in that technology, as well as our ability to defend against adverse claims of third

parties with respect to our technology and intellectual property. To protect our proprietary technology, we rely primarily on a combination of contractual provisions, confidentiality procedures, trade secrets, copyright and trademark laws, and patents. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult. In addition, the laws of some foreign countries, including countries where we sell products and have operations, do not protect our proprietary rights to as great an extent as do the laws of the United States. Our means of protecting our proprietary rights may not be adequate and unauthorized third parties, including current and future competitors, may independently develop similar or superior technology, duplicate or reverse engineer aspects of our products, or design around our patented technology or other intellectual property.

As of October 31, 2010, we had 122 issued U.S. patents, 64 pending U.S. patent applications (provisional and non-provisional), 4 foreign issued patents and 1 pending foreign patent applications. There can be no assurance that any of our pending patent applications will issue or that the patent examination process will not result in our narrowing the claims applied for. Furthermore, there can be no assurance that we will be able to detect any infringement of our existing or future patents (if any) or, if infringement is detected, that our patents will be enforceable or that any damages awarded to us will be sufficient to adequately compensate us for the infringement.

There can be no assurance or guarantee that any products, services or technologies that we are presently developing, or will develop in the future, will result in intellectual property that is subject to legal protection under the laws of the United States or a foreign jurisdiction and that produces a competitive advantage for us.

Our ability to sell our products depends on the quality of our support and services offerings.

Our end user customers look to us and, as applicable, to our channel partners to ensure that our products are properly configured and installed, and efficiently and effectively operate within their networks. To the extent we or our channel partners fail to effectively assist our end user customers in their efforts to deploy and operate our products, or fail to timely and adequately address product problems, it may adversely affect our ability to sell our products to those customers in the future and could harm our business and product reputation and impact other sales. Failure to maintain high quality support and services may harm our business, financial condition and results of operations.

Product quality problems may result in delayed market acceptance, additional costs, reduced sales or litigation.

Our products are highly complex and may contain undetected operating errors or quality problems, particularly when first introduced or as new versions or upgrades are released. Despite testing by us and by current and potential customers, errors or quality problems may not be found in new products or new versions until after commencement of commercial shipments, resulting in customer dissatisfaction and loss of or delay in market acceptance and sales opportunities. This could materially adversely affect our operating results. These errors and quality problems could also cause us to incur significant repair or replacement costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems. We may also incur significant costs in connection with a product recall and any related indemnification obligations, which could materially adversely affect our operating results. In addition, many of our products operate on our internally developed operating system, and any error in the operating system may affect those products. We have experienced errors or quality problems in the past in connection with new products and enhancements to existing products. We expect that errors or quality problems will be found from time to time in new or enhanced products after commencement of commercial shipments, which could seriously harm our business.

Since our end user customers install our appliances directly into their network infrastructures, any errors, defects or other problems with our products could negatively impact their networks or other Internet users,

resulting in financial or other losses. While we typically seek by contract to limit our exposure to damages, it is possible that such limitations might not exist or might not be enforced in the event of a product liability claim. Moreover, a product liability claim brought against us, even if not successful, would likely be time-consuming and costly to defend or settle, and could seriously harm the reputation of our business and products.

We may not be able to successfully manage the growth of our business and may suffer other losses if we are unable to improve our systems and processes.

Our growth, including growth through the acquisition of Packeteer, together with evolving regulatory requirements and changes in financial accounting and reporting standards, has placed increased demands on our management and our business infrastructure. We need to continue to improve our systems and processes to effectively manage our operations and growth, including our growth into new geographies. We may not be able to successfully implement improvements to these systems and processes in a timely or efficient manner. As well, our systems and processes may not prevent or detect all errors, omissions or fraud. Our failure to improve our systems and processes, or their failure to operate in the intended manner, may result in our inability to manage the growth of our business and to accurately forecast our revenue, expenses and earnings, or to prevent certain losses. This could adversely affect our business, financial condition and results of operations.

Third parties may bring legal actions against us.

In the past third parties have brought legal actions against us and other parties to whom we provided indemnification. We incurred substantial costs to defend those lawsuits and related legal proceedings. It is likely that in the future other parties may bring legal actions against us. Such actions, even if without merit, could harm our business. Any material litigation or arbitration inevitably results in the diversion of the attention of our management and other relevant personnel. To the extent uninsured, such claims further require the expenditure of our resources for defense costs for us and for parties to whom we may have indemnification obligations. We also may be required to pay material amounts in settlement costs or damages. As well, if the matter relates to intellectual property infringement, we may be required to enter into royalty or licensing agreements or to develop non-infringing technology, and injunctive relief could be entered against us. Customer concerns with respect to material litigation can result in delayed or lost sales. Any of the foregoing could seriously harm our business and have a material adverse effect on our business, financial condition and results of operations.

Forecasting our estimated annual effective tax rate is complex and subject to uncertainty, and there may be material differences between our forecasted and actual tax rates.

Forecasts of our income tax position and effective tax rate are complex and subject to uncertainty because our income tax position for each year combines the effects of a mix of profits and losses earned by us and our subsidiaries in various tax jurisdictions with a broad range of income tax rates, as well as changes in the valuation of deferred tax assets and liabilities, the impact of various accounting rules and changes to these rules and tax laws, the results of examinations by various tax authorities, and the impact of any acquisition, business combination or other reorganization or financing transaction. To forecast our global tax rate, we estimate our pre-tax profits and losses by jurisdiction and forecast our tax expense by jurisdiction. If the mix of profits and losses, our ability to use tax credits, or effective tax rates by jurisdiction is different than those estimated, our actual tax rate could be materially different than forecasted, which could have a material impact on our financial condition and results of operations.

uncertainty. Tax laws themselves are subject to change as a result of changes in fiscal policy, changes in legislation, and the evolution of regulations and court rulings. Consequently, taxing authorities may impose tax assessments or judgments against us that could materially impact our tax liability and/or our effective income tax rate.

In addition, we may be subject to examination of our income tax returns by the Internal Revenue Service and other tax authorities. If tax authorities challenge the relative mix of U.S. and international income, our future effective income tax rates could be adversely affected. While we regularly assess the likelihood of adverse outcomes from such examinations and the adequacy of our provision for income taxes, there can be no assurance that such provision is sufficient and that a determination by a tax authority will not have an adverse effect on our business, financial condition and results of operations.

We rely on technology that we license from third parties, including software that is integrated with internally developed software and used with our products.

We rely on technology that we license from third parties, including third party commercial software and open source software that is used with certain of our products. If we are unable to continue to license any of this software on commercially reasonable terms, we will face delays in releases of our software or we will be required to delete this functionality from our software until equivalent technology can be licensed or developed and integrated into our current product. In addition, the inability to obtain certain licenses or other rights might require us to engage in litigation regarding these matters, which could have a material adverse effect on our business, financial condition and results of operations.

We are subject to various governmental regulations that could subject us to liability or impair our ability to compete in international markets.

Our products are subject to various governmental regulations, including U.S. and foreign import and export control laws and various environmental regulations, including the Waste Electrical and Electronic Equipment (WEEE) and Restriction of the Use of Certain Hazardous Substances in Electrical and Electric Equipment (RoHS) regulations adopted by the European Union. In addition, our products contain encryption technology and various countries regulate the import of certain encryption technology and have enacted laws that could limit our ability to distribute our products or could limit our customers’ ability to implement our products in those countries. Changes in our products or changes in applicable regulations or enforcement may create delays in the introduction of our products in international markets, prevent our customers with international operations from deploying our products globally or, in some cases, prevent the export or import of our products to certain countries altogether. Any decreased use of our products or limitation on our ability to export or sell our products would likely adversely affect our business, financial condition and results of operations.

We issued convertible notes to fund our acquisition of Packeteer, which could impact our liquidity.

We issued zero coupon convertible senior notes in an aggregate principal amount of $80 million that mature in 2013, in order to acquire Packeteer. If these notes are not converted prior to maturity we will be required to repay the principal amount, which could impact our liquidity. As well, the notes contain certain conditions of default and, should a default occur, the holders of the notes may be able to require early payment of the notes.

We may be unable to raise additional capital.

We believe that our available cash, cash equivalents and short term investments will enable us to meet our liquidity and capital requirements for at least the next 12 months. However, if cash is required for unanticipated needs, including payment of our zero coupon convertible senior notes in the event of default or in connection with a proposed acquisition of a company or technology, we may need additional capital during that period. The development and marketing of new products and our investment in sales and marketing efforts require a

significant commitment of resources. If the market for our products develops at a slower pace than anticipated, we could be required to raise additional capital. We cannot guarantee that, should it be required, sufficient debt or equity capital will be available to us under acceptable terms, if at all. If we were unable to raise additional capital when required, our business, financial condition and results of operations could be seriously harmed.

Our operations could be significantly hindered by the occurrence of a natural disaster, terrorist attack or other catastrophic event.

Our business operations are susceptible to outages due to fire, floods, power loss, telecommunications failures, terrorist attacks and other events beyond our control. In addition, a substantial portion of our facilities, including our headquarters, are located in Northern California, an area susceptible to earthquakes. We do not carry earthquake insurance for earthquake-related losses. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any of these events. To the extent that such events disrupt our business or adversely impact our reputation, such events could adversely affect our business, financial condition and results of operations.

The market price of our stock is volatile, and is likely to be volatile in the future.

The market price of our common stock has experienced significant fluctuations and may continue to fluctuate significantly. Such volatility in the trading price of our stock can occur in response to general market conditions, changes in the IT or technology market generally or changes in the specific markets in which we operate, and cause an increase or decline in our stock price without regard to our operating performance. The market price of our common stock could decline quickly and significantly if we fail to achieve our guidance or if our performance fails to meet the expectation of public market analysts or investors.

The market price of our common stock may fluctuate significantly in response to the following factors, among others:

•

variations in our quarterly operating results;

•

changes in financial estimates or investment recommendations by securities analysts;

•

changes in macroeconomic conditions;

•

the introduction of new products by our competitors;

•

our ability to keep pace with changing technological requirements;

•

changes in market valuations of information technology companies;

•

announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments, or other significant transactions;

•

loss of customers who represent a significant portion of our revenues;

•

additions or departures of key personnel;

•

fluctuations in stock market volumes;

•

investor confidence in our stock, technology stocks and the stock market in general;

•

speculation in the press or investment community about our strategic position, financial condition, results of operations or business; and

•

regulatory or litigation matters.

It is not uncommon for securities class actions or other litigation to be brought against a company after periods of volatility in the market price of a company’s stock, and we have been subject to such litigation in the past. Such actions could result in management distraction and expense and could result in a decline in our stock price.

We must attract, assimilate and retain key personnel on a cost-effective basis.

We depend on our ability to attract and retain highly qualified and skilled personnel on an ongoing basis. Our success will depend in part on our ability to recruit and retain key personnel and to effectively transition management responsibilities when key personnel are replaced. We recently have experienced changes in our senior executive team and our sales team and may continue to experience such changes in the future. Effective September 1, 2010, Michael J. Borman was appointed President and Chief Executive Officer and our former President and Chief Executive Officer, Brian M. NeSmith, became Chief Product Officer. As well, Mr. NeSmith presently serves as our interim chief marketing officer.

The majority of our U.S.-based employees, including our senior management personnel, are employed on an “at-will” basis, which may make it easier for key employees to move to new employment. Our inability to timely hire replacement or additional employees may impact our operations, since new hires, particularly sales personnel, frequently require extensive training before they achieve desired levels of productivity. This may affect our ability to grow our net revenue. In addition, we may increase our hiring in locations outside of the U.S., such as in connection with our research and development facility in India, which could subject us to additional geopolitical and exchange rate risks.

Item 6. Exhibits


Number		Description

10.71		Offer Letter Agreement by and between Blue Coat Systems, Inc. and Michael J. Borman, dated August 30, 2010 (which is incorporated herein by reference to Exhibit 10.1 of Form 8-K filed by the Registrant with the Commission on August 31, 2010).

10.72		CEO Change in Control Severance Agreement, between the Company and its Chief Executive Officer, effective August 30, 2010 (which is incorporated herein by reference to Exhibit 10.2 of Form 8-K filed by the Registrant with the Commission on August 31, 2010).

10.73		Blue Coat Systems, Inc. 2010 New Employee Stock Incentive Plan, as amended, effective September 1, 2010 (which is incorporated herein by reference to Exhibit 99.1 of Form S-8 filed by the Registrant with the Commission on September 1, 2010).

10.74		Stock Option Agreement with Michael J. Borman (which is incorporated herein by reference to Exhibit 99.2 of Form S-8 filed by the Registrant with the Commission on September 1, 2010).

10.75		Restricted Stock Unit Agreement with Michael J. Borman (which is incorporated herein by reference to Exhibit 99.3 of Form S-8 filed by the Registrant with the Commission on September 1, 2010).

10.76		Amended and Restated 2007 Stock Incentive Plan (which is incorporated herein by reference to Exhibit 10.2 of Form 8-K filed by the Registrant with the Commission on October 7, 2010).

10.77		Blue Coat Systems, Inc. Amended and Restated Fiscal 2011 Profit Sharing Plan, as amended effective November 1, 2010 (which is incorporated herein by reference to Exhibit 99.1 of Form 8-K filed by the Registrant with the Commission on November 2, 2010).

10.78		Stipulation of Settlement, dated October 1, 2010 (which is incorporated by reference to Exhibit 99.1 of Form 8-K filed by the Registrant with the Commission on November 22, 2010).

31.1		Principal Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Principal Financial and Accounting Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Principal Executive Officer and Principal Financial and Accounting Officer Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS*		XBRL Instance Document

101.SCH*		XBRL Taxonomy Extension Schema Document

101.CAL*		XBRL Taxonomy Extension Calculation Linkbase Document

101.LAB*		XBRL Taxonomy Extension Label Linkbase Document

101.PRE*		XBRL Taxonomy Extension Presentation Linkbase Document

XBRL (Extensible Business Reporting Language) information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, and is not otherwise subject to liability under those sections.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

BLUE COAT SYSTEMS, INC.

/s/ Gordon C. Brooks

Gordon C. Brooks

Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)

Dated: November 29, 2010

BLUE COAT SYSTEMS INC - FORM 10-Q - November 29, 2010

Attached files

BLUE COAT SYSTEMS INC Reports