UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 3, 2016

Commission file number 0-23298

 

QLogic Corporation

(Exact name of registrant as specified in its charter)

 

 

26650 Aliso Viejo Parkway

Aliso Viejo, California 92656

(Address of principal executive office and zip code)

(949) 389-6000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  o

Indicate by check mark whether the Registrant 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  þ    No  o

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.

 

 

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

As of August 4, 2016, 84,625,000 shares of the Registrant’s common stock were outstanding.

 

 

 

 

 

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QLOGIC CORPORATION

INDEX

PART I. FINANCIAL INFORMATION

 

 

 

 

 

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PART I.

FINANCIAL INFORMATION

QLOGIC CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

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QLOGIC CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

 

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QLOGIC CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

 

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QLOGIC CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

 

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QLOGIC CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1.Basis of Presentation 

In the opinion of management of QLogic Corporation (QLogic or the Company), the accompanying unaudited condensed consolidated financial statements contain all normal recurring accruals and adjustments necessary to present fairly the Company’s consolidated financial position, results of operations and cash flows. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended April 3, 2016. The results of operations for the three months ended July 3, 2016 are not necessarily indicative of the results that may be expected for the entire fiscal year. The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates that affect the amounts reported in the Company’s consolidated financial statements and accompanying notes. The Company evaluates its estimates on an ongoing basis using historical experience and other factors, including the current economic environment. Among the significant estimates affecting the consolidated financial statements are those related to revenue recognition, income taxes, inventories, goodwill and long-lived assets. The actual results experienced by the Company could differ materially from management’s estimates.

Pending Acquisition by Cavium, Inc.

On June 15, 2016, the Company entered into an Agreement and Plan of Merger (Merger Agreement) with Cavium, Inc., a Delaware corporation (Parent or Cavium), and Quasar Acquisition Corp., a Delaware corporation and a wholly owned subsidiary of Parent (the Offeror or Sub).

Pursuant to the Merger Agreement, on July 13, 2016, the Offeror commenced an offer to exchange (the Offer) each outstanding share of the Company’s common stock for (i) $11.00 in cash (Cash Consideration) and (ii) 0.098 (Exchange Ratio) shares of common stock (Cavium Common Stock) of Cavium (Share Consideration) and, together with the Cash Consideration, (Offer Consideration), without interest and subject to any required withholding for taxes. The Offer is scheduled to expire at midnight, Eastern Standard Time (EST), at the end of August 9, 2016 unless extended by the Offeror pursuant to the terms of the Merger Agreement and applicable law. As soon as practicable following the consummation of the Offer, and subject to the satisfaction or waiver of certain conditions set forth in the Merger Agreement, the Offeror will merge with and into the Company (the Merger) pursuant to the provisions of Section 251(h) of the Delaware General Corporation Law, with no stockholder vote required to consummate the Merger. In the Merger, the Company will survive as a wholly owned subsidiary of Cavium, and each issued and outstanding share of the Company’s common stock, other than shares of the Company’s common stock held in treasury of the Company, shares of the Company’s common stock owned by Cavium or any subsidiary of Cavium (including the Offeror) or shares of the Company’s common stock owned by stockholders who are entitled to and validly exercise appraisal rights under Delaware law, will be converted into the right to receive the Offer Consideration. Cavium intends to fund the Offer Consideration with a combination of cash on hand and committed debt financing.

In general, as a result of the Merger, at the effective time of the Merger, (i) unvested Company stock options that are in-the-money will be assumed by Cavium and converted into Cavium stock options; (ii) vested Company stock option that are in-the-money will receive a portion of the Offer Consideration based on the in-the-money spread value of the Company stock options; (iii) out-of-the-money Company stock options (whether vested or unvested) will be cancelled and receive no payment; (iv) unvested Company restricted stock units will be assumed and converted into Cavium restricted stock units; (v) vested Company restricted stock units (which includes restricted stock units that will vest just prior to the effective time of the Merger) will receive the Offer Consideration based on the number of shares of the Company’s common stock underlying the restricted stock unit;  and (vi) unvested Company restricted stock units subject to performance based vesting will be assumed by Cavium and converted into Cavium restricted stock units (based on the level of performance achieved as of the last trading day prior to the closing of the Merger).

 

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QLOGIC CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The obligation of each party to consummate the Offer and the Merger is subject to the satisfaction or waiver of customary closing conditions set forth in the Merger Agreement, including (i) at least a majority of the outstanding shares of the Company’s common stock, when added to shares of the Company’s common stock already owned by the Offeror, having been validly tendered into (and not withdrawn from) the Offer prior to the expiration date of the Offer (Minimum Condition), (ii) the exchange of shares of Cavium Common Stock pursuant to the Offer and the Merger having been registered pursuant to a registration statement filed by Cavium with the Securities and Exchange Commission (SEC) and declared effective by the SEC, (iii) shares of Cavium Common Stock issuable pursuant to the Offer and the Merger having been authorized for listing on Nasdaq, (iv) the expiration or termination of any applicable regulatory waiting periods and/or receipt of regulatory clearance, (v) the absence of any order or ruling prohibiting the consummation of the Merger, and (vi) subject to certain exceptions, the accuracy of the other party’s representations and warranties and compliance with covenants. In addition, the obligation of Cavium and the Offeror to consummate the Merger is also subject to the satisfaction or waiver of the condition that no material adverse effect on the Company shall have occurred since the date of the Merger Agreement. Cavium’s and the Company’s obligations are not subject to any financing condition.

The Merger Agreement contains certain termination rights for each of the Company and Cavium, including, among others, if the Offer is not consummated at or prior to 11:59 p.m. EST on November 12, 2016. Upon termination of the Merger Agreement under specified circumstances, including a termination by the Company to enter into an agreement for an alternative transaction pursuant to a “superior proposal,” the Company has agreed to pay Cavium a termination fee of $47.8 million.

The Company expects the transaction to be completed in the second quarter of fiscal 2017.

Recently Issued Accounting Standards Not Yet Effective

In May 2014, the Financial Accounting Standards Board (FASB) issued an accounting standard update that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This standard will replace most existing revenue recognition guidance when it becomes effective. In July 2015, the FASB amended this standard to defer the effective date by one year and permit early adoption as of the original effective date. This amended standard is effective for the Company in the first quarter of fiscal 2019. This standard permits the use of either the retrospective or cumulative effect transition method. The Company is currently evaluating the effect this new guidance will have on its consolidated financial statements and has not yet selected a transition method.

 

Note 2.Marketable Securities

The Company’s portfolio of available-for-sale marketable securities consists of the following:

 

 

The amortized cost and estimated fair value of debt securities as of July 3, 2016, by contractual maturity, are presented below. Expected maturities will differ from contractual maturities because the issuers of securities may have the right to repay obligations

 

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QLOGIC CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

without prepayment penalties. Certain debt instruments, although possessing a contractual maturity greater than one year, are classified as short-term marketable securities based on their ability to be traded on active markets and availability for current operations.

 

 

 

The following table presents the Company’s marketable securities with unrealized losses by investment category and length of time that individual securities have been in a continuous unrealized loss position as of July 3, 2016 and April 3, 2016.

 

 

As of July 3, 2016 and April 3, 2016, the fair value of certain of the Company’s available-for-sale securities was less than their cost basis. Management reviewed various factors in determining whether to recognize an impairment charge related to these unrealized losses, including the current financial and credit market environment, the financial condition and near-term prospects of the issuer of the security, the magnitude of the unrealized loss compared to the cost of the investment, the length of time the investment had been in a loss position and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery of market value. As of July 3, 2016 and April 3, 2016, the Company determined that the unrealized losses were temporary in nature and recorded them as a component of accumulated other comprehensive income.

 

 

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QLOGIC CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Note 3.Fair Value of Financial Instruments 

The Company’s financial instruments consist principally of cash and cash equivalents, marketable securities, accounts receivable and accounts payable. The carrying value of cash equivalents, accounts receivable and accounts payable approximates fair value because of the nature and short-term maturity of these financial instruments.

A summary of the assets measured at fair value on a recurring basis as of July 3, 2016 and April 3, 2016 are as follows:

 

 

The Company’s investments classified within Level 2 were primarily valued based on valuations obtained from a third-party pricing service. To estimate fair value, the pricing service utilizes industry-standard valuation models, including both income and market-based approaches for which all significant inputs are observable either directly or indirectly. The Company obtained documentation from the pricing service as to the methodology and summary of inputs used for the various types of securities. The pricing service maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. These observable inputs include reported trades and broker/dealer quotes of the same or similar securities, issuer credit spreads, benchmark securities and other observable inputs. The Company compares valuation information from the pricing service with other pricing sources to validate the reasonableness of the valuations.

 

 

Note 4.Inventories

Components of inventories are as follows:

 

 

 

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QLOGIC CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Note 5.Special Charges 

In connection with the Company’s restructuring plans discussed below, management recorded special charges of $(0.6) million and $1.1 million during the three months ended July 3, 2016 and June 28, 2015, respectively.

September 2015 Initiative

In September 2015, the Company commenced a restructuring plan (September 2015 Initiative) designed to align its future operating expenses with its revenue expectations.  The restructuring plan included a workforce reduction and the consolidation and elimination of certain engineering activities.  

During the three months ended July 3, 2016, the Company recorded special charges of $(0.8) million, related to the September 2015 Initiative. In June 2016, the Company negotiated a lease termination and settlement of the obligation associated with a facility that it ceased using during fiscal 2016.  Accordingly, the Company reduced the previously-established lease obligation with a corresponding reduction in special charges.  

The aggregate amount of the special charges recorded in connection with the September 2015 Initiative was $9.9 million and consisted of $7.8 million of severance and related costs associated with involuntarily terminated employees, $2.0 million of asset impairment charges related to property and equipment and $0.1 million of facilities and other costs.

Activity and liability balances for exit costs related to this initiative are as follows:

 

 

The Company completed these restructuring activities and all amounts were paid as of July 3, 2016.

May 2015 Initiative

In May 2015, the Company commenced a restructuring plan (May 2015 Initiative) designed to streamline business operations and recorded special charges of $0.7 million during the three months ended June 28, 2015. The special charges consisted entirely of exit costs associated with severance benefits for the involuntarily terminated employees. The Company completed these restructuring activities and all amounts were paid as of September 27, 2015.

June 2013 Initiative

In June 2013, the Company commenced a restructuring plan (June 2013 Initiative) designed to enhance product focus and streamline business operations. The restructuring plan includes a workforce reduction and the consolidation and elimination of certain engineering activities.  In connection with this plan, the Company ceased development of future application-specific integrated circuits for switch products.

In connection with the June 2013 Initiative, the Company recorded special charges of $0.1 million and $0.4 million during the three months ended July 3, 2016 and June 28, 2015, respectively.  Special charges for both periods consisted entirely of exit costs associated with severance and related costs for involuntarily terminated employees. Certain employees that were notified of their termination are required to provide future services for varying periods in excess of statutory notice periods. Severance costs related to these services are recognized ratably over the estimated requisite service period. The Company expects to incur less than $1 million of additional severance costs in connection with these employees over the remaining requisite service period.

The aggregate amount of the special charges recorded in connection with the June 2013 Initiative is $25.7 million and consisted of $15.3 million of severance and related costs associated with involuntarily terminated employees, $5.9 million of facilities and other costs and $4.5 million of asset impairment charges primarily related to abandoned property and equipment.

 

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QLOGIC CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Activity and liability balances for exit costs related to the June 2013 Initiative are as follows:

 

 

The unpaid exit costs related to the June 2013 Initiative are expected to be paid over the terms of the related agreements through fiscal 2019.

A summary of the total unpaid exit costs for all restructuring plans, by classification, included in the condensed consolidated balance sheets is as follows:

 

 

 

Note 6. Income Taxes

The Company’s income tax expense (benefit) was $(1.0) million and $4.9 million for the three months ended July 3, 2016 and June 28, 2015, respectively.  Income tax benefit for the three months ended July 3, 2016 was favorably impacted by the resolution of tax examinations for prior years. Income tax expense for the three months ended June 28, 2015 was impacted by the negative effect of a discrete tax-related item associated with the difference between stock-based compensation expense and the deduction related to stock-based awards on income tax returns.  The Company’s income tax expense is based on the estimated income for the year, the composition of the estimated income in different tax jurisdictions, and the tax effect, if any, of newly enacted tax legislation, resolution of tax audits, changes in uncertain tax positions, and other discrete tax-related items during the applicable quarterly periods. The allocation of taxable income to domestic and foreign tax jurisdictions impacts the effective tax rate, as the Company’s income tax rate in foreign jurisdictions is generally lower than its income tax rate in the United States.

 

 

Note 7.Net Income Per Share

The following table sets forth the computation of basic and diluted net income per share:

 

 

Stock-based awards, including stock options and restricted stock units, representing 5.0 million and 6.1 million shares of common stock have been excluded from the diluted per share calculations for the three months ended July 3, 2016 and June 28, 2015,

 

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QLOGIC CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

respectively.  These stock-based awards have been excluded from the diluted per share calculations because their effect would have been antidilutive.

 

 

Note 8.Legal Proceedings

   On September 28, 2015, a purported class action was commenced in the U.S. District Court for the Central District of California asserting claims arising under federal securities laws against the Company and certain individual defendants.  The plaintiff, Phyllis Hull, purported to represent a class of persons who purchased the Company’s common stock between April 30, 2015 and July 30, 2015.  The plaintiff alleged that the defendants, including a former officer and a current officer, engaged in a scheme to inflate the Company’s stock price by making false and misleading statements regarding the Company’s operations, financial results and future business prospects in violation of federal securities laws.  The plaintiff sought compensatory damages, interest and an award of reasonable attorneys’ fees and costs.  On March 4, 2016, the parties filed a Joint Stipulation with the Court to voluntarily dismiss the case. On March 7, 2016, the Court dismissed the case with prejudice as to Phyllis Hull and her individual claims and without prejudice as to the unnamed class members.

On October 23 2015, Stephen Kramer filed a shareholder derivative complaint in the California Superior Court in and for the County of Orange County purportedly on behalf of the Company against certain current and former officers and directors of the Company.  The plaintiff alleged breaches of fiduciary duty, unjust enrichment, corporate waste, aiding and abetting breaches of fiduciary duty, and improper insider sales of stock in violation of California law based on the allegation that, since October 17, 2014, the individual defendants engaged in a scheme to inflate the Company’s stock price by making false and misleading statements regarding the Company’s operations, financial results, internal controls and future business prospects.  The plaintiff sought an award of damages and restitution to the Company from the individual defendants, disgorgement of the individual defendants’ profits and compensation, an order requiring the Company to reform and improve its corporate governance, and an award of costs and attorneys’ fees to the plaintiff and its counsel.  On March 14, 2016, a second shareholder derivative complaint was filed in the same Court. The plaintiff in the second suit, Indiana Laborers Pension and Welfare Funds, made similar allegations against certain current and former officers and directors of the Company, and sought similar demands.  On June 8, 2016, the parties in both cases filed Joint Stipulations with the Court to voluntarily dismiss the respective cases.  On June 13, 2016, the Court dismissed the second shareholder derivative suit without prejudice as to Indiana Laborers Pension and Welfare Funds and on June 14, 2016 the Court dismissed the first shareholder derivative suit without prejudice as to Stephen Kramer.

On July 22, 2016, a putative securities class action was commenced in the U.S. District Court for the Central District of California asserting claims arising under federal securities laws against the Company and certain defendants, including the directors and an officer. The plaintiff, Stephen Bushansky, purports to represent the public stockholders of the Company.  The plaintiff alleges that the proposed acquisition of QLogic by Cavium pursuant to the Merger Agreement (the Proposed Transaction), is the result of an unfair process and coercive deal-protection devices and provides the Company’s stockholders with inadequate consideration. The plaintiff further alleges that the Company’s Solicitation/Recommendation Statement on Schedule 14D-9, filed with the SEC on July 13, 2016, omits or misrepresents material information concerning the Proposed Transaction in violation of federal securities laws.  The plaintiff seeks class certification, an injunction enjoining the Proposed Transaction, a declaration that the defendants violated certain federal securities laws, compensatory damages, and reasonable attorney’s fees and costs.

Because the lawsuit is in its early stages, it is not possible to determine the potential outcome of the lawsuit or to make any estimate of probable losses at this time.  The Company believes that the claims asserted in the lawsuit are without merit and intends to defend its position.  A negative outcome in the lawsuit could have a material adverse effect on the Company if it results in preliminary or permanent injunctive relief or rescission of the Merger Agreement.  The Company currently believes the disposition of this matter will not have a material adverse effect on the Company’s financial condition or results of operations.

Various other lawsuits, claims and proceedings have been or may be instituted against the Company. The outcome of litigation cannot be predicted with certainty and some lawsuits, claims and proceedings may be disposed of unfavorably to the Company. Many intellectual property disputes have a risk of injunctive relief and there can be no assurance that a license will be granted. Injunctive relief could have a material adverse effect on the Company’s financial condition or results of operations.  Based on an evaluation of such other matters that are pending or asserted, management believes the disposition of such matters will not have a material adverse effect on the Company’s financial condition or results of operations.

 

 

 

 

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This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes. In this discussion and elsewhere in this report, we make forward-looking statements. These forward-looking statements are made in reliance upon safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include, without limitation, descriptions of our expectations regarding future trends affecting our business and other statements regarding future events or our objectives, goals, strategies, beliefs and underlying assumptions that are other than statements of historical fact. When used in this report, the words “anticipates,” “believes,” “can,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “should,” “will” and similar expressions, or the negative of such expressions, are intended to identify these forward-looking statements. Statements concerning current conditions may also be forward-looking if they imply a continuation of current conditions. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of several factors, including, but not limited to those factors set forth and discussed in Part II, Item 1A “Risk Factors” and elsewhere in this report. In light of the significant uncertainties inherent in the forward-looking information included in this report, the inclusion of this information should not be regarded as a representation by us or any other person that our objectives or plans will be achieved. You are cautioned, therefore, not to place undue reliance on these forward-looking statements, which are made only as of the date of this report. We undertake no obligation to update or revise these forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

We design and supply high performance server and storage networking connectivity products that provide, enhance and manage computer data communication. These products facilitate the rapid transfer of data and enable efficient resource sharing between servers, networks and storage. Our products are used in enterprise, managed service provider and cloud service provider data centers, along with other environments dependent on high performance, reliable data networking.

Our products are based primarily on Fibre Channel and Ethernet technologies and are used in connection with storage networks, data networks and converged networks. Storage networks are used to provide access to storage across enterprise environments. Fibre Channel is currently a dominant technology for enterprise storage networking.  Data networks are used to provide workstation-to-server, server-to-server, and server-to-storage connectivity using Ethernet.  Converged networks are designed to address the evolving data center by consolidating and unifying storage and data networks, using high-speed Ethernet.  Fibre Channel over Ethernet (FCoE) is a converged networking technology that uses high-speed Ethernet for both storage and data transmission.  Internet Small Computer System Interface (iSCSI) is an alternative to FCoE and provides storage over Ethernet capabilities.  Our converged network products can support storage networking and data networking capability covering a variety of protocols either individually or in combination.

We classify our products into two categories – Advanced Connectivity Platforms and Legacy Connectivity Products. Advanced Connectivity Platforms are comprised primarily of adapters and application-specific integrated circuits (ASICs) for server and storage connectivity applications. Legacy Connectivity Products are comprised primarily of Fibre Channel switch products.

Our products are sold worldwide, primarily to original equipment manufacturers (OEMs) and distributors. Our customers rely on our various server and storage connectivity products to deliver solutions to information technology professionals in virtually every business sector. Our products are found primarily in server and storage subsystem solutions that are used by enterprises with critical business data requirements, as well as managed service and cloud service providers.  These products are incorporated in solutions from a number of server and storage system OEM customers, including Cisco Systems, Inc., Dell Inc., EMC Corporation, Fujitsu Ltd., Hewlett Packard Enterprise Company, Huawei Technologies Co. Ltd., Inspur Group Co., Ltd., International Business Machines Corporation, Lenovo Group Ltd., NetApp, Inc., Oracle Corporation and Pure Storage, Inc.

Pending Acquisition by Cavium, Inc.

On June 15, 2016, QLogic Corporation (the Company) entered into an Agreement and Plan of Merger (Merger Agreement) with Cavium, Inc., a Delaware corporation (Parent or Cavium), and Quasar Acquisition Corp., a Delaware corporation and a wholly owned subsidiary of Parent (the Offeror or Sub).

Pursuant to the Merger Agreement, on July 13, 2016, the Offeror commenced an offer to exchange (the Offer) each outstanding share of the Company’s common stock for (i) $11.00 in cash (Cash Consideration) and (ii) 0.098 (Exchange Ratio) shares of common stock (Cavium Common Stock) of Cavium (Share Consideration) and, together with the Cash Consideration, (Offer Consideration), without interest and subject to any required withholding for taxes. The Offer is scheduled to expire at midnight, Eastern Standard Time (EST), at the end of August 9, 2016 unless extended by the Offeror pursuant to the terms of the Merger Agreement and applicable law. As soon as practicable following the consummation of the Offer, and subject to the satisfaction or waiver of certain

 

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conditions set forth in the Merger Agreement, the Offeror will merge with and into the Company (the Merger) pursuant to the provisions of Section 251(h) of the Delaware General Corporation Law, with no stockholder vote required to consummate the Merger. In the Merger, the Company will survive as a wholly owned subsidiary of Cavium, and each issued and outstanding share of the Company’s common stock, other than shares of the Company’s common stock held in treasury of the Company, shares of the Company’s common stock owned by Cavium or any subsidiary of Cavium (including the Offeror) or shares of the Company’s common stock owned by stockholders who are entitled to and validly exercise appraisal rights under Delaware law, will be converted into the right to receive the Offer Consideration. Cavium intends to fund the Offer Consideration with a combination of cash on hand and committed debt financing.

In general, as a result of the Merger, at the effective time of the Merger, (i) unvested Company stock options that are in-the-money will be assumed by Cavium and converted into Cavium stock options; (ii) vested Company stock option that are in-the-money will receive a portion of the Offer Consideration based on the in-the-money spread value of the Company stock options; (iii) out-of-the-money Company stock options (whether vested or unvested) will be cancelled and receive no payment; (iv) unvested Company restricted stock units will be assumed and converted into Cavium restricted stock units; (v) vested Company restricted stock units (which includes restricted stock units that will vest just prior to the effective time of the Merger) will receive the Offer Consideration based on the number of shares of the Company’s common stock underlying the restricted stock unit; and (vi) unvested Company restricted stock units subject to performance based vesting will be assumed by Cavium and converted into Cavium restricted stock units (based on the level of performance achieved as of the last trading day prior to the closing of the Merger).

The obligation of each party to consummate the Offer and the Merger is subject to the satisfaction or waiver of customary closing conditions set forth in the Merger Agreement, including (i) at least a majority of the outstanding shares of the Company’s common stock, when added to shares of the Company’s common stock already owned by the Offeror, having been validly tendered into (and not withdrawn from) the Offer prior to the expiration date of the Offer (Minimum Condition), (ii) the exchange of shares of Cavium Common Stock pursuant to the Offer and the Merger having been registered pursuant to a registration statement filed by Cavium with the Securities and Exchange Commission (SEC) and declared effective by the SEC, (iii) shares of Cavium Common Stock issuable pursuant to the Offer and the Merger having been authorized for listing on Nasdaq, (iv) the expiration or termination of any applicable regulatory waiting periods and/or receipt of regulatory clearance, (v) the absence of any order or ruling prohibiting the consummation of the Merger, and (vi) subject to certain exceptions, the accuracy of the other party’s representations and warranties and compliance with covenants. In addition, the obligation of Cavium and the Offeror to consummate the Merger is also subject to the satisfaction or waiver of the condition that no material adverse effect on the Company shall have occurred since the date of the Merger Agreement. Cavium’s and the Company’s obligations are not subject to any financing condition.

The Merger Agreement contains certain termination rights for each of the Company and Cavium, including, among others, if the Offer is not consummated at or prior to 11:59 p.m. EST on November 12, 2016. Upon termination of the Merger Agreement under specified circumstances, including a termination by the Company to enter into an agreement for an alternative transaction pursuant to a “superior proposal,” the Company has agreed to pay Cavium a termination fee of $47.8 million.

The Company expects the transaction to be completed in the second quarter of fiscal 2017.

First Quarter Financial Highlights

A summary of our financial performance during the first quarter of fiscal 2017 is as follows:

 

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Results of Operations

Net Revenues

A summary of our net revenues by product category is as follows:

 

Historically, the global marketplace for server and storage connectivity solutions has expanded in response to the information requirements of enterprise, managed service provider and cloud service provider data centers, along with other environments dependent on high performance, reliable data networking. The markets we serve have been characterized by rapid advances in technology and related product performance, which has generally resulted in declining average selling prices for existing products over time.

The market for our Fibre Channel products is mature and has declined during recent periods. The lack of growth in the Fibre Channel market may be the result of a shift in the information technology (IT) data center deployment model, as more enterprise workloads are moving to cloud data centers, which primarily use Ethernet solutions as their connectivity protocol. To the extent the Fibre Channel market declines, our quarterly operating results would be negatively impacted. In addition, some of our customers may purchase products strategically in advance of demand to take advantage of favorable pricing or to mitigate risks around product availability. As a result of these and other factors, it is extremely difficult for us to forecast future sales levels and historical information may not be indicative of future trends.

Net revenues of $116.4 million for the three months ended July 3, 2016 increased 3% from $113.4 million for the three months ended June 28, 2015. The increase in net revenues was the result of a $6.1 million, or 6%, increase in revenue from Advanced Connectivity Platforms, partially offset by a $3.1 million, or 28%, decrease in revenue from Legacy Connectivity Products. The increase in revenue from Advanced Connectivity Platforms was primarily due to an increase in adapter units sold.  The decrease in revenue from Legacy Connectivity Products was primarily due to a decrease in the units sold.  We expect net revenue from our Legacy Connectivity Products to continue to decline over time. As part of the restructuring plan we implemented in June 2013, we ceased development of future ASICs for switch products; however, we will continue to sell and support products based on the current generation switch ASICs.

A small number of our customers account for a substantial portion of our net revenues, and we expect that a small number of customers will continue to represent a substantial portion of our net revenues for the foreseeable future. Our top ten customers accounted for 85% and 82% of net revenues during the three months ended July 3, 2016 and June 28, 2015, respectively.

We believe our major customers continually evaluate whether or not to purchase products from alternative or additional sources. Accordingly, there can be no assurance that a major customer will not reduce, delay or eliminate its purchases from us. Any such reduction, delay or loss of purchases could have a material adverse effect on our business, financial condition or results of operations.

 

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Net revenues by geographic area are as follows:

 

 

Revenues by geographic area are presented based upon the ship-to location of the customer, which is not necessarily indicative of the location of the ultimate end-user of our products. The United States, China and Singapore are the only countries that represented 10% or more of net revenues during the three months ended July 3, 2016.  Net revenues from customers in China and Singapore were $21.4 million and $12.7 million, respectively, during the three months ended July 3, 2016.  The United States, China and Hong Kong are the only countries that represented 10% or more of net revenues during the three months ended June 28, 2015, respectively.  Net revenues from customers in China and Hong Kong were $23.8 million and $11.7 million, respectively, during the three months ended June 28, 2015.

Gross Profit

Gross profit represents net revenues less cost of revenues.  Cost of revenues consists primarily of the cost of purchased products, assembly and test services; costs associated with product procurement, inventory management, logistics and product quality; and the amortization of purchased intangible assets and other assets.  A summary of our gross profit and related percentage of net revenues is as follows:

 

 

Gross profit for the three months ended July 3, 2016 increased $1.8 million, or 3%, from gross profit for the three months ended June 28, 2015 and was consistent as a percentage of revenue compared to the prior period.  The increase in gross profit was primarily due to an increase in net revenues.

Our ability to maintain our current gross profit percentage may be significantly affected by factors such as the mix of products shipped, manufacturing volumes over which fixed costs are absorbed, sales discounts and customer incentives, component costs, the transition to new products, competitive price pressures, the timeliness of volume shipments of new products, our ability to achieve manufacturing cost reductions, and amortization and impairments of purchased intangible assets and other assets. We anticipate that it will continue to be difficult to reduce manufacturing costs. As a result of these and other factors, our gross profit percentage may vary over time and could decline in future periods.

 

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Operating Expenses

Our operating expenses are summarized in the following table:

 

 

Engineering and Development. Engineering and development expenses consist primarily of compensation and related employee benefit costs, outside service and material costs, occupancy and equipment costs and related computer support costs. During the three months ended July 3, 2016, engineering and development expenses decreased 14% to $30.6 million from $35.6 million for the three months ended June 28, 2015. The decrease was primarily due to a $1.7 million decrease in equipment depreciation and maintenance costs and a $1.5 million decrease in cash compensation and related employee benefit costs, principally due to cost savings achieved as a result of our restructuring plans.

We believe continued investments in engineering and development activities are critical to achieving future design wins, expansion of our customer base and revenue growth opportunities.

Sales and Marketing. Sales and marketing expenses consist primarily of compensation and related employee benefit costs, sales commissions, promotional activities and travel for sales and marketing personnel. Sales and marketing expenses decreased 13% to $13.5 million for the three months ended July 3, 2016 from $15.5 million for the three months ended June 28, 2015.  The decrease was primarily due to a decrease in cash compensation and related employee benefit costs, principally due to cost savings achieved as a result of our restructuring plans.  

General and Administrative. General and administrative expenses consist primarily of compensation and related employee benefit costs for executive, finance, accounting, human resources, legal and information technology personnel. Non-compensation components of general and administrative expenses include accounting, legal and other professional fees, facilities expenses and other corporate expenses. General and administrative expenses increased to $9.6 million for the three months ended July 3, 2016 from $7.0 million for the three months ended June 28, 2015. The increase was primarily due to transaction related costs in connection with the pending acquisition by Cavium.  

Special Charges. During the three months ended July 3, 2016 and June 28, 2015, we recorded special charges of $(0.6) million and $1.1 million, respectively, consisting entirely of exit costs.

Exit costs incurred during the three months ended July 3, 2016 are comprised primarily of the reversal of a previously-established lease obligation for a facility that we ceased using in fiscal 2016.  Such adjustment was the result of the termination of the lease and settlement of the associated lease obligation.  Exit costs incurred during the three months ended June 28, 2015 are comprised of severance and related costs associated with involuntarily terminated employees. Certain employees that were notified of their termination are required to provide future services for varying periods in excess of statutory notice periods. Severance costs related to these services are recognized ratably over the estimated requisite service period.  We expect to incur less than $1 million of additional severance costs for these employees over the remaining requisite service period.

The total unpaid exit costs of $6.5 million as of July 3, 2016 are expected to be paid over the terms of the related agreements through fiscal 2019, including $3.1 million during the next twelve months.

 

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Income Taxes

Our income tax expense (benefit) was $(1.0) million and $4.9 million for the three months ended July 3, 2016 and June 28, 2015, respectively.  Income tax benefit for the three months ended July 3, 2016 was favorably impacted by the resolution of tax examinations for prior years.  Income tax expense for the three months ended July 28, 2015 was impacted by the negative effect of a discrete tax-related item associated with the difference between stock-based compensation expense and the deduction related to stock-based awards on income tax returns.  Our income tax expense is based on the estimated income for the year, the composition of the estimated income in different tax jurisdictions, and the tax effect, if any, of newly enacted tax legislation, resolution of tax audits, changes in uncertain tax positions, and other discrete tax-related items during the applicable quarterly periods.

Considering the global scope of our operations and the complexity of global tax and transfer pricing rules and regulations, it is difficult to estimate earnings within each tax jurisdiction. If actual earnings within each tax jurisdiction differ materially from our estimates, we may not achieve our expected effective tax rate. Additionally, our effective tax rate may be impacted by other items, including the tax effects of acquisitions and dispositions, changes to tax laws or regulations, examinations by tax authorities, stock-based compensation, uncertain tax positions and changes in our ability to realize deferred tax assets.  While we believe that our provision for income taxes is appropriate, there can be no assurance that the effect of any of these or other items will not have a material impact on our consolidated financial statements.  In December 2015, a final decision was entered by the U.S. Tax Court in Altera Corp. v. Commissioner related to the treatment of stock-based compensation in intercompany cost-sharing agreements. On June 27, 2016, the Internal Revenue Service filed an appeal to this decision in the U.S. Court of Appeals for the Ninth Circuit. At this time, the U.S. Department of the Treasury has not withdrawn the requirement from its regulations to include stock-based compensation in intercompany cost-sharing arrangements. Due to the uncertainty surrounding the status of the current regulations, questions related to the scope of potential benefits, and the risk of the Tax Court’s decision being overturned upon appeal, we have concluded that no adjustment to our condensed consolidated financial statements is appropriate as of July 3, 2016. We will continue to monitor ongoing developments and potential impacts to our consolidated financial statements.

Liquidity and Capital Resources

Our combined balances of cash, cash equivalents and marketable securities increased to $365.3 million as of July 3, 2016 from $354.8 million as of April 3, 2016. As of July 3, 2016 and April 3, 2016, our international subsidiaries held $296.8 million and $302.3 million, respectively, of our total cash, cash equivalents and marketable securities. These holdings by our international subsidiaries consisted primarily of debt securities due from U.S. issuers, including the U.S. government and related agencies, and U.S. dollar denominated cash and money market funds. Certain foreign regulations could impact our ability to transfer funds to the United States. We currently intend to invest the funds held outside of the United States in our international operations and, as a result, do not intend to repatriate these funds. Should we decide to repatriate funds held outside of the United States, we may incur a significant tax obligation.

We believe that existing cash, cash equivalents, marketable securities and expected cash flow from operations will provide sufficient funds to finance our operations for at least the next twelve months. However, it is possible that we may need to supplement our existing sources of liquidity to finance our activities beyond the next twelve months or for the future acquisition of businesses, products or technologies and there can be no assurance that sources of liquidity will be available to us at that time.

Revolving Credit Facility

We have a credit agreement that provides us with a $125 million unsecured revolving credit facility that matures in March 2018. Borrowings under the credit agreement may be used for general corporate purposes, including permitted share repurchases and acquisitions. Under the credit agreement, we may increase the revolving commitments or obtain incremental term loans in an aggregate amount up to $100 million, subject to certain conditions. There were no borrowings outstanding under the credit agreement as of July 3, 2016.

Operating, Investing and Financing Activities

Cash provided by operating activities increased to $17.7 million for the three months ended July 3, 2016 from $9.5 million for the three months ended June 28, 2015. Operating cash flow for the three months ended July 3, 2016 consisted of our net income of $18.3 million and net non-cash expenses of $13.2 million, partially offset by net cash used as a result of changes in operating assets and liabilities of $13.8 million. Net non-cash expenses consisted primarily of $10.0 million of depreciation and amortization and $5.2 million of stock-based compensation.  The changes in operating assets and liabilities during this period consisted primarily of an $18.9 million increase in accounts receivable, partially offset by a $6.8 million increase in accounts payable.  The increase in accounts receivable was primarily due to the timing and mix of customer shipments.  The increase in accounts payable was primarily due to the timing of payment obligations.  

 

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Operating cash flow for the three months ended June 28, 2015 consisted of our net income of $2.6 million and net non-cash expenses of $20.5 million, partially offset by net cash used as a result of changes in operating assets and liabilities of $13.6 million. Net non-cash expenses consisted primarily of $10.6 million of depreciation and amortization and $6.0 million of stock-based compensation. The changes in operating assets and liabilities consisted primarily of an $8.7 million increase in inventory and a $4.9 million decrease in accrued compensation. The increase in inventory was primarily due to product purchases in connection with our transition away from one of our contract manufacturers and in support of anticipated future customer demand, as well as changes in our product fulfillment model. The decrease in accrued compensation was primarily due to the timing of payment obligations.

Cash used in investing activities was $22.5 million for the three months ended July 3, 2016 and consisted primarily of $16.0 million of net purchases of available-for-sale securities and $7.8 million of purchases of property and equipment.  During the three months ended June 28, 2015, cash used in investing activities was $27.2 million and consisted of $16.4 million of net purchases of available-for-sale securities and $10.8 million of purchases of property and equipment.

We expect capital expenditures to remain significant in the future as we continue to invest in more costly engineering and production tools for new technologies and machinery and equipment.

Cash used in financing activities was $1.0 million for the three months ended July 3, 2016 and consisted primarily of $4.1 million for minimum tax withholdings paid on behalf of employees for restricted stock units that vested during the period, partially offset by $2.6 million of proceeds from the issuance of common stock under stock-based awards.  During the three months ended June 28, 2015, cash used in financing activities was $5.3 and consisted primarily of our purchase of $17.9 million of common stock under our stock repurchase program and $5.1 million for minimum tax withholdings paid on behalf of employees for restricted stock units that vested during the period, partially offset by $16.5 million of proceeds from the issuance of common stock under stock-based awards.

Since fiscal 2003, our Board of Directors has authorized various programs to purchase shares of our outstanding common stock.  In November 2015, our Board of Directors approved a program authorizing the purchase of up to $125 million of our outstanding common stock over a period of up to two years from the date of the initial purchase under the new program.  No shares have been purchased under this program as of July 3, 2016.

Contractual Obligations and Commitments

We have certain contractual obligations and commitments to make future payments in the form of non-cancelable purchase orders to our suppliers and commitments under operating lease arrangements. A summary of our contractual obligations as of July 3, 2016, and their impact on our cash flows in future fiscal years, is as follows:

 

 

Our liability for unrecognized tax benefits, including related accrued interest and penalties, was $8.5 million as of July 3, 2016. We are not able to provide a reasonable estimate of the timing of future tax payments related to these obligations.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenues and expenses during the reporting period. We base our estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances, including the current economic environment, in making judgments about the carrying values of assets and liabilities.

For a description of the accounting policies that we believe to be our most critical accounting policies and estimates, see Critical Accounting Policies and Estimates included in Part II, Item 7 of our Annual Report on Form 10-K for the year ended April 3, 2016. There have been no material changes in any of our critical accounting policies and estimates during the three months ended July 3, 2016. These accounting policies are significantly affected by judgments, assumptions and estimates used in the preparation of the financial statements and actual results could differ materially from the amounts reported based on these policies.

 

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Recently Issued Accounting Standards Not Yet Effective

In May 2014, the Financial Accounting Standards Board (FASB) issued an accounting standard update that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This standard will replace most existing revenue recognition guidance when it becomes effective. In July 2015, the FASB amended this standard to defer the effective date by one year and permit early adoption as of the original effective date. This amended standard is effective for us in the first quarter of fiscal 2019. This standard permits the use of either the retrospective or cumulative effect transition method. We are currently evaluating the effect this new guidance will have on our consolidated financial statements and related disclosures, and have not yet selected a transition method.

In February 2016, the FASB issued an accounting standard update that replaces existing lease guidance and requires, among other things, on-balance sheet recognition by lessees for operating leases greater than 12 months. It also changes the definition of a lease and expands the disclosure requirements of lease arrangements. This standard is effective for us in the first quarter of fiscal 2020, with early adoption permitted. This standard requires adoption using a modified retrospective approach and provides for certain practical expedients. We are currently evaluating the effect this new guidance will have on our consolidated financial statements.

In March 2016, the FASB issued an accounting standard update that revises the accounting for share-based payment transactions, including the accounting for income taxes, forfeitures and statutory tax withholding requirements, as well as classification in the statement of cash flows. This standard is effective for us in the first quarter of fiscal 2018, with early adoption permitted.  We are currently evaluating the effect this new guidance will have on our consolidated financial statements.

In June 2016, the FASB issued an accounting standard update that changes the accounting for recognizing impairments of financial assets. This standard requires that credit losses for certain types of financial instruments be estimated based on expected losses. This standard also modifies the impairment models for available-for-sale debt securities. This standard is effective for us in the first quarter of fiscal 2021, with early adoption permitted. We are currently evaluating the effect this new guidance will have on our consolidated financial statements.

Off-Balance Sheet Arrangements

During the periods presented, we did not have any off-balance sheet arrangements other than operating leases.

 

Our cash and cash equivalents are not subject to significant interest rate risk due to the short maturities of these instruments. As of July 3, 2016, the carrying value of our cash and cash equivalents approximates fair value.

We maintain a portfolio of marketable securities consisting primarily of U.S. government and agency securities, corporate debt obligations and mortgage-backed securities, the majority of which have remaining terms of three years or less. We are exposed to fluctuations in interest rates as movements in interest rates can result in changes in the market value of our investments in debt securities. However, due to the short-term expected duration of our portfolio of marketable securities, we do not believe that we are subject to material interest rate risk.

In accordance with our investment guidelines, we only invest in instruments with high credit quality ratings and we limit our exposure to any one issuer or type of investment. Our portfolio of marketable securities as of July 3, 2016 consists of $245.7 million of securities that are classified as available-for-sale. As of July 3, 2016, we had gross unrealized losses associated with our available-for-sale securities of $0.1 million that were determined by management to be temporary in nature.

We do not use derivative financial instruments.

 

 

We maintain disclosure controls and procedures to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934, as amended, (i) is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and (ii) is accumulated and communicated to our management, including our principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.

 

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Our management evaluated, with the participation of our principal executive officer and principal financial officer, the effectiveness of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on this evaluation, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures were effective at a reasonable assurance level as of July 3, 2016. There was no change in our internal control over financial reporting during our quarter ended July 3, 2016 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

 

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PART II.

OTHER INFORMATION

On September 28, 2015, a purported class action was commenced in the U.S. District Court for the Central District of California asserting claims arising under federal securities laws against the Company and certain individual defendants.  The plaintiff, Phyllis Hull, purported to represent a class of persons who purchased the Company’s common stock between April 30, 2015 and July 30, 2015.  The plaintiff alleged that the defendants, including a former officer and a current officer, engaged in a scheme to inflate the Company’s stock price by making false and misleading statements regarding the Company’s operations, financial results and future business prospects in violation of federal securities laws.  The plaintiff sought compensatory damages, interest and an award of reasonable attorneys’ fees and costs.  On March 4, 2016, the parties filed a Joint Stipulation with the Court to voluntarily dismiss the case. On March 7, 2016, the Court dismissed the case with prejudice as to Phyllis Hull and her individual claims and without prejudice as to the unnamed class members.

On October 23, 2015, Stephen Kramer filed a shareholder derivative complaint in the California Superior Court in and for the County of Orange County purportedly on behalf of the Company against certain current and former officers and directors of the Company.  The plaintiff alleged breaches of fiduciary duty, unjust enrichment, corporate waste, aiding and abetting breaches of fiduciary duty, and improper insider sales of stock in violation of California law based on the allegation that, since October 17, 2014, the individual defendants engaged in a scheme to inflate the Company’s stock price by making false and misleading statements regarding the Company’s operations, financial results, internal controls and future business prospects.  The plaintiff sought an award of damages and restitution to the Company from the individual defendants, disgorgement of the individual defendants’ profits and compensation, an order requiring the Company to reform and improve its corporate governance, and an award of costs and attorneys’ fees to the plaintiff and its counsel.  On March 14, 2016, a second shareholder derivative complaint was filed in the same Court. The plaintiff in the second suit, Indiana Laborers Pension and Welfare Funds, made similar allegations against certain current and former officers and directors of the Company and sought similar demands.  On June 8, 2016, the parties in both cases filed Joint Stipulations with the Court to voluntarily dismiss the respective cases. On June 13, 2016, the Court dismissed the second shareholder derivative suit without prejudice as to Indiana Laborers Pension and Welfare Funds and on June 14, 2016 the Court dismissed the first shareholder derivative suit without prejudice as to Stephen Kramer.

On July 22, 2016, a putative securities class action was commenced in the U.S. District Court for the Central District of California asserting claims arising under federal securities laws against the Company and certain defendants, including the directors and an officer. The plaintiff, Stephen Bushansky, purports to represent the public stockholders of the Company.  The plaintiff alleges that the proposed acquisition of QLogic Corporation by Cavium pursuant to the Merger Agreement (the Proposed Transaction), is the result of an unfair process and coercive deal-protection devices and provides the Company’s stockholders with inadequate consideration. The plaintiff further alleges that the Company’s Solicitation/Recommendation Statement on Schedule 14D-9, filed with the Securities and Exchange Commission on July 13, 2016, omits or misrepresents material information concerning the Proposed Transaction in violation of federal securities laws.  The plaintiff seeks class certification, an injunction enjoining the Proposed Transaction, a declaration that the defendants violated certain federal securities laws, compensatory damages, and reasonable attorney’s fees and costs.

Because the lawsuit is in its early stages, it is not possible to determine the potential outcome of the lawsuit or to make any estimate of probable losses at this time.  The Company believes that the claims asserted in the lawsuit are without merit and intends to defend its position.  A negative outcome in the lawsuit could have a material adverse effect on the Company if it results in preliminary or permanent injunctive relief or rescission of the Merger Agreement.  The Company currently believes the disposition of this matter will not have a material adverse effect on the Company’s financial condition or results of operations.

Various other lawsuits, claims and proceedings have been or may be instituted against the Company. The outcome of litigation cannot be predicted with certainty and some lawsuits, claims and proceedings may be disposed of unfavorably to the Company. Many intellectual property disputes have a risk of injunctive relief and there can be no assurance that a license will be granted. Injunctive relief could have a material adverse effect on the Company’s financial condition or results of operations.  Based on an evaluation of such other matters that are pending or asserted, management believes the disposition of such matters will not have a material adverse effect on the Company’s financial condition or results of operations.

 

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We have updated the risk factors discussed in Item 1A of our Annual Report on Form 10-K for the year ended April 3, 2016, as set forth below. Except for the addition of risk factors below regarding our pending acquisition by Cavium, Inc., we do not believe any of the updates constitute material changes from the risk factors previously discussed in our Annual Report on Form 10-K for the year ended April 3, 2016.

The announcement and pendency of our agreement to be acquired by Cavium may have an adverse effect on our business, operating results and our stock price.

On June 15, 2016, we entered into the Merger Agreement with Cavium.  Our announcement of having entered into the Merger Agreement and Cavium’s and Sub’s commencement of the Offer could cause a material disruption to our business.  Additionally, we are subject to additional risks in connection with the announcement and pendency of the Offer and the Merger, including, but not limited to, the following:

Since a portion of the Offer Consideration consists of Cavium common stock, our stock price will be adversely affected by a decline in Cavium’s stock price and any adverse developments in Cavium’s business. Changes in Cavium’s stock price and business may result from a variety of factors, including changes in its business operations and changes in general market and economic conditions. These factors are beyond our control.

The failure of the Offer and the Merger to be completed may adversely affect our business and our stock price.

Cavium’s and Sub’s obligation to accept for exchange, and to exchange, shares of our common stock for the Offer Consideration in the Offer is subject to a number of conditions, including (i) at least a majority of the outstanding shares of our common stock, when added to shares of our common stock already owned by Sub, having been validly tendered into (and not withdrawn from) the Offer prior to the expiration date of the Offer, (ii) the exchange of shares of Cavium common stock pursuant to the Offer and the Merger having been registered pursuant to a registration statement filed by Cavium with the Securities and Exchange

 

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Commission (SEC) and declared effective by the SEC, (iii) shares of Cavium common stock issuable pursuant to the Offer and the Merger having been authorized for listing on Nasdaq, (iv) the expiration or termination of any applicable regulatory waiting periods and/or receipt of regulatory clearance, (v) the absence of any order or ruling prohibiting the consummation of the Merger, and (vi) subject to certain exceptions, the accuracy of the other party’s representations and warranties and compliance with covenants. In addition, the obligation of Cavium and Sub to consummate the Offer and the Merger is also subject to the satisfaction or waiver of the condition that no material adverse effect on the Company shall have occurred since the date of the Merger Agreement.  There can be no assurance that these conditions to the completion of the Offer will be satisfied, or that the Merger will be completed on the proposed terms, within the expected timeframe or at all.  In addition, other factors, such as Cavium’s ability to obtain the debt financing it needs to consummate the Merger, may affect when and whether the Merger will occur.  If the Offer and the Merger are not completed, our stock price could fall to the extent that our current stock price reflects an assumption that the Offer and the Merger will be completed.  Furthermore, if the Offer and the Merger are not completed, we may suffer other consequences that could adversely affect our business, results of operations and stock price, including the following:

The Merger Agreement with Cavium limits our ability to pursue alternative transactions, and in certain instances requires payment of a termination fee, which could deter a third party from proposing an alternative transaction.

The Merger Agreement contains provisions that, subject to certain exceptions, limit our ability to initiate, solicit or knowingly take any action to facilitate or encourage, or participate or engage in any negotiations, inquiries or discussions with respect to an alternative transaction. In addition, under specified circumstances in which the Merger Agreement is terminated, we could be required to pay a termination fee of $47.8 million. It is possible that these or other provisions in the Merger Agreement might discourage a potential competing acquirer that might have an interest in acquiring all or a significant part of our company from considering or proposing an acquisition or might result in a potential competing acquirer proposing to pay a lower per share price to acquire our common stock than it might otherwise have proposed to pay.

Litigation challenging the Merger Agreement may prevent the Merger from being consummated at all or within the expected timeframe and may result in substantial costs to us.

A class-action lawsuit has been filed against us, our Board of Directors and other parties to the Merger Agreement, challenging our acquisition by Cavium.  This lawsuit brought by a purported stockholder of QLogic Corporation seeks, among other things, to enjoin consummation of the Merger. One of the conditions to the consummation of the Merger is that no governmental entity having jurisdiction over us, Cavium, or any of the other parties to the Merger Agreement shall have issued an order, decree or ruling or taken any other material action enjoining or otherwise prohibiting consummation of the Merger substantially on the terms contemplated by the Merger Agreement.  As such, if the plaintiff is successful in his effort, then our acquisition by Cavium may not be consummated at all or within the expected timeframe.

Our operating results may fluctuate in future periods, which could cause our stock price to decline.

We have experienced, are currently experiencing, and expect to experience in future periods, fluctuations in sales and operating results from quarter to quarter. For example, the market for our Fibre Channel products is mature and has declined during recent periods. The lack of growth in the Fibre Channel market may be the result of a shift in the information technology (IT) data center deployment model, as more enterprise workloads are moving to cloud data centers, which primarily use Ethernet solutions as their connectivity protocol.  To the extent the Fibre Channel market declines, our quarterly operating results would be negatively impacted.

We have made, and continue to make, significant investments in the development and sale of our Ethernet products. The market for our Ethernet products is highly competitive. Some of our competitors are large, well-established companies that have significant

 

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competitive advantages over us. To the extent that we are unable to effectively compete in this market, our quarterly operating results would be negatively impacted.

A significant portion of our net revenues in each fiscal quarter results from orders booked in that quarter. Orders placed by major customers are typically based on their forecasted sales and inventory levels for our products. Accordingly, it is extremely difficult for us to forecast future sales levels and historical information may not be indicative of future trends. In addition, there can be no assurance that we will maintain our current gross margins or profitability in the future.

Fluctuations in our quarterly operating results may also be the result of:

In addition, our quarterly results of operations are influenced by competitive factors, including the pricing and availability of our products and our competitors’ products. Furthermore, communications regarding new products and technologies could cause our customers to defer or cancel purchases of our products. Order deferrals by our customers, delays in our introduction of new products, and longer than anticipated design-in cycles for our products have in the past adversely affected our quarterly results of operations. Due to these factors, as well as other unanticipated factors, it is likely that in some future quarter or quarters our operating results will be below the expectations of public market analysts or investors, and as a result, the price of our common stock could significantly decrease.

Competition within the markets for products such as ours is intense and includes various established competitors.

The markets for networking connectivity products are highly competitive and characterized by short product life cycles, price erosion, rapidly changing technology, frequent product performance improvements and evolving industry standards. Due to the diversity of products required in storage, data and converged networking, we compete with many companies. In the traditional enterprise storage Fibre Channel adapter and ASIC markets, our primary competitor is Broadcom Limited (formerly known as Avago Technologies Limited), who acquired our former long-time competitor Emulex Corporation (Emulex) in May 2015. In the high-speed Ethernet adapter and ASIC markets, which include converged networking products such as Fibre Channel over Ethernet (FCoE) and

 

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Internet Small Computer Systems Interface (iSCSI), we compete primarily with Broadcom Limited, Mellanox Technologies, Ltd. and Intel Corporation (Intel). We may also compete with some of our server and storage systems customers, some of which have the capability to develop products comparable to those we offer.

Some of our competitors, including Broadcom Limited and Intel, have significantly more engineering, sales and marketing resources than us to dedicate to developing and penetrating markets, offer a much broader portfolio of products to customers, and have cost advantages over us due to their vertical integration and greater scale of operations. Should these companies successfully leverage these competitive advantages, our business could significantly deteriorate and our results of operations would be materially and adversely affected.

As noted above, Broadcom Limited acquired Emulex in May 2015 and, as a result, Broadcom Limited is a competitor in both the Fibre Channel and Ethernet markets. In February 2016, Avago Technologies Limited (now known as Broadcom Limited) acquired Broadcom Corporation, which was our primary supplier of Ethernet ASICs. Broadcom Limited is our primary Fibre Channel ASIC supplier and is now our primary Ethernet ASIC supplier. We have long-term supply contracts in place that we believe safeguard our supply of Fibre Channel and Ethernet ASICs. Should this supplier fail to adhere to the terms of our supply contracts and if the remedies in the contracts fail to adequately protect us, our supply of Fibre Channel and Ethernet ASICs could be at risk or more costly, and our business and results of operations could be materially and adversely affected.

We need to continue to develop products appropriate to our markets to remain competitive as our competitors continue to introduce products with improved features. While we continue to devote significant resources to engineering and development, these efforts may not be successful or competitive products may not be developed and introduced in a timely manner. If we are unable to design, develop or introduce competitive new products on a timely basis, or if our competitors introduce new products that are more successful than ours in the marketplace, our future operating results may be materially and adversely affected.

Our operating results have been, are being, and may in the future be, adversely affected by unfavorable economic conditions.

Certain countries around the world, including but not limited to China, have experienced and are continuing to experience economic weakness and uncertainty. Political instability in certain regions of the world is significantly contributing to this economic uncertainty. Economic uncertainty is adversely affecting, and in the future may continue to adversely affect, IT spending rates. For example, certain of our large OEM customers are reporting significant weakness in particular markets and geographies. Reductions in IT spending rates have resulted in reduced sales volumes, and could result in lower prices for our products, longer sales cycles, increased inventory provisions and increased production costs, all of which could negatively impact our results of operations.

As a result of worldwide economic weakness and uncertainty, it is extremely difficult for us and our customers to forecast future revenue levels based on historical information and trends. To the extent that we do not achieve our anticipated level of revenue, our operating results could be adversely affected.

If we are unable to attract and retain key personnel, we may not be able to sustain or grow our business.

Our future success largely depends on our key engineering, sales, marketing and executive personnel, including highly skilled ASIC design personnel and software developers. Our Chief Executive Officer resigned in August 2015 and we appointed Jean Hu as Acting Chief Executive Officer and Christine King as Executive Chairman. It is important that we retain key personnel. If we lose the services of key personnel, or do not hire or retain other personnel for key positions, our business could be adversely affected.

We believe that the market for key personnel in the industries in which we compete is highly competitive. In particular, we have periodically experienced difficulty in attracting and retaining qualified engineers and other technical personnel and anticipate that competition for such personnel will increase in the future. As a result, we may not be able to attract and retain key personnel with the skills and expertise necessary to develop new products in the future or to manage our business, both in the United States and abroad.

We have historically used equity awards and our employee stock purchase program as key components of our total employee compensation program in order to align employees’ interests with the interests of our stockholders, encourage retention of key personnel, and provide competitive compensation packages. However, the guidelines of proxy advisory firms relating to stockholder approval of shares available under equity compensation plans and share usage could make it more difficult for us to obtain such approval and therefore grant stock-based awards to employees in the future, which may result in changes in our stock-based compensation strategy. These and other developments relating to the provision of stock-based compensation to employees could make it more difficult to attract, retain and motivate key personnel.

 

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We expect gross margin to vary over time primarily due to product mix.

Our gross margin is expected to vary over time primarily due to product mix, including the mix of Fibre Channel and Ethernet product sales. Our gross margins may also be adversely affected by numerous factors, including:

A decrease in our gross margin could adversely affect the market price of our common stock.

Our stock price may be volatile.

The market price of our common stock has fluctuated substantially and there can be no assurance that such volatility will not continue. Several factors could impact our stock price, including:

In addition, stock markets have experienced extreme price and volume volatility in recent years and stock prices of technology companies have been especially volatile. This volatility has had a substantial effect on the market prices of securities of many public companies for reasons frequently unrelated to the operating performance of the specific companies. These broad market fluctuations could adversely affect the market price of our common stock, which could have a material adverse impact on investor confidence and employee retention.

 

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Our business is dependent, in large part, on the continued growth of the networking markets that we serve and if these markets do not continue to develop, our business will suffer.

Our products are used in storage, data and converged networks, and therefore our business is dependent on these markets. Our success in generating revenue in these markets will depend on, among other things, our ability to:

If we are not successful in any or all of these items, our business and results of operations could be materially and adversely affected.

We depend on a small number of customers and any decrease in revenues from any one of our major customers could adversely affect our results of operations and cause our stock price to decline.

A small number of customers account for a substantial portion of our net revenues, and we expect that a small number of customers will continue to represent a substantial portion of our net revenues for the foreseeable future. Our top ten customers accounted for 85% and 82% of net revenues for the three months ended July 3, 2016 and June 28, 2015, respectively. Total revenue from our three largest customers, Hewlett Packard Enterprise Company, Dell Inc. (Dell) and Lenovo Group Ltd. (Lenovo), collectively accounted for more than 50% of net revenues for the three months ended July 3, 2016. Total revenue from our three largest customers, Hewlett-Packard Company, Dell and Lenovo, collectively accounted for more than 50% of net revenues for the three months ended June 28, 2015. In November 2015, Hewlett-Packard Company separated itself into two new public companies, HP Inc. and Hewlett Packard Enterprise Company. 

A significant portion of the products we sell are incorporated into servers manufactured by our major customers for use in enterprise environments. Certain of our large OEM customers are reporting weakness in this market. If server sales by our major customers continue to be adversely affected by the IT spending environment or server market factors (such as an acceleration in the shift from servers used in enterprise environments to servers used in cloud environments), demand for our products could decrease further, which could have a material adverse effect on our business, financial condition or results of operations.

Our customers generally order products through written purchase orders instead of long-term supply contracts and, therefore, are generally not obligated to purchase products from us for any extended period. Customers typically incorporate our products into complex devices and systems, which creates supply chain cross-dependencies. Accordingly, supply chain disruptions affecting components of our customers’ devices and/or systems could negatively impact the demand for our products, even if the supply of our products is not directly affected. Major customers also have significant leverage over us and may attempt to change the sales terms, including pricing, customer incentives and payment terms, or insist that we undertake or fund significant aspects of the design, qualification and testing that our customers have typically been responsible for, either of which could have a material adverse effect on our business, financial condition or results of operations. As our customers are pressured to reduce prices as a result of competitive factors, we may be required to contractually commit to price reductions for our products before we know how, or if, cost reductions can be achieved. If we are unable to achieve these cost reductions, our gross margins could decline and such a decline could have a material adverse effect on our business, financial condition or results of operations.

The ongoing consolidation in the technology industry could adversely impact our business. There is the potential for some of our customers to merge with or acquire one or more of our other customers. For example, Dell is in the process of completing the acquisition of EMC Corporation. There is also a possibility that one of our large customers could acquire one of our current competitors. As a result of such transactions, demand for our products could decrease, which could have a material adverse effect on our business, financial condition or results of operations.

 

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Our financial condition will be materially harmed if we do not maintain and gain market acceptance of our products.

The markets in which we compete involve rapidly changing technologies, evolving industry standards and continuing improvements in products and services. Examples of these changing technologies include system-on-chip products and both software-defined-networking and software-defined-storage products. Our future success depends, in part, on our ability to:

We believe that to remain competitive, we will need to continue to develop new products and enter new markets, which will require significant investment. Some new markets may require engagement with customers with whom we have limited or no prior experience. Our competitors may be developing alternative technologies, or entering into exclusive strategic alliances with our major customers, either of which may adversely affect the market acceptance of our products, our ability to enter new markets, or our ability to secure customer design wins. Although we continue to explore and develop products based on new technologies, a substantial portion of our revenues is generated today from Fibre Channel technology. If alternative technologies are adopted by the industry, we may not be able to develop products for these technologies in a timely manner. Further, even if alternative technologies do augment Fibre Channel revenues, our products may not be fully developed in time to be accepted by our customers. Even if our new products are developed in time, we may not be able to manufacture them at competitive prices or in sufficient volumes.

Some of our products are based on FCoE or high-speed Ethernet technologies. FCoE is a converged networking technology that provides a unified storage and data network over Enhanced Ethernet, while preserving the investment by end users in their existing Fibre Channel infrastructure and storage. High-speed Ethernet is a technology for use in enterprise, managed service provider and cloud service provider data centers. The market for high-speed Ethernet products includes well-established participants who have significantly more engineering, sales and marketing resources to dedicate to developing and penetrating the market than we do. An inability to maintain, or build on, our market share in the Fibre Channel, high-speed Ethernet or converged markets, or the failure of these markets to expand, could have a material adverse effect on our business or results of operations.

We are dependent on sole source and limited source suppliers for certain key components.

Certain key components used in the manufacture of our products are purchased from single or limited sources. ASICs are purchased from single sources. For example, in connection with our acquisition of certain 10/25/40/50/100Gb Ethernet controller-related assets, we entered into a development and supply agreement which requires us to purchase certain ASICs used in the related products exclusively from Broadcom Corporation. Other key components such as microprocessors, logic chips, power supplies and programmable logic devices are purchased from limited sources. If one of these suppliers experiences an interruption in its ability to supply our needs, or chooses to sever or significantly change its relationship with us, we may be unable to produce certain of our products, which could result in the loss of customers and have a material adverse effect on our results of operations.

Broadcom Limited, our primary Fibre Channel ASIC supplier, acquired Emulex in May 2015. Emulex had historically been our principal competitor in the Fibre Channel market. In February 2016, Avago Technologies Limited (now known as Broadcom Limited) acquired Broadcom Corporation, which was our primary supplier of Ethernet ASICs. We have long-term supply contracts in place that we believe safeguard our supply of Fibre Channel and Ethernet ASICs. Should our suppliers fail to adhere to the terms of our supply contracts and if the remedies in the contracts fail to adequately protect us, our supply of Fibre Channel and Ethernet ASICs could be at risk or more costly, and our business and results of operations could be materially and adversely affected.

We are dependent on worldwide third-party subcontractors and contract manufacturers.

Third-party subcontractors located outside the United States assemble and test certain products for us. To the extent that we rely on third-party subcontractors to perform these functions, we will not be able to directly control product delivery schedules and quality assurance. This lack of control may result in product shortages or quality assurance problems that could delay shipments of products or increase manufacturing, assembly, testing or other costs. If a subcontractor experiences capacity constraints or financial difficulties, suffers damage to its facilities, experiences power outages, natural disasters, labor shortages or labor strikes, or any other disruption of assembly or testing capacity, we may not be able to obtain alternative assembly and testing services in a timely manner or on commercially acceptable terms.

In addition, the loss of our largest third-party contract manufacturer could significantly impact our ability to produce products for an indefinite period of time. Qualifying a new contract manufacturer and commencing volume production is a lengthy and

 

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expensive process. Some customers will not purchase any products, other than a limited number of evaluation units, until they qualify the manufacturing line for the product. If we are required to change a contract manufacturer or if a contract manufacturer moves the production lines for our products to new locations, or otherwise experiences delays, disruptions, capacity constraints, component part shortages or quality control problems in its manufacturing operations, shipment of our products to our customers could be delayed, resulting in loss or postponement of revenues and potential harm to our competitive position and relationships with customers.

We may engage in mergers, acquisitions, divestitures and strategic investments and these activities could adversely affect our results of operations and stock price.

Our future growth may depend in part on our ability to identify and acquire businesses, technologies or product lines. Mergers and acquisitions involve numerous risks, including:

Further, we may never realize the perceived benefits of a business combination or divestiture. Acquisitions by us could negatively impact gross margins or dilute stockholders’ investment and cause us to incur debt, contingent liabilities and amortization/impairment charges related to intangible assets, all of which could materially and adversely affect our financial condition or results of operations. Divestitures involve risks, such as difficulty splitting up businesses, distracting employees, potential loss of revenue and negatively impacting margins, and potentially disrupting customer relationships. In addition, our effective tax rate for future periods could be negatively impacted by acquisitions or divestitures.

We have made, and could make in the future, investments in technology companies, including privately-held companies in a development stage. Many of these private equity investments are inherently risky because the companies’ businesses may never develop, and we may incur losses related to these investments. In addition, we may be required to write down the carrying value of these investments to reflect other-than-temporary declines in their value, which could have a material adverse effect on our financial condition and results of operations.

Our products are complex and may contain undetected software or hardware errors that could lead to an increase in our costs, reduce our net revenues or damage our reputation.

Our products are complex and may contain undetected software or hardware errors when first introduced or as newer versions are released. We are also exposed to risks associated with latent defects in existing products and to risks that components purchased from third-party subcontractors and incorporated into our products may not meet our specifications or may otherwise fail prematurely.

 

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From time to time, we have found errors in existing, new or enhanced products. In addition, our products are frequently combined with other products, including software, from other vendors, and these products often need to interface with existing networks, each of which have different specifications and utilize multiple protocol standards. As a result, when problems occur, it may be difficult to identify the source of the problems. The occurrence of hardware or software errors could adversely affect the sales of our products, cause us to incur significant warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems, any of which could materially and adversely affect our operating results.

We expect the pricing of our products to continue to decline, which could reduce our revenues, gross margins and profitability.

We expect the average unit prices of our products (on a like-for-like product comparison basis) to decline in the future as a result of competitive pricing pressures, increased sales discounts and customer incentives, new product introductions by us or our competitors, or other factors. In addition, the market opportunities we are pursuing in managed service provider and cloud service provider data centers are more price competitive than other markets we serve. If we are unable to offset these factors by increasing sales volumes or reducing product manufacturing costs, our total revenues and gross margins may decline. Moreover, most of our expenses are fixed in the short-term or incurred in advance of receipt of corresponding revenues. As a result, we may not be able to decrease our spending to offset any unexpected shortfall in revenues. If this occurs, our revenues, gross margins and profitability could decline.

The migration of our customers toward new products could adversely affect our results of operations.

As new or enhanced products are introduced, we must successfully manage the transition from older products in order to minimize the effects of product inventories that may become excess and obsolete, as well as ensure that sufficient supplies of new products can be delivered to meet customer demand. Our failure to manage the transition to newer products in the future or to develop and successfully introduce new products and product enhancements could adversely affect our business or results of operations. In addition, our customers are demanding a higher level of customization for new products, which prevents us from fully leveraging our product design work and adds to our new product development costs. When we introduce new products and product enhancements, we face additional risks relating to product transitions, including risks relating to forecasting demand and longer lead times associated with smaller product geometries and more complex production operations. Any such adverse event or increased costs could have a material adverse effect on our business, financial condition or results of operations.

Historically, the technology industry has developed higher performance ASICs, which create chip-level solutions that replace selected board-level or box-level solutions at a significantly lower average selling price. We have previously offered ASICs to customers for certain applications that have effectively resulted in a lower-priced solution when compared to an adapter solution. This transition to ASICs may also occur with respect to other current and future products. The result of this transition may have an adverse effect on our business, financial condition or results of operations. In the future, a similar adverse effect to our business could occur if there were rapid shifts in customer purchases from our midrange networking connectivity products to lower-cost products.

Sales and purchasing patterns with our customers and suppliers are uneven and subject to seasonal fluctuations.

A large percentage of our products are sold to customers who experience seasonality and uneven sales patterns in their own businesses. As a result, we experience similar seasonality and uneven sales and purchasing patterns with our customers and suppliers. We believe the variability in sales and purchasing patterns results from many factors, including:

This variability makes it extremely difficult to predict the demand and buying patterns of our customers and, in turn, causes challenges for us in sourcing goods and services from our suppliers, adjusting manufacturing capacity, and forecasting cash flow and working capital needs. If we predict demand that is substantially greater than actual customer orders, we will have excess inventory. Alternatively, if customer orders substantially exceed predicted demand, the ability to assemble, test and ship orders received in the last weeks and days of each quarter may be limited, or be completed at an increased cost, which could have a material adverse effect on our business, financial condition or results of operations.

 

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Unanticipated changes in our tax provisions or adverse outcomes resulting from examination of our income tax returns could adversely affect our results of operations.

We are subject to income taxes in the United States and various foreign jurisdictions. Our effective tax rate has been and could in the future be adversely affected by changes in tax laws or interpretations of those tax laws, by changes in the mix of earnings in countries with differing statutory tax rates, or by changes in the valuation of our deferred tax assets and liabilities. Our effective tax rate is also affected by intercompany transactions for licenses, services, funding and other items. Given the global scope of our operations, and the complexity of global tax and transfer pricing rules and regulations, it is difficult to estimate earnings within each tax jurisdiction. If actual earnings within a tax jurisdiction differ materially from our estimates, we may not achieve our expected effective tax rate.

Additionally, our effective tax rate may be impacted by the tax effects of acquisitions, dispositions, changes to tax laws or regulations, examinations by tax authorities, stock-based compensation, uncertain tax positions, and changes in our ability to realize deferred tax assets. Significant judgment and estimates are required in determining the impact on our effective tax rate related to these items, including whether it is more likely than not that some or all of our deferred tax assets will be realized. Such estimates are subject to uncertainty due to various factors, including the economic environment, industry and market conditions, and the length of time of the projections included in the analyses. If our actual results are less favorable than current estimates, or we revise our estimates downward in future analyses, a valuation allowance may be required related to our deferred tax assets with a corresponding adjustment to earnings in the period in which such determination is made, which could have a material effect on our results of operations. In addition, the Organisation for Economic Co-operation and Development (OECD), an international association of 34 countries including the United States, as well as other taxing authorities have made or are contemplating changes to numerous long-standing tax principles. In particular, due to inconsistencies in application of the arm’s length standard among tax authorities, as well as lack of adequate treaty-based protection, transfer pricing challenges by tax authorities could, if successful, result in adjustments for prior or future tax years.  Any enacted or contemplated changes may increase tax uncertainty and adversely affect our provision for income taxes.

Finally, we are subject to examination of our income tax returns by the United States Internal Revenue Service and other tax authorities, which may result in the assessment of additional income taxes. We regularly assess the likelihood of adverse outcomes resulting from examinations to determine the adequacy of our provisions for income taxes. However, unanticipated outcomes from examinations could have a material adverse effect on our financial condition or results of operations.

Because we have operations in foreign countries and depend on foreign customers and suppliers, we are subject to international economic, currency, regulatory, political and other risks that could harm our business, financial condition and results of operations.

International revenues accounted for 69% and 68% of our net revenues for the three months ended July 3, 2016 and June 28, 2015, respectively. We expect that international revenues will continue to account for a significant percentage of our net revenues for the foreseeable future. In addition, we maintain operations in foreign countries and a significant portion of our inventory purchases are from suppliers that are located outside the United States. As a result, we are subject to several risks, which include:

As of July 3, 2016, our international subsidiaries held $296.8 million of our total cash, cash equivalents and marketable securities. These holdings by our international subsidiaries consist primarily of debt securities due from U.S. issuers, including the U.S. government and related agencies, and U.S. dollar denominated cash and money market funds. Certain foreign regulations could impact our ability to transfer funds to the United States. Additionally, should we decide to repatriate cash held outside of the United States, we may incur a significant tax obligation.

 

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Our international sales are invoiced in U.S. dollars and, accordingly, if the relative value of the U.S. dollar in comparison to the currency of our foreign customers should increase, the resulting effective price increase of our products to such foreign customers could result in decreased sales. In addition, a significant portion of our inventory is purchased from international suppliers, who invoice us in U.S. dollars. If the relative value of the U.S. dollar in comparison to the currency of our foreign suppliers should decrease, our suppliers may increase prices, which could result in a decline of our gross margin. Any of the foregoing factors could have a material adverse effect on our business, financial condition or results of operations.

Changes in and compliance with regulations could materially and adversely affect us.

Our business, results of operations or financial condition could be materially and adversely affected if new laws, regulations or standards relating to us or our products are implemented or existing ones are changed. In addition, our compliance with existing regulations may have a material adverse impact on us. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was enacted in 2010. There are significant corporate governance and executive compensation related provisions in the Dodd-Frank Act that require the SEC to adopt additional rules and regulations in these areas. The SEC has also issued disclosure requirements relating to the sourcing of so-called conflict minerals from the Democratic Republic of Congo and certain other adjoining countries. Our disclosures have been and will be predicated upon the timely receipt of accurate information from suppliers, who may be unwilling or unable to provide us with the relevant information. As a result, these requirements could adversely affect our costs, the availability of minerals used in our products and our relationships with customers and suppliers. In addition, we are subject to laws, rules and regulations in the United States and other countries relating to the collection, use and security of personal information and data. We have incurred, and will continue to incur, expenses to comply with privacy and security standards, protocols and obligations imposed by applicable laws, regulations, industry standards and contracts. Any inability to comply with applicable privacy or data protection laws, regulations or other obligations, could result in significant cost and liability, damage our reputation, and adversely affect our business.

Under applicable federal securities laws, including the Sarbanes-Oxley Act of 2002, we are required to evaluate and determine the effectiveness of our internal control structure and procedures for financial reporting. Should we or our independent auditors determine that we have material weaknesses in our internal controls, our business, financial condition or results of operations may be materially and adversely affected and our stock price may decline.

We and our customers are subject to various import and export regulations of the United States government and other countries. Certain government export regulations apply to the encryption or other features contained in some of our products. Changes in or violations of any such import or export regulations could materially and adversely affect our business, financial condition or results of operations.

In many foreign countries, particularly in those with developing economies, it is common to engage in business practices that are prohibited by regulations applicable to us, such as the Foreign Corrupt Practices Act and other anti-bribery laws. Although we have policies and procedures designed to ensure compliance with these laws, our employees, contractors and agents, as well as those companies to which we outsource certain of our business operations, may take actions in violation of our policies. Any such violation, even if prohibited by our policies, could have a material adverse effect on our business, financial condition or results of operations.

We face increasing complexity in our product design and procurement operations as we adjust to new and future requirements relating to the chemical and material composition of our products, their safe use, the energy consumption associated with those products and product take-back legislation (i.e., legislation that makes producers of electrical goods financially responsible for specified collection, recycling, treatment and disposal of past and future covered products). We could incur substantial costs, our products could be restricted from entering certain jurisdictions, and we could face other sanctions, if we were to violate or become liable under environmental laws or if our products become non-compliant with environmental laws.

We continually seek ways to increase the energy efficiency of our products. Recent analyses have estimated the amount of global carbon emissions that are due to information technology products. As a result, governmental and non-governmental organizations have turned their attention to development of regulations and standards to drive technological improvements and reduce the amount of carbon emissions. There is a risk that these regulations or standards, once developed, will not fully address the complexity of the technology developed by the IT industry or will favor certain technological approaches that we do not currently utilize. Depending on the regulations or standards that are ultimately adopted, compliance could adversely affect our business, results of operations or financial condition.

 

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System security risks, data protection breaches and cyber-attacks could disrupt our internal operations, and any such disruption could reduce our expected revenues, increase our expenses, damage our reputation and adversely affect our stock price.

Experienced computer programmers and hackers may be able to penetrate our network and misappropriate or compromise our confidential information or that of third parties, create system disruptions or cause shutdowns. Computer programmers and hackers also may be able to develop and deploy viruses, worms, and other malicious software programs that attack our products or otherwise exploit any security vulnerabilities of our products. In addition, sophisticated hardware and operating system software and applications that we produce or procure from third parties may contain defects in design or manufacture, including “bugs” and other problems that could unexpectedly interfere with the operation of the system. The costs to us to eliminate or alleviate cyber or other security problems, bugs, viruses, worms, malicious software programs and security vulnerabilities could be significant and, if our efforts to address these problems are not successful, this could result in interruptions, delays, cessation of service and loss of existing or potential customers that may impede our sales, manufacturing, distribution or other critical functions.

We manage and store various proprietary information and sensitive or confidential data relating to our business. We have also outsourced a number of our business functions to third party contractors. Breaches of our or our third party contractors’ security measures or the accidental loss, inadvertent disclosure or unapproved dissemination of proprietary information or sensitive or confidential data about us or our customers, including the potential loss or disclosure of such information or data as a result of fraud, trickery or other forms of deception, could expose us or our customers to a risk of loss or misuse of this information, result in litigation and potential liability for us, damage our brand and reputation or otherwise harm our business. In addition, the cost and operational consequences of implementing further data protection measures could be significant.

Our proprietary rights may be inadequately protected and difficult to enforce.

In some jurisdictions, we have patent protection on certain aspects of our technology. However, we rely primarily on trade secrets, trademarks, copyrights and contractual provisions to protect our proprietary rights. There can be no assurance that these protections will be adequate to protect our proprietary rights, that others will not independently develop or otherwise acquire equivalent or superior technology, or that we can maintain such technology as trade secrets. There also can be no assurance that any patents we possess will not be invalidated, circumvented or challenged. We have taken steps in several jurisdictions to enforce our trademarks against third parties. No assurances can be given that we will ultimately be successful in protecting our trademarks. The laws of certain countries in which our products are or may be developed, manufactured or sold, including various countries in Asia, may not protect our products and intellectual property rights to the same extent as the laws of the United States, or at all. If we fail to protect our intellectual property rights, our business could be negatively impacted.

Disputes relating to claimed infringement of intellectual property rights may adversely affect our business.

We have in the past received notices of claimed infringement of intellectual property rights and been involved in intellectual property litigation. There can be no assurance that third parties will not assert future claims of infringement of intellectual property rights against us, or against customers or others whom we are contractually obligated to indemnify, with respect to existing and future products. In addition, our supply of ASICs and other components can also be interrupted by intellectual property infringement claims against our suppliers.

Individuals and groups are purchasing intellectual property assets for the sole purpose of making claims of infringement and attempting to extract settlements from companies such as ours. Although patent and intellectual property disputes may be settled through licensing or similar arrangements, costs associated with these arrangements may be substantial and the necessary licenses or similar arrangements may not be available to us on satisfactory terms, or at all. As a result, we could be prevented from manufacturing and selling some of our products. In addition, if we litigate these kinds of claims, the litigation could be expensive, time consuming and could divert management’s attention from other matters and there is no guarantee we would prevail. Our business could suffer regardless of the outcome of the litigation.

Our facilities and the facilities of our suppliers and customers are located in regions that are subject to natural disasters.

Our California facilities, including our principal executive offices, our principal design facilities and our critical business operations, are located near major earthquake faults. We are not specifically insured for earthquakes or other natural disasters. Any personal injury at, or damages to, the facilities as a result of such occurrences could have a material adverse effect on our business, results of operations or financial condition. Additionally, we have operations, suppliers and customers in regions that have historically experienced natural disasters. Furthermore, as a result of a natural disaster, our major customers may face shortages of components that could negatively impact their ability to build the servers and data center devices into which our products are integrated, thereby negatively impacting the demand for our products even if the supply of our products is not directly affected by the natural disaster.

 

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Any earthquake or other natural disaster, including a hurricane, flood, volcanic eruption, tsunami or fire, affecting any of these regions could adversely affect our business, results of operations and financial condition.

Our portfolio of marketable securities could experience a decline in market value, which could materially and adversely affect our financial results.

As of July 3, 2016, we held short-term marketable securities totaling $245.7 million. We invest in debt securities, the majority of which are high investment grade, and we limit the exposure to credit risk through diversification and investment in highly-rated securities. However, investing in highly-rated securities does not entirely mitigate the risk of potential declines in market value. A deterioration in the economy, including tightening of credit markets or significant volatility in interest rates, could cause declines in value of our marketable securities or could impact the liquidity of the portfolio. If market conditions deteriorate significantly, our results of operations or financial condition could be materially and adversely affected.

We may experience difficulties in transitioning to smaller geometry process technologies.

We expect to continue to transition our ASICs to increasingly smaller line width geometries. This transition requires us to modify the manufacturing processes for our products and to redesign some products, as well as standard cells and other integrated circuit designs that we may use in multiple products. We periodically evaluate the benefits, on a product-by-product basis, of migrating to smaller geometry process technologies. In the past, we have experienced some difficulties in shifting to smaller geometry process technologies or new manufacturing processes, which resulted in reduced manufacturing yields, delays in product deliveries and increased expenses. We may face similar difficulties, delays and expenses as we continue to transition our products to smaller geometry processes.

If we fail to carefully manage the use of “open source” software in our products, we may be required to license key portions of our products on a royalty-free basis or expose key parts of our source code.

Certain of our software may be derived from “open source” software that is generally made available to the public by its authors and/or other third parties. Such open source software is often made available to us under licenses, such as the GNU General Public License, that impose certain obligations on us in the event we were to distribute derivative works of the open source software. These obligations may require us to make source code for the derivative works available to the public and license such derivative works under a particular type of license, rather than the forms of licenses customarily used to protect our intellectual property. In the event the copyright holder of any open source software were to successfully establish in court that we had not complied with the terms of a license for a particular work, we could be required to release the source code of that work to the public or stop distributing that work.

Our ability to borrow and maintain outstanding borrowings under our credit agreement is subject to certain covenants.

We have a credit agreement that provides us with a $125 million unsecured revolving credit facility that matures in March 2018. Borrowings under the credit agreement may be used for general corporate purposes, including permitted share repurchases and acquisitions. Under the credit agreement, we may increase the revolving commitments or obtain incremental term loans in an aggregate amount up to $100 million, subject to certain conditions. Our ability to borrow under the credit agreement is subject to continued compliance with certain financial and non-financial covenants. In addition, a breach of any of the covenants or other provisions in the credit agreement could result in an event of default, which if not cured or waived, could result in outstanding borrowings becoming immediately due and payable. We may be unable to maintain compliance with these covenants and, if we fail to do so, we may be unable to obtain waivers or amend the covenants. In the event that some or all of our outstanding borrowings are accelerated and become immediately due and payable, we may not have the funds to repay, or the ability to refinance, our borrowings. There were no borrowings outstanding under the credit agreement as of July 3, 2016.

 

 

 

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Item 6.Exhibits 

Exhibits

 

 

* Schedules and exhibits have been omitted pursuant to Item 601(b)(2) of Regulation S-K. The Company will furnish copies of any such schedules and exhibits to the SEC upon request.

 

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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.

 

Date: August 8, 2016

 

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EXHIBIT INDEX

 

 

* Schedules and exhibits have been omitted pursuant to Item 601(b)(2) of Regulation S-K. The Company will furnish copies of any such schedules and exhibits to the SEC upon request.

 

 

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