Item 1A. Risk Factors
Failure to successfully compete in the networking market could prevent Brocade from increasing or maintaining revenue, profitability, and cash flows with respect to its networking solutions.
The networking market, particularly the data center market, is highly competitive and is undergoing significant transitions due to the adoption of new technologies, such as cloud computing, virtualization, software networking, and infrastructure-as-a-service. For example, companies such as Amazon Web Services, Inc., Microsoft Corporation, and more recently both Cisco Systems, Inc. (“Cisco”) and Hewlett Packard Enterprise Company (“HPE”) offer cloud computing services for the enterprise market, and some customers may choose to procure networking as a service rather than implement in-house networking solutions. Cisco and Microsoft Corporation have also collaborated on data center and cloud computing initiatives involving sales, marketing, and research and development (“R&D”). Additionally, Dell Inc. (“Dell”) announced an agreement to acquire EMC Corporation (“EMC”), and if that acquisition is completed, the resulting company’s technology may compete directly with some of Brocade’s solutions. Also, Juniper Networks, Inc. (“Juniper”) and HPE have launched new offerings, including “whitebox” switches, which those companies have promoted as a low-cost option for networking equipment purchasers. These and other market dynamics, as well as further commoditization of networking products, could negatively impact Brocade’s business and financial results.
Other shifts in the networking market are also creating competitive challenges for Brocade. For example, data center buying patterns are shifting to converged infrastructures in which computer, network, and storage systems are sold as bundled solutions. If Brocade is unsuccessful in having its products included in those bundled solutions, Brocade’s market share could be adversely affected. In addition, following its acquisition of Ruckus Wireless, Inc. (“Ruckus”), Brocade became a vendor of wireless networking products. Previously, Brocade had relied on partner relationships developed with other companies for access to wireless networking technologies, including access to wireless networking products to supplement Brocade’s wireline campus business. Those partner relationships may be adversely affected by the fact that Brocade now competes with those companies’ wireless networking businesses.
Cisco maintains a dominant position in the networking market; however, customers also have many choices in both traditional and emerging networking technology and networking providers. These other competitors in the networking market include A10 Networks, Inc.; Alcatel-Lucent (recently acquired by Nokia Corporation); Arista Networks, Inc.; Avaya Inc.; Extreme Networks, Inc.; F5 Networks, Inc.; Huawei Technologies Co. Ltd.; Juniper; and QLogic Corporation (“QLogic”). Many of Brocade’s competitors have longer operating histories; greater financial, technical, sales, marketing, and other resources; more name recognition; and larger customer installed bases than Brocade. These companies’ businesses may have better economies of scale, and therefore these companies could also adopt more aggressive pricing policies than Brocade. Some of these companies’ brands are better known by end users than Brocade’s brand, and channel partners often prefer to sell well-known brands to end-user accounts. In addition, these companies have in the past, and could in the future, enhance their business models through divestitures and acquisitions, which could impact Brocade’s partner ecosystem and Brocade’s go-to-market model. Also, any one of these competitors could devote more resources to develop, promote, and sell their products, and, therefore, could respond more quickly to changes in customer or market requirements and adopt more aggressive pricing policies. Brocade’s failure to successfully compete in the networking market would harm its business and financial results.
Conditions in the Storage Area Networking (“SAN”) market could adversely affect Brocade’s business, financial results, and growth prospects.
Approximately two-thirds of Brocade’s fiscal year 2015 revenue was generated from its SAN business. As such, Brocade’s business, financial results, and growth prospects may be impacted significantly by SAN market conditions. For example, the overall size of the SAN market contracted in 2015 from a revenue perspective due to, among other factors, the increasing efficiency of SAN products, the adoption of other networking protocols, changes in data center architectures, hyper-converged solutions and other new storage technologies, and the other competitive factors described in the risk factor above.
Revenue generated from sales of Brocade’s SAN products is also impacted by the amount of storage capacity deployed by its SAN customers. While the amount of storage capacity deployed is growing, the rate of that growth has declined in recent years.
In addition, revenue generated from sales of Brocade’s SAN products is impacted by the average selling price for those products. While the overall average selling price for Brocade’s SAN products has increased in recent periods, that increase has been largely due to the introduction of new products. Accordingly, that trend may not be sustained if we are unable to continue to successfully introduce and obtain customer acceptance of new SAN products at the same rate, or at all.
If Brocade fails to successfully address these SAN market conditions, Brocade’s business, financial results, and growth prospects may be adversely affected.
A limited number of major original equipment manufacturer (“OEM”) partners comprise a significant portion of Brocade’s revenues; the loss of revenue from, or decreased inventory levels held by, any of these major OEM partners could significantly reduce Brocade’s revenues and adversely affect its financial results.
Brocade’s SAN business depends on recurring purchases from a limited number of large OEM partners for a substantial portion of its revenues, specifically EMC, HPE, and International Business Machines Corporation (“IBM”). As a result, revenues from these large OEM partners have a significant impact on Brocade’s quarterly and annual financial results. For fiscal years 2015, 2014, and 2013, these three OEM partners each represented 10% or more of Brocade’s total net revenues, for a combined total of 41%, 46%, and 46% of total net revenues, respectively. Brocade’s agreements with its OEM partners are typically cancellable, non-exclusive, and have no minimum or specific timing requirements for purchases. Brocade’s OEM partners could increase the amount purchased from Brocade’s competitors, introduce their own technology, or experience lower demand for Brocade SAN products from their end customers.
Also, one or more of Brocade’s OEM partners could elect to divest certain lines of business, split their business, or consolidate or enter into a strategic partnership with one of Brocade’s competitors, such as IBM’s sale of certain lines of business to Lenovo Group Limited, HPE recently becoming a separate public company, and Dell’s announced agreement to acquire EMC, which could reduce or eliminate Brocade’s future revenue opportunities with that OEM partner. In addition, business execution or other operating performance issues experienced by our OEM partners may adversely affect Brocade’s revenue and financial results. Brocade anticipates that a significant portion of its revenues and operating results from its SAN business will continue to depend on sales to a relatively small number of OEM partners. Brocade’s business and financial results could be harmed by the loss of any one significant OEM partner, a decrease in the level of sales to any one such partner, a change in any one such partner’s go-to-market strategy, or an unsuccessful negotiation on key terms, conditions, or timing of purchase orders placed during a quarter.
Brocade may not realize the anticipated benefits of past or future acquisitions, divestitures, and strategic investments, and the integration of acquired companies or technologies or divestiture of businesses may negatively impact Brocade’s business and financial results.
Brocade has acquired—or made strategic investments in—other companies, products, or technologies, and Brocade expects to make additional acquisitions and strategic investments in the future. In the third quarter of fiscal year 2016, Brocade acquired Ruckus. In the second quarter of fiscal year 2015, Brocade acquired its virtual evolved packet core software product line and related assets from Connectem Inc. and its virtual application delivery controller software product line and related assets from Riverbed Technology, Inc. The ability of Brocade to realize the anticipated benefits of its acquisitions and strategic investments involves numerous risks, including, but not limited to, the following:
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Difficulties in successfully integrating the acquired businesses and realizing any expected synergies;
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Failure to communicate to customers the capabilities of the combined company;
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Unanticipated costs, litigation, and other contingent liabilities, including liabilities associated with acquired intellectual property;
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Diversion of management’s attention from Brocade’s daily operations and business;
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Adverse effects on existing business relationships with suppliers and customers, including delays or cancellations of customer purchases, as well as revenue attrition in excess of anticipated levels if existing customers alter or reduce their historical buying patterns;
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Risks associated with entering into markets in which Brocade has limited or no prior experience, including the potential for a lower level of understanding of specific market dynamics;
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Inability to attract and retain key employees;
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Inability to successfully develop new products and services on a timely basis to address the market opportunities of the combined company;
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Inability to compete effectively against companies already serving the broader market opportunities expected to be available to the combined company;
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Inability to qualify the combined company’s products with OEM partners on a timely basis, or at all;
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Inability to successfully integrate financial reporting and IT systems;
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Inability to develop software-oriented back office systems and processes necessary to sell and support a variety of software-based offerings;
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Failure to successfully manage additional business locations, including the infrastructure and resources necessary to support and integrate such locations;
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Assumption or incurrence of debt and contingent liabilities and related obligations to service such liabilities and potential limitations on Brocade’s operations in order to satisfy financial and other negative operating covenants;
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Additional costs, such as increased costs of manufacturing and service; costs associated with excess or obsolete inventory; costs of employee redeployment, relocation, and retention, including salary increases or bonuses; accelerated amortization of deferred equity compensation, severance payments, reorganization, or closure of facilities; taxes; advisor and professional fees; and termination of contracts that provide redundant or conflicting services;
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Incurrence of acquisition- and integration-related costs, goodwill or in-process research and development impairment charges, or amortization costs for acquired intangible assets, that could negatively impact Brocade’s operating results and financial condition; and
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The target market for the acquired products may not develop within the expected time frame or may evolve in a different technical direction.
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Integration and other risks associated with acquisitions can be more pronounced for larger and more complicated transactions. For example, Brocade completed its acquisition of Ruckus in May 2016 and is in the process of combining the businesses and operations of the two companies. The size of the acquisition of Ruckus increases both the scope and consequence of the ongoing risks and challenges associated with those efforts. Brocade may not successfully address those risks and challenges in a timely manner, or at all. If that occurs, Brocade may not fully realize all of the anticipated benefits of the Ruckus acquisition, and its revenue, expenses, operating results and financial condition could be adversely affected.
Brocade may also divest certain businesses or product lines from time to time. For example, Brocade sold its network adapter business to QLogic during the first quarter of fiscal year 2014. Such divestitures involve risks, such as difficulty separating out portions of or entire businesses, distracting employees, incurring potential loss of revenue, negatively impacting margins, and potentially disrupting customer relationships. Brocade may also incur significant costs associated with exit or disposal activities, related impairment charges, or both.
Uncertainty about or a slowdown in the domestic and/or international economies has adversely affected, and may increasingly adversely affect, Brocade’s operating results and financial condition.
In recent years, the rate of economic growth in the United States and in certain other countries, including China, has declined. In addition, uncertainty exists about the future growth of the domestic and international economies. Such uncertainty and slowdowns have resulted in, and may again result in, lower growth or a decline in information technology (“IT”)-related spending, and, consequently, lead to lower growth or a decline in the networking market (including high-performance data networking solutions). Historically, IT spending has declined as general economic and market conditions have worsened due to geopolitical uncertainty. In addition, IT spending by international customers may decline as the value of the local currencies weaken against the U.S. dollar. Brocade is particularly susceptible to reductions in IT spending because the purchase of networking solutions is often discretionary and may involve a significant commitment of capital and other resources. The loss or delay of orders from any of Brocade’s more significant customers, such as individual branches or agencies within the U.S. federal government (including the Department of Defense or certain intelligence agencies where Brocade’s revenue is concentrated), or customers within the service provider, financial services, education (including technology improvements for schools funded by the U.S. federal government commonly known as the E-Rate program), and health sectors, could also cause Brocade’s revenue and profitability to suffer. For example, Brocade’s revenue and operating results could be negatively impacted if the U.S. federal government experiences delays in procurement due to longer decision-making time frames and/or a shift in IT procurement priorities. Economic uncertainty has caused—and may cause further—reductions in Brocade’s revenue, profitability, and cash flows, along with increased price competition, increased operating costs, and longer fulfillment cycles. Moreover, economic uncertainty may exacerbate many other risks noted elsewhere in this Form 10-Q, which could adversely affect Brocade’s business operations and financial condition.
The prices of Brocade’s Internet Protocol (“IP”) Networking products have declined in the past and Brocade expects the prices of its products to decline in the future, which could reduce Brocade’s revenues, gross margins, and profitability.
The average selling price for Brocade’s IP Networking products has typically declined in the past and will likely decline in the future as a result of competitive pricing pressures, broader macroeconomic factors, product mix, new product introductions by Brocade or competitors, the entrance of new competitors, and other factors. In particular, if economic conditions deteriorate and create a more cautious capital spending environment in the IT sector, Brocade and its competitors could pursue more aggressive pricing strategies in an effort to maintain or increase revenues. If Brocade is unable to offset a decline in the average selling price of Brocade’s IP Networking products by increasing the volume of products shipped and/or reducing product manufacturing costs, including key components such as optics, Brocade’s revenues, gross margins, and profitability could be adversely affected.
Brocade’s future revenue growth depends on its ability to successfully introduce and achieve market acceptance of new products, services, and support offerings on a timely basis.
Developing new products, services (including software networking), and support offerings requires significant up-front investments that may not result in revenues for an extended period of time, if at all. Brocade must achieve market acceptance of its new product and support offerings on a timely basis in order to realize the benefits of its investments. However, the market for networking solutions, driven in part by the growth and evolution of the Internet and adoption of new technologies, such as software-defined networking (“SDN”) and network functions virtualization (“NFV”), is characterized by rapidly changing technology, accelerated product introduction cycles, changes in customer requirements, and evolving industry standards. In addition, many of Brocade’s new products, services, and support offerings will be directed towards customers, including hyperscale cloud providers and large service providers, with which Brocade does not have strong existing sales relationships. Sales to these customers may be challenging because sales are often based on long-term relationships and network incumbency and the complex system environments maintained by these customers often require interoperation with a variety of other vendors and back office applications. Brocade’s future success depends largely upon its ability to address the rapidly changing needs of both new and existing customers by: allowing connectivity to other devices and partnering effectively; keeping pace with technological developments and emerging industry standards; and delivering high-quality, reliable, and cost-effective products, product enhancements, and services and support offerings on a timely basis.
Other factors that may affect Brocade’s successful introduction of new products, services, and support offerings include, but are not limited to, Brocade’s ability to:
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Properly predict the market for new products, services, and support offerings, including features, cost-effectiveness, scalability, and pricing—all of which can be particularly challenging for initial product offerings in new markets;
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Differentiate Brocade’s new products, services, and support offerings from its competitors’ offerings;
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Address the interoperability complexities of Brocade’s products with its OEM partners’ server and storage products and Brocade’s competitors’ products;
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Determine which route(s) to market will be most effective; and
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Manage product transitions, including forecasting demand, managing excess and obsolete inventories, addressing product cost structures, and managing different sales and support requirements.
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Failure to successfully introduce competitive products, services, and support offerings on a timely basis may harm Brocade’s business and adversely affect Brocade’s financial results.
If Brocade is unable to successfully transition from older products and corresponding support and service offerings to new products and corresponding support and service offerings on a timely basis, its business and financial results could be adversely affected.
As Brocade introduces new or enhanced products, such as Brocade’s recently introduced Gen 6 Fibre Channel switching platform, it must successfully manage the transition from older products to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories, maintain existing support revenue streams, and provide sufficient supplies of new products to meet customer demands. The introduction of new or enhanced products may shorten the life cycle of Brocade’s existing products or replace the sales of some of Brocade’s current products, thereby offsetting the benefit of a successful product introduction. When Brocade introduces new or enhanced products, it faces numerous risks related to product transitions, including the inability to accurately forecast demand, manage excess and obsolete inventories, address new or higher product cost structures, and manage different sales and support requirements due to the type or complexity of the new or enhanced products. In addition, any customer uncertainty regarding the timeline for rolling out new products, or Brocade’s plans for future support of existing products, may cause customers to delay purchase decisions or to purchase competing products, which would adversely affect Brocade’s business and financial results.
Brocade’s failure to execute on its overall sales strategy or successfully leverage its channel and direct sales capabilities could significantly reduce its revenues and negatively affect its business, financial results, and growth prospects.
Brocade offers networking solutions through a multipath distribution strategy, including distributors, resellers, a direct sales force, and OEMs. However, Brocade’s efforts to increase sales through this multipath distribution strategy may not generate incremental revenue opportunities. Several of Brocade’s major OEM customers, including Dell, IBM, HPE, and Oracle Corporation, have acquired companies that offer IP Networking solutions that are competitive with Brocade offerings. A loss of, or significant reduction in, revenue through one of Brocade’s paths to market would negatively impact its business and financial results.
As the networking industry continues to evolve, partners with which Brocade does not have long-standing relationships, such as cloud service providers that provide routing and infrastructure-as-a-service and global systems integrators that provide complete solutions to end users interested in upgrading to more modern architectures, may become increasingly important. In addition, as more enterprises purchase infrastructure-as-a-service offerings from hyperscale cloud providers and large service providers, sales through some of Brocade’s existing paths to market could decline. If Brocade fails to build or grow successful relationships with these partners and service providers, Brocade’s business and financial results could be adversely affected.
Brocade’s failure to successfully develop new and/or maintain its current channel partner relationships, or the failure of these partners to sell Brocade’s products, could reduce Brocade’s growth prospects significantly. In addition, Brocade’s ability to respond to the needs of its distribution and reseller partners in the future may also depend on third parties producing complementary products and applications for Brocade products to enable these partners to be competitive in the market. In addition, Brocade may not successfully achieve its expanded go-to-market objectives, which include effectively maintaining or expanding sales through its distribution channels and successfully managing distribution and reseller partner relationships. If Brocade fails to respond successfully to the needs of these distribution and reseller partners and their customers, Brocade’s business and financial results could be adversely affected.
If Brocade does not manage the risks associated with its wireless networking business properly, its revenue and profitability could be adversely affected.
As described below, the risks that accompany Brocade’s new wireless networking business differ from those of Brocade’s other businesses.
The success of Brocade’s wireless networking business depends on the continued growth and reliance on Wi-Fi, particularly in the service provider and enterprise markets. The recent growth of the market for Wi-Fi networks is being driven by the increased use of Wi-Fi-enabled mobile devices and the use of Wi-Fi as a preferred connectivity option to support video, voice, and other higher-bandwidth uses. As a result, mobile service providers and enterprises are struggling to address the capacity gap. A number of barriers may prevent service providers or their subscribers from adopting Wi-Fi technology to address the capacity gap in wireless networks. For example, Wi-Fi operates over an unlicensed radio spectrum, and if the Wi-Fi spectrum becomes crowded, Wi-Fi solutions will be a less attractive option for service providers. In addition, in order for Wi-Fi solutions to adequately address the capacity gap, mobile devices should automatically switch from a cellular data network to the service provider’s Wi-Fi network, when available and appropriate, which does not generally occur. There is no guarantee that service providers and enterprises will continue to utilize Wi-Fi technology, that use of Wi-Fi-enabled mobile devices will continue to increase, or that Wi-Fi will continue to be the preferred connectivity option for the uses described above. If another technology were found to be superior to Wi-Fi by service providers or enterprises, it could adversely affect Brocade’s revenue and profitability.
Brocade’s wireless products are designed to interoperate with cellular networks and mobile devices using Wi-Fi technology. These networks and devices have varied and complex specifications. As a result, Brocade must attempt to ensure that its products interoperate effectively with all of these existing and planned networks and devices. To meet these requirements, Brocade must continue to undertake development and testing efforts that require significant capital and employee resources. Brocade may not accomplish these development efforts quickly or cost-effectively, or at all. If Brocade’s wireless products do not interoperate effectively, orders for Brocade’s wireless products could be delayed or canceled, potentially resulting in the loss of existing and potential end customers; Brocade could experience significant warranty, support and repair costs; and the attention of Brocade’s engineering personnel could be diverted from its product development efforts. In addition, Brocade’s end customers may require Brocade’s products to comply with new and rapidly evolving security or other certifications and standards. If Brocade’s wireless products are late in achieving or fail to achieve compliance with these certifications and standards, or if Brocade’s competitors achieve compliance with these certifications and standards, such end customers may not purchase Brocade’s products, which would adversely affect Brocade’s revenue and profitability.
Brocade’s wireless products have been deployed in many different locations and user environments and are capable of providing connectivity to many different types of Wi-Fi-enabled devices operating a variety of applications. The ability of Brocade’s wireless products to operate effectively can be negatively impacted by many different elements unrelated to its products. For example, a user’s experience may suffer from an incorrect setting in a Wi-Fi device. Although certain technical problems experienced by users may not be caused by Brocade’s products, users often perceive the underlying cause to be a result of poor performance of the wireless network. This perception, even if incorrect, could harm Brocade’s business and reputation.
Brocade has a substantial amount of acquired intangible assets, goodwill, and deferred tax assets on its balance sheet, and if Brocade is required to record impairment charges for these assets, such impairment charges could adversely affect Brocade’s financial results.
Brocade has a substantial amount of acquired intangible assets, goodwill, and deferred tax assets on its balance sheet related to Brocade’s prior acquisitions. Brocade’s determination of the fair value of its long-lived assets relies on management’s assumptions of future revenues, operating costs, and other relevant factors. Brocade’s estimates with respect to the useful life or ultimate recoverability of Brocade’s carrying basis of assets, including acquired intangible assets, could change as a result of changes in management’s assumptions. If management’s estimates of future operating results change or if there are changes to other assumptions, such as the discount rate applied to future cash flows, then the estimated fair value of Brocade’s reporting units could change significantly, which could result in goodwill impairment charges. The risk of a future goodwill impairment charge is comparatively high for the IP Networking Products reporting unit because based on the Company’s fiscal year
2016
annual goodwill impairment test, the estimated fair value of that reporting unit’s net assets, which include goodwill, exceeded the carrying value of those net assets by only approximately $80 million. For a sensitivity analysis that quantifies the impact of certain key assumptions used by Brocade on the fair value estimates for the IP Networking Products reporting unit, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” in Part I, Item 2 of this Form 10-Q. If future impairment tests should result in a charge to earnings, Brocade’s financial results would be adversely affected.
Brocade has determined that, more likely than not, it will realize its deferred tax assets based on positive evidence of its historical operations and projections of future income, except for the deferred tax assets related to California and remaining capital loss carryforwards for which a valuation allowance has been applied. In the event that future income by jurisdiction is less than what is currently projected, Brocade may be required to apply a valuation allowance to these deferred tax assets in jurisdictions where realization of such assets is no longer more likely than not, which could result in a charge to earnings that would adversely affect Brocade’s financial results.
Cyberattacks and data security breaches could disrupt Brocade’s operations, negatively impact Brocade’s reputation, and erode customers’ trust.
Cyberattacks and other malicious attacks could lead to data breaches, computer break-ins, malware, viruses, and unauthorized tampering with Brocade’s computer systems, intellectual property, and confidential information about its customers, and partners. These attacks could disrupt Brocade’s operations, negatively impact Brocade’s reputation, and erode customers’ trust. Brocade may not successfully limit attacks by malicious third parties if they attempt to undermine or disrupt Brocade’s cybersecurity, despite implementation of cybersecurity measures.
Additionally, if an actual or perceived cyberattack or data security breach occurs in Brocade’s network or in one of Brocade’s customer’s network, regardless of whether the breach is attributable to Brocade’s products, the market perception of the effectiveness of Brocade’s products could be harmed. Brocade may suffer reputational harm and Brocade’s customers’ trust may be eroded as a result of a data security breach involving customers’ or employees’ information, either or both of which could negatively impact profitability and/or increase expenses. Customers have become increasingly sensitive to government-sponsored surveillance and may believe that, as a U.S.-based manufacturer, Brocade’s equipment contains “backdoor” code that would allow customer data to be compromised by either governmental bodies or other third parties. As a result, customers may choose not to deploy Brocade networking products, which could negatively impact Brocade’s business and financial results.
Brocade’s revenues, operating results, and cash flows may fluctuate from period to period due to a number of factors, which makes predicting financial results difficult.
IT spending is subject to cyclical and uneven fluctuations, which could cause Brocade’s financial results to fluctuate unevenly and unpredictably. For example, the U.S. federal budget for government IT spending can be highly seasonal and subject to delays, reductions, and uncertainty due to changes in the political and legislative environment. It can be difficult to predict the degree to which end-customer demand and the seasonality and uneven sales patterns of Brocade’s OEM partners or other customers will affect Brocade’s business in the future, particularly as Brocade releases new or enhanced products. While Brocade’s first and fourth fiscal quarters are typically stronger quarters for SAN products and Brocade’s third and fourth fiscal quarters are typically stronger quarters for IP Networking solutions, future buying patterns may differ from historical seasonality. If the mix of revenue changes, it may also cause results to differ from historical seasonality. Accordingly, Brocade’s quarterly and annual revenues, operating results, cash flows, and other financial and operating metrics may vary significantly in the future, and the results of any prior periods should not be relied upon as an indication of future performance.
If Brocade loses key employees or is unable to hire additional qualified employees, its business may be negatively impacted.
Brocade’s success depends, to a significant degree, upon the continued contributions of its employees, including executive officers, engineering, sales, and others, many of whom would be difficult to replace. Departures, appointments, and changes in roles and responsibilities of officers or other key members of management may disrupt Brocade’s business and adversely affect Brocade’s operating results.
Brocade believes its future success depends, in large part, upon its ability to attract highly skilled employees and operate effectively in geographically diverse locations. Brocade has relied heavily on equity awards in the form of stock options and restricted stock units as one means for recruiting and retaining highly skilled employees. The number of shares available for issuance under Brocade’s 2009 Stock Plan is limited, and any increase in the number of shares available under that plan must be approved by Brocade’s stockholders. The extent to which Brocade is able to obtain such stockholder approval depends on a variety of factors, including assessments by stockholders and proxy advisory firms of Brocade’s historical equity award granting practices. The effectiveness of these equity awards in recruiting and retaining employees could be reduced if Brocade has to reduce the size of the equity awards granted to its employees or if there is a sustained decline in the trading price of Brocade’s shares. There are also limited qualified employees in each of Brocade’s markets, and competition for such employees is very aggressive. In particular, Brocade operates in various locations with highly competitive labor markets, including Bangalore, India, and San Jose, California. Brocade may experience difficulty in hiring key management and qualified employees with skills in nearly all areas of Brocade’s business and operations.
The loss of the services of any of Brocade’s key employees, the inability to attract or retain qualified employees in the future, or delays in hiring required employees—particularly sales and engineering employees—could delay the development and introduction of Brocade’s products or services and/or negatively affect its ability to sell products or services.
Failure to accurately forecast demand for Brocade’s products, or failure to successfully manage the production of its products, could increase Brocade’s product cost and adversely affect its revenue, margins and profitability.
Brocade provides product forecasts to its contract manufacturers (“CMs”) and places purchase orders with them in advance of the scheduled delivery of products to Brocade’s customers. In preparing sales and demand forecasts, Brocade relies largely on input from its sales force, partners, resellers, and end-user customers. If Brocade is unable to accurately forecast demand, or if Brocade fails to effectively communicate with its distribution partners about end-user demand or other time-sensitive information, Brocade’s ability to successfully manage production could be negatively impacted. Brocade’s ability to accurately forecast demand also may become increasingly limited as Brocade introduces new or enhanced products, begins phasing out certain products, or acquires other companies or businesses. If these forecasts are inaccurate, Brocade may be unable to obtain adequate manufacturing capacity from its CMs to meet customers’ delivery requirements, which could cause customers to cancel their orders for Brocade products. Inaccurate forecasts also could cause Brocade to accumulate excess inventories or incur costs associated with excess manufacturing capacity. If customers cancel their orders, Brocade’s revenue may be adversely affected. If excess inventories accumulate, Brocade’s gross margins may be negatively impacted by write-downs for excess and/or obsolete inventory. In addition, Brocade will experience higher fixed costs as it expands its CMs’ capabilities for forecasted demand, which could negatively affect Brocade’s margins if demand decreases suddenly and Brocade is unable to reduce these fixed costs.
Additionally, most of Brocade’s manufacturing overhead and expenses are fixed in the short term or incurred in advance of receipt of corresponding revenue, and Brocade may not be able to reduce such expenses sufficiently to offset declining product prices. As a result, Brocade’s gross margins may be adversely affected by fluctuations in manufacturing volumes, component costs, foreign currency exchange rates, the mix of product configurations sold, and the mix of distribution channels through which its products are sold. Brocade’s gross margins may also be adversely affected if product or related warranty costs associated with Brocade’s products are greater than previously experienced.
Brocade has extensive international operations, which expose its business and operations to additional risks.
Brocade has significant international operations, and a significant portion of Brocade’s sales occurs in international jurisdictions. In addition, Brocade’s CMs have significant operations in China and other locations outside the United States. Brocade’s international sales of its IP Networking solutions have primarily depended on its distributors and resellers. Maintenance or expansion of international sales or international operations involves inherent risks that Brocade may not be able to control, including, but not limited to, the following:
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Compliance with U.S. and other applicable government regulations prohibiting certain end-uses and restricting trade with embargoed or sanctioned countries, such as Iran and Russia, and with denied parties;
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Difficulty in conducting due diligence with respect to business partners in certain international markets;
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Exposure to economic instability or fluctuations in international markets, such as China, that could cause reductions in IT spending;
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Exposure to inflationary risks and/or wage inflation in certain countries, such as India;
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Increased exposure to foreign currency exchange rate fluctuations, including currencies such as the British pound, the Chinese yuan, the euro, the Indian rupee, the Japanese yen, the Singapore dollar, and the Swiss franc;
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Exposure to sovereign debt risk and political and economic instability in certain regions of Europe, including Russia, and certain emerging countries, including China and Brazil;
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Multiple potentially conflicting and changing governmental laws, regulations, and practices, including differing environmental, data privacy, export, import, trade, manufacturing, tax, labor, and employment laws;
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Compliance with U.S. and other applicable government regulation of exports and imports, and associated licensing requirements, particularly in the area of encryption technology;
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Reduced or limited protection of intellectual property rights, particularly in jurisdictions that have less developed intellectual property regimes, such as China and India;
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Commercial laws and business practices that favor local competition;
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In certain international regions, particularly those with rapidly developing economies, it may be common to engage in business practices that are prohibited by anti-bribery laws, such as the U.S. Foreign Corrupt Practices Act and the U.K. Bribery Act;
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Increased complexity, time, and costs of managing international operations;
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Managing research and development and sales teams in geographically diverse locations, including teams divided between the United States, the United Kingdom, and India;
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Effective communications across multiple geographies, cultures, and languages;
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Recruiting sales and technical support personnel with the skills to design, manufacture, sell, and support Brocade’s products in international markets;
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Longer sales cycles and manufacturing lead times;
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Increased complexity and cost of providing customer support and maintenance for international customers;
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Difficulties in collecting accounts receivable;
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Increased complexity of logistics and distribution arrangements; and
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Increased complexity of accounting rules and financial reporting requirements.
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Any of these factors could negatively impact Brocade’s business, revenues, and profitability.
If product orders are received late in a fiscal quarter, Brocade may be unable to recognize revenue for these orders in the same quarter, which could adversely affect quarterly financial results.
Brocade’s IP Networking business typically experiences significantly higher levels of customer orders toward the end of a fiscal period. Customer orders received toward the end of the period may not ship within the period due to a lack of available inventory and manufacturing lead times. The inability to ship within the quarter in which the customer orders are received could negatively impact Brocade’s financial results in a particular quarter.
Brocade is subject to—and will continue to be subject to—intellectual property infringement claims and litigation that are costly to defend and/or settle, which could result in significant damages and other costs to Brocade and limit Brocade’s ability to use certain technologies in the future.
Brocade competes in markets in which companies are frequently subject to claims and related litigation regarding patent and other intellectual property rights. Third parties have, from time to time, asserted patent, copyright, trade secret, and/or other intellectual property-related claims against Brocade and/or employees of Brocade. These claims may be, and have in the past been, made against Brocade’s products and services, subcomponents of its products, methods performed by its products or a combination of products, including third-party products, methods used in its operations, or uses of its products by its customers. The claimant may seek various remedies against Brocade, such as money damages, disgorgement of profits, injunctions barring sales of infringing goods, or exclusion orders barring import of products into the U.S., among other possible remedies. Moreover, these claims may concern Brocade’s hiring of a former employee of the third-party claimant. Brocade and companies acquired by Brocade have in the past incurred, and will likely incur in the future, substantial expenses to defend against such third-party claims. Brocade’s suppliers and customers also may be subject to third-party intellectual property claims with respect to their own products, which could negatively impact the suppliers’ ability to supply Brocade with components or customers’ willingness to purchase products from Brocade. In addition, Brocade may be subject to claims, defenses, and indemnification obligations with respect to third-party intellectual property rights pursuant to Brocade’s agreements with suppliers, OEM and channel partners, or customers. If Brocade refuses to indemnify or defend such claims, for instance, even in situations where the allegations are meritless, then suppliers, partners, or customers may refuse to do business with Brocade. Parties that assert such intellectual property claims may be unreasonable in their demands, or may simply refuse to settle, which could lead to prolonged periods of litigation, additional burdens on employees or other resources, distraction from Brocade’s business operations, component supply stoppages, expensive settlement payments, and lost sales. Furthermore, there is little or no information publicly available concerning market or fair values for licenses and/or settlement fees, which can lead to overpayment of license or settlement fees. Any of the above scenarios could have an adverse effect on Brocade’s financial position, financial results, cash flows, and future business prospects.
Undetected software or hardware errors could increase Brocade’s costs, reduce its revenues, and delay market acceptance of its products.
Networking products frequently contain undetected software or hardware errors when first introduced or as new versions are released. As Brocade continues to expand its product portfolio to include software-centric products, which may include software licensed from third parties, errors may be found from time to time in these products. In addition, through its acquisitions, Brocade has assumed—and may in the future assume—products previously developed by an acquired company that have not been through the same level of product development, testing, and quality control processes used by Brocade, and may have known and/or undetected errors. Some types of errors may not be detected until the product is installed in a user environment. In addition, Brocade products are often combined with other products, including software from other vendors, and these products often need to interoperate. For IT products that have different specifications, utilize multiple protocol standards, or may be procured from other vendors, it may be difficult to identify the source of any problems. Identifying the source of and remediating these problems may cause Brocade to incur significant warranty and repair costs, divert the attention of engineering personnel from product development efforts, and cause significant customer relations problems, resulting in lower profitability from increased costs and/or decreased revenue. Moreover, the occurrence of hardware and software errors, whether caused by Brocade products or another vendor’s products, could delay market acceptance of new or enhanced Brocade products.
Brocade’s supply chain is dependent on sole-source and limited-source suppliers and a limited number of major CMs, either one or both of which may significantly impact Brocade’s financial results.
Although Brocade uses standard parts and components for its products where possible, Brocade’s CMs currently purchase, on Brocade’s behalf, several key components used in the manufacture of its products from single or limited-source suppliers. Brocade’s single-source components include, but are not limited to, its application-specific integrated circuits (commonly referred to as “ASICs”). Brocade’s principal limited-source components include memory, certain oscillators, microprocessors, certain connectors, certain logic chips, power supplies, programmable logic devices, printed circuit boards, certain optical components, packet processors, and switch fabric components. Brocade generally acquires these components through purchase orders and has no long-term commitments regarding supply or pricing with such suppliers. If Brocade is unable to obtain these and other components when required, or if Brocade’s suppliers experience component defects, Brocade may not be able to deliver its products to customers in a timely manner and may be required to repair or retrofit products previously delivered to customers, at significant expense to Brocade. In addition, a challenging economic or industry environment could cause some of these sole-source or limited-source suppliers to delay or halt production, go out of business, or be acquired by third parties, which could result in a disruption in Brocade’s supply chain. Brocade’s supply chain could also be disrupted in a variety of other circumstances that may impact its suppliers and partners, including adverse results from intellectual property litigation or natural disasters. Any manufacturing disruption by these sole-source or limited-source suppliers could severely impair Brocade’s ability to fulfill orders and may significantly impact its financial results.
In addition, the loss of any of Brocade’s major CMs, or portions of their capacity, could significantly impact Brocade’s ability to produce its products for an indefinite period of time. Qualifying a new CM and commencing volume production is typically a lengthy and expensive process. A CM may move the production lines for Brocade’s products to new locations or factories, and this may result in delays or disruptions. If Brocade changes any of its CMs or if any of its CMs experience unplanned delays, disruptions, capacity constraints, component parts shortages, or quality control problems in their manufacturing operations, shipment of Brocade’s products to customers could be delayed and result in loss of revenues.
Brocade’s intellectual property rights may be infringed upon or misappropriated by others, and Brocade may not be able to protect or enforce its intellectual property rights.
Brocade’s intellectual property rights may be infringed upon or misappropriated by others, including by competitors, partners, former employees, foreign governments, or other third parties. In some cases, such infringement or misappropriation may be undetectable, or enforcement of Brocade’s intellectual property rights may be impractical. Brocade has filed, and may in the future file, lawsuits against third parties in an effort to enforce its intellectual property rights. Intellectual property litigation is expensive and unpredictable. There can be no assurance that Brocade will prevail in such assertions or enforcement efforts, either on the merits, or with respect to particular relief sought, such as damages or an injunction. Nor can there be any assurance that any awarded damages ultimately will be paid to Brocade. Furthermore, the opposing party may attempt to prove that the asserted intellectual property rights are invalid or unenforceable, and, if successful, may seek recompense for its attorneys’ fees and costs or countersue Brocade as part of its defense. Finally, there can be no assurance that any attempt by Brocade to enforce its intellectual property rights, even if successful in court, will improve Brocade’s sales, diminish the defendant’s sales, or stop the defendant’s allegedly unfair competition.
Brocade relies on a combination of patent, copyright, trademark, and trade secret laws, along with measures such as physical and operational security and contractual restrictions, to protect its intellectual property rights in its proprietary technologies, but none of these methods of protection may be entirely appropriate or adequate to address all risks that could result in a loss of intellectual property rights. Loss or violation of Brocade’s intellectual property rights could adversely affect Brocade’s business and operating results, through a loss of revenue or an increase in expenses.
Brocade relies on licenses from third parties, and the loss or inability to obtain any such license could adversely affect its business.
Many Brocade products are designed to include software or other intellectual property licensed from third parties. There can be no assurance that the necessary licenses will be available on acceptable terms, if at all. Brocade’s inability to obtain certain licenses or other rights on favorable terms could have an adverse effect on Brocade’s business, operating results, and financial condition, including its ability to continue to distribute or support affected products.
In addition, if Brocade has failed, or in the future fails to, adequately manage the use of commercial or “open-source” software in Brocade’s products, or if companies acquired by Brocade fail in such regard, Brocade may be subject to copyright infringement litigation or other claims. Furthermore, Brocade may be required, for commercially licensed software, to pay penalties or undergo costly audits pursuant to the license agreement. In the case of open-source software, Brocade may be required to license proprietary portions of its products on a royalty-free basis, disclose proprietary parts of source code, or commence costly product redesigns that could result in a loss of intellectual property rights, product performance degradation, or a delay in shipping products to customers and result in loss of revenue.
Brocade’s planned upgrade of its enterprise resource planning (“ERP”) software solution could result in significant disruptions to its operations.
Brocade is in the process of upgrading its ERP software solution to a newer version. Brocade expects the upgrade to be completed in fiscal year 2017. Implementation of the upgraded solution is highly dependent on coordination of numerous software and system providers and internal business teams. Brocade may experience difficulties as it transitions to the upgraded systems and processes, including loss or corruption of data, delayed shipments, decreases in productivity as our personnel implement and become familiar with new systems and processes, increased costs and lost revenues. In addition, transitioning to the upgraded solution requires a significant capital investment and personnel resources. Difficulties in implementing the upgraded solution or significant system failures could disrupt Brocade’s operations and have an adverse effect on its capital resources, financial condition, results of operations or cash flows.
Implementation of the upgraded ERP solution will have a significant impact on Brocade’s business processes and information systems across a significant portion of its operations. As a result, Brocade will be undergoing significant changes in its operational processes and internal controls as the implementation progresses, which in turn will require significant change management. If Brocade is unable to successfully manage these changes as it implements the upgraded ERP solution, its ability to conduct, manage and control routine business functions could be negatively affected, and significant disruptions to our business could occur. In addition, Brocade could incur material unanticipated expenses, including additional costs of implementation or costs of conducting business. These risks could result in significant business disruptions or divert management’s attention from key strategic initiatives and have an adverse effect on Brocade’s capital resources, financial condition, results of operations, or cash flows.
Business interruptions could adversely affect Brocade’s business operations.
Brocade’s business operations and the operations of its suppliers, CMs, and customers are vulnerable to interruptions caused by acts of terrorism, fires, earthquakes, tsunamis, nuclear reactor leaks, hurricanes, power losses, telecommunications failures, and other events beyond Brocade’s control. For example, a substantial portion of Brocade’s facilities, including its corporate headquarters, are located near major earthquake faults. Brocade does not have multiple-site capacity for all of its services in the event of a business disruption. In the event of a major earthquake, Brocade could experience business interruption resulting from destruction of facilities or other infrastructure and from loss of life. Brocade carries a limited amount of earthquake insurance, which may not be sufficient to cover earthquake-related losses, and has not set aside funds or reserves to cover other potential earthquake-related losses. Additionally, major public health issues, such as an outbreak of a pandemic or epidemic, may interrupt business operations of Brocade, its CMs, its customers, or its suppliers in those geographic regions affected by that particular health issue. In addition, one of Brocade’s CMs has a major facility located in an area that is subject to hurricanes, and Brocade’s suppliers could face other natural disasters, such as floods, earthquakes, extreme weather, and fires. In the event that a business interruption occurs that affects Brocade, its suppliers, CMs, or customers, shipments could be delayed or cancelled, and Brocade’s business operations and financial results could be harmed.
In addition, Brocade may suffer reputational harm and may not carry sufficient insurance to compensate for financial losses that may occur as a result of any of these events. Any such event could have an adverse effect on Brocade’s business, operating results, and financial condition, and could expose Brocade to significant third-party claims of liability and damages.
Any failure by Brocade to meet its current capital return objectives could have an adverse effect on its reputation and stock price.
Based on past performance and current expectations, we believe that internally generated cash flows and cash on hand will be generally sufficient to support business operations, contractual obligations, and other liquidity requirements, including our debt service requirements, associated with our operations for at least the next 12 months. We also use our operating cash flows, proceeds from the issuance of new shares, access sources of capital, or a combination thereof, to strengthen our business through acquisitions and strategic investments.
Brocade has, in the past, stated its priorities for the use of operating cash flows and its intent to, after those priorities are met, return at least 60% of its annual adjusted free cash flow to stockholders in the form of stock repurchases or dividends. Brocade’s ability to return at least 60% of its annual adjusted free cash flow to stockholders is limited by, among other things, Delaware law. In addition, Brocade’s plans and expectations relating to its return of capital to stockholders may change, as they did in May 2016, due to, among other things, the need to allocate capital to other priorities, such as the acquisition of Ruckus. If Brocade is unable to meet its stated past or current capital return objectives, or if the Board of Directors decides to further alter the capital return objective, Brocade’s reputation and its stock price may be adversely affected.
Brocade’s business is subject to increasingly complex and changing legal and regulatory requirements that could adversely affect its business, financial results, and stock price.
Brocade is subject to the changing rules and regulations of federal and state governments, as well as the stock exchange on which Brocade’s common stock is listed. These entities, including the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, the U.S. Securities and Exchange Commission, the Internal Revenue Service (the “IRS”), the Financial Industry Regulatory Authority, Inc., and the NASDAQ Stock Market LLC (“NASDAQ”), have issued a significant number of new regulations over the last several years and continue to develop additional regulations and requirements. Further, Brocade is subject to various rules and regulations of certain foreign jurisdictions. Brocade’s efforts to comply with these requirements have resulted in, and are likely to continue to result in, an increase in expenses and a diversion of management’s time from other business activities.
For example, The Sarbanes-Oxley Act of 2002 requires Brocade to furnish a report by Brocade’s management on internal control over financial reporting. This report contains, among other matters, an assessment of the effectiveness of internal control over financial reporting as of the end of the fiscal year. This assessment includes disclosure of any material weaknesses in internal control over financial reporting identified by management. If the assessment does not assert that internal control over financial reporting is effective (or if Brocade’s independent registered public accounting firm is unable to express an opinion on the effectiveness of Brocade’s internal control over financial reporting), Brocade’s stockholders could lose confidence in the accuracy and completeness of Brocade’s financial reports, which could have an adverse effect on Brocade’s stock price.
Additionally, the Dodd-Frank Wall Street Reform and Consumer Protection Act requires that public companies disclose whether certain minerals, commonly known as “conflict minerals,” are necessary to the functionality or production of a product manufactured or contracted to be manufactured by those companies, and, if so, if those minerals originated in the Democratic Republic of the Congo or an adjoining country. These requirements could adversely affect the sourcing, availability, and pricing of minerals used in the manufacture of certain components that are incorporated in Brocade products. In addition, Brocade’s supply chain is complex, so Brocade may face reputational challenges with its partners, customers, stockholders, and other stakeholders if the origins of the conflict minerals used in its products cannot be verified sufficiently.
Similarly, Brocade is subject to environmental and other regulations governing product safety, materials usage, packaging, and other environmental impacts in the countries where Brocade products are sold. For example, many Brocade products are subject to laws and regulations that restrict the use of certain substances such as lead, mercury, hexavalent chromium, and cadmium, and that require Brocade to assume responsibility for collecting, treating, recycling, and disposing of products when they have reached the end of their useful life. For example, in Europe, environmental restrictions apply to products sold in that region, and certain Brocade partners require compliance with these or other more stringent requirements. In addition, recycling, labeling, and related requirements apply to Brocade products sold in Europe and China. If Brocade products do not comply with local environmental laws, Brocade could be subject to fines, civil and criminal sanctions, and contract damage claims. In addition, Brocade could be prohibited from shipping non-compliant products into certain jurisdictions and required to recall and replace any non-compliant products already shipped, which would disrupt the ability to ship products and result in reduced revenue, increased warranty expense, increased obsolete or excess inventories, and harm to Brocade’s business and customer relationships.
Brocade’s wireless products are subject to governmental regulations in a variety of jurisdictions. In order to achieve and maintain market acceptance, Brocade’s wireless products must continue to comply with these regulations, as well as a significant number of industry standards. In the United States, Brocade’s products must comply with various regulations defined by the Federal Communications Commission (“FCC”), Underwriters Laboratories, and others. Brocade must also comply with similar international regulations. For example, Brocade’s wireless communication products operate through the transmission of radio signals, and radio emissions are subject to regulation in the United States and in other countries in which Brocade does business. In the United States, various federal agencies including the Center for Devices and Radiological Health of the United States Food and Drug Administration, the FCC, the Occupational Safety and Health Administration, and various state agencies have promulgated regulations that concern the use of radio/electromagnetic emissions standards. Member countries of the European Union have enacted similar standards concerning electrical safety and electromagnetic compatibility and emissions, and chemical substances and use standards. As these regulations and standards evolve, and if new regulations or standards are implemented, Brocade will be required to modify its products or develop and support new versions of its products, and Brocade’s compliance with these regulations and standards may become more burdensome. The failure of Brocade’s wireless products to comply, or delays in compliance, with the various existing and evolving industry regulations and standards could prevent or delay introduction of Brocade’s products, which could harm Brocade’s business. End-customer uncertainty regarding future policies may also affect demand for communications products, including Brocade’s wireless products. If existing laws or regulations regarding the use of Brocade’s wireless products or related services are enforced in a manner not contemplated by Brocade’s end customers, it could expose them or Brocade to liability and adversely affect Brocade’s wireless networking business. Moreover, channel partners or end customers may require Brocade, or Brocade may otherwise deem it necessary or advisable, to alter its wireless products to address actual or anticipated changes in the regulatory environment. Brocade’s inability to alter its wireless products to address these requirements and any regulatory changes may adversely affect Brocade’s wireless networking business.
In addition, Brocade is 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. Brocade has 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. In addition, such data privacy laws, regulations, and other obligations may negatively impact Brocade’s ability to execute transactions and pursue business opportunities. The privacy and data protection-related laws, rules, and regulations applicable to Brocade are also subject to significant change. For example, in October 2015, the Court of Justice of the European Union invalidated a safe harbor framework that allowed Brocade and other U.S. companies to meet certain European legal requirements for transferring personal data from Europe to the United States. Brocade is in the process of evaluating and considering changes to its data handling practices as a result of this court decision. In April 2016, the European Parliament approved the General Data Protection Regulation. This regulation, when effective in May 2018, will impose more stringent data protection requirements on U.S. companies collecting personal data from European Union residents and establish greater penalties for noncompliance. Any inability to comply with applicable privacy or data protection laws, regulations, or other obligations, could result in significant cost and liability, damage Brocade’s reputation, and adversely affect its business.
Changes to Brocade’s provision for income taxes or unfavorable outcomes of tax audits could adversely impact Brocade’s financial condition or results.
Brocade is subject to income and other taxes in the United States, including those required by both state and federal governmental agencies, such as the IRS, and numerous foreign jurisdictions. Brocade’s provision for income taxes could be increased due to changes in tax laws in the jurisdictions in which Brocade does business, including an increase in tax rates or an adverse change in the treatment of an item of income or expense. In this regard, the United States, countries in the European Union, and other countries where Brocade operates have enacted or are proposing changes to relevant tax, accounting, and other laws, regulations, and interpretations, including fundamental changes to tax laws applicable to multinational corporations. In addition, future effective tax rates could be subject to volatility or adversely affected by changes in the geographic mix of earnings in countries with differing statutory rates, changes in the valuation of deferred tax assets and liabilities, and tax effects of stock-based compensation. These potential changes could increase Brocade’s effective tax rate or result in other costs in the future.
Brocade is subject to periodic audits or other reviews by such governmental agencies, and is currently under examination by the IRS and several state and foreign tax jurisdictions for various years. Audits by the IRS and other governmental tax agencies are subject to inherent uncertainties and could result in unfavorable outcomes, including potential fines or penalties. While Brocade regularly assesses the likely outcomes of these audits in order to determine the appropriateness of its tax provision, the occurrence of an unfavorable outcome in any specific period could have an adverse effect on Brocade’s financial condition or results for that period or future periods. The expense of defending and resolving such an audit may be significant.
Brocade is exposed to various risks related to legal proceedings or claims that could adversely affect its financial condition or results.
Brocade is a party to lawsuits in the normal course of its business. Litigation in general can be expensive, lengthy, and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. Responding to lawsuits brought against Brocade, or legal actions initiated by Brocade, can often be expensive and time-consuming. Unfavorable outcomes from these claims and/or lawsuits could adversely affect Brocade’s business, financial results, or financial condition, and Brocade could incur substantial monetary liability and/or be required to change its business practices. In view of the uncertainties, potential risks, and expenses of litigation, Brocade may, from time to time, settle such disputes, even where Brocade had meritorious claims or defenses, by agreeing to settlement agreements that, depending on their terms, may significantly impact Brocade’s financial condition or results.
Brocade’s stock price may fluctuate, which could cause the value of an investment in Brocade’s shares to decline.
Brocade’s stock price has fluctuated in the past and may be subject to wide fluctuations in the future in response to various factors. Brocade does not have the ability to influence or control many of these factors. In addition to the factors discussed elsewhere in this “Risk Factors” section, factors that could affect Brocade’s stock price include, among others:
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Actual or anticipated changes in Brocade’s operating results;
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Whether Brocade’s operating results or forecasts meet the expectations of securities analysts or investors;
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Actual or anticipated changes in the expectations of securities analysts or investors;
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Recommendations by securities analysts or changes in their earnings estimates;
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The announcement or timing of announcement of Brocade’s quarterly or annual operating results;
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Announcements of actual or anticipated operating results by Brocade’s competitors, Brocade’s OEM partners, and other companies in the IT industry;
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Speculation, coverage or sentiment in the media or the investment community about, or actual changes in, Brocade’s business, strategic position, competitive position, market share, operations, prospects, future stock price performance, or Brocade’s industry in general;
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The announcement of new, planned, or contemplated products; services; commercial relationships; technological innovations; acquisitions; divestitures; or other significant transactions by Brocade or its competitors;
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Brocade’s level of success, or perceived level of success, in integrating acquisitions, including the Ruckus acquisition;
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Adverse changes to Brocade’s relationships with any of its OEM partners;
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Changes in the business strategy or execution of any of Brocade’s OEM partners;
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Departures of key employees;
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Litigation or disputes involving Brocade, Brocade’s industry, or both;
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General economic conditions and trends;
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Sales of Brocade’s stock by Brocade’s officers, directors, or significant stockholders; and
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The timing and amount of dividends and stock repurchases.
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In addition, the stock market in general, and the market for technology companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Accordingly, broad market and industry factors may adversely affect Brocade’s stock price regardless of Brocade’s operating performance. In addition, Brocade’s stock price might also fluctuate in reaction to events that affect other companies in Brocade’s industry even if these events do not directly affect or involve Brocade.
If Brocade’s stock price fluctuates widely, Brocade may become the target of securities litigation. Securities litigation could result in substantial costs and divert Brocade’s management’s attention and resources from Brocade’s business.
Brocade has incurred substantial indebtedness that may decrease its business flexibility, access to capital, and/or increase its borrowing costs, which may adversely affect Brocade’s operations and financial results.
As of
April 30, 2016
, Brocade had approximately $875 million in principal amount of outstanding indebtedness, including $575 million of indebtedness under the 1.375% convertible senior unsecured notes due 2020 (the “2020 Convertible Notes”) and $300 million of unsecured indebtedness under the 4.625% senior notes due 2023 (the “2023 Notes”) (see Note
8
, “
Borrowings
,” of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q). Subsequently, in connection with the completion of the Ruckus acquisition in May 2016, Brocade entered into a Credit Agreement (the “Credit Agreement”) with Wells Fargo Bank, National Association, and certain other lenders from time to time party thereto (collectively, the “Lenders”) pursuant to which the Lenders have provided Brocade with a term loan facility of
$800 million
(the “Term Loan Facility”) and a revolving credit facility of
$100 million
(the “Revolving Facility,” and together with the Term Loan Facility, the “Senior Credit Facility”). Brocade’s indebtedness after giving effect to the borrowings under the Term Loan Facility is approximately $1.7 billion. Brocade’s substantially increased indebtedness could have the effect, among other things, of reducing Brocade’s flexibility to respond to changing business and economic conditions. In addition, a substantial amount of cash will be required to pay interest on, make scheduled principal amortization payments, and repay at maturity Brocade’s indebtedness, which may adversely impact Brocade’s cash resources, reduce Brocade’s business flexibility and reduce the funds otherwise available for working capital, capital expenditures, acquisitions, share repurchases, and other general corporate purposes and may limit the ability of Brocade to meet its target of returning at least 60% of its annual adjusted free cash flow to Brocade stockholders in the form of share repurchases or cash dividends. Moreover, Brocade’s increased indebtedness may put the company at a competitive disadvantage relative to other companies with lower indebtedness levels.
The Credit Agreement contains financial maintenance covenants, including a maximum total leverage ratio and a minimum interest coverage ratio. The Credit Agreement also contains restrictive covenants that limit, among other things, Brocade’s and certain of its subsidiaries’ ability to incur additional indebtedness or issue certain preferred equity, pay dividends or make other distributions or other restricted payments (including stock repurchases), sell assets other than on terms specified by the Credit Agreement, amend the terms of certain other indebtedness and organizational documents, create liens on certain assets to secure debt, consolidate, merge, sell or otherwise dispose of all or substantially all of their assets, enter into certain transactions with affiliates and change their lines of business, fiscal years and accounting practices, in each case, subject to certain exceptions. The indenture governing the 2023 Notes contains several negative covenants that restrict the incurrence of debt by Brocade’s subsidiaries, restrict the incurrence of liens on principal properties, and restrict Brocade and its subsidiaries from engaging in certain sale-leaseback transactions. In addition, the indentures governing both the 2020 Convertible Notes and the 2023 Notes impose covenants that restrict Brocade’s ability to effect certain mergers, consolidations, or sales of assets and require Brocade to offer to repurchase the notes upon the occurrence of certain “fundamental changes” or “change of control triggering events.”
The financial and other covenants agreed to by Brocade in connection with such indebtedness could have the effect, among other things, of reducing Brocade’s flexibility to respond to changing business and economic conditions and increasing borrowing costs, should further debt financing be desired, and may adversely affect Brocade’s operations and financial results. Brocade’s failure to comply with these covenants would result in a default under the applicable indenture or the Credit Agreement, which could permit the holders to accelerate such debt or demand payment in exchange for a waiver of such default. A default under one debt instrument could also result in cross-defaults under Brocade’s other debt instruments, negatively impact the price and liquidity of Brocade’s debt and equity securities, negatively impact Brocade’s credit ratings, and impair Brocade’s ability to access sources of capital. If any of Brocade’s debt is accelerated, Brocade may not have sufficient funds available to repay such debt.
Agencies rating Brocade’s debt securities may lower Brocade’s credit rating. This could further negatively impact the price and liquidity of Brocade’s debt and equity securities and Brocade’s ability to access sources of capital. In addition, in the event of certain credit rating downgrades, then Brocade’s obligations under the Senior Credit Facility, which are currently unsecured, will be required to be secured, subject to certain exceptions, by the equity interests of certain Brocade subsidiaries.
Although interest rates have remained at low levels in recent years, they may increase for various reasons, including an increase in inflation, Federal Reserve Board actions, domestic or international fiscal policies, or domestic or international events impacting financial or capital markets. Higher interest rates or an increase in the credit spread for Brocade’s rating could negatively impact Brocade’s ability to raise additional debt or refinance existing debt. In addition, the indebtedness under the Senior Credit Facility has a floating interest rate, and an increase in interest rates may negatively impact Brocade’s financial results.
The occurrence of a “Fundamental Change” with respect to the 2020 Convertible Notes or a “Change of Control Triggering Event” with respect to the 2023 Notes or a conversion of the 2020 Convertible Notes could negatively impact Brocade’s cash flows and financial position.
Holders of the 2020 Convertible Notes have the right to require Brocade to repurchase their convertible notes upon the occurrence of a “Fundamental Change” and holders of the 2023 Notes have the right to require Brocade to repurchase their senior notes upon the occurrence of a “Change of Control Triggering Event,” in each case at a repurchase price equal to 100% of the principal amount of the applicable notes to be repurchased, plus
accrued and unpaid interest, if any. In addition, upon conversion of the 2020 Convertible Notes, Brocade will be required to make cash payments up to the full conversion value in respect of the convertible notes being converted, unless Brocade elects to only deliver shares of its common stock to settle such conversion (other than paying cash in lieu of delivering any fractional share). It is Brocade’s current intent and policy to settle conversions of the 2020 Convertible Notes through the delivery of cash up to the principal amount of converted convertible notes, together with shares of common stock to satisfy any conversion obligation in excess of such specified dollar amount. However, if Brocade elects to settle conversions of the 2020 Convertible Notes solely in shares of common stock, such settlement would result in additional dilution to Brocade’s stockholders and could result in more dilutive accounting treatment for the 2020 Convertible Notes. The 2020 Convertible Notes may be converted at the option of the holders during certain periods as a result of, among other things, fluctuations in Brocade’s stock price.
If Brocade is required to make repurchases of the 2020 Convertible Notes or the 2023 Notes or make cash payments in respect of conversions of the 2020 Convertible Notes, Brocade may not have enough available cash or be able to obtain financing on acceptable terms (or at all) at the time. Further, these obligations would negatively impact Brocade’s cash flows and could limit its ability to use its available cash and cash flow for other liquidity needs, including working capital, capital expenditures, acquisitions, investments, and other general corporate purposes. Brocade’s ability to repurchase the notes or to pay cash upon conversions of the 2020 Convertible Notes may also be limited by law, by regulatory authority, or by agreements governing its future indebtedness.
Provisions in Brocade’s charter documents, customer agreements, and Delaware law could discourage, delay, or prevent a change in control of Brocade, which could hinder stockholders’ ability to receive a premium for Brocade’s common stock and adversely affect the value of Brocade’s convertible notes.
Provisions of Brocade’s certificate of incorporation and bylaws may discourage, delay, or prevent a merger or mergers that a stockholder may consider favorable. These provisions include, but are not limited to:
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Authorizing the issuance of preferred stock without stockholder approval;
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Prohibiting cumulative voting in the election of directors;
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Limitations on who may call special meetings of stockholders and when special meetings of stockholders may be called; and
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Prohibiting stockholder actions by written consent.
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Certain provisions of Delaware law also may discourage, delay, or prevent someone from acquiring or merging with Brocade, and Brocade’s agreements with certain Brocade customers require that Brocade give prior notice of a change of control and grant certain manufacturing rights following a change of control. Brocade’s various change of control provisions could prevent or delay a change in control of Brocade, which could hinder stockholders’ ability to receive a premium for Brocade’s common stock and could adversely affect the value of Brocade’s convertible notes.