ITEM 1A. Risk Factors
The risk factors presented below update the risk factors previously disclosed in our Annual Report. The following factors, along with those in the Annual Report and those described above under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” should be reviewed carefully, in conjunction with the other information contained in this Form 10-Q and our financial statements. These factors, among others, could cause actual results to differ materially from those currently anticipated and contained in forward-looking statements made in this Form 10-Q and presented elsewhere by our management from time to time. See the discussion of forward-looking statements in "Part I, Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
U.S. Government Sales—We derive a significant portion of our revenue from customers who directly or indirectly receive funding from the U.S. government. If our U.S. government-related sales decrease, or our ability to do business with the U.S. government or entities funded by the U.S. government is disrupted or limited, our operating performance could be adversely affected.
We generally derive a significant portion of our revenue directly from U.S. government entities, from education and research institutions funded by the U.S. government and from system integrators that sell to the U.S. government. For the three months ended
March 25, 2016
, such sales represented approximately 30% of our total revenue. These sales present risks in addition to those involved in sales to commercial customers, including potential disruptions and delays due to changes in appropriation and spending priorities by the U.S. government. In addition, the U.S. government can terminate or modify its contracts with us at any time for its convenience. A significant reduction in such sales could adversely affect our operating performance.
Our U.S. government business is also subject to specific procurement regulations and a variety of other requirements applicable to companies doing business with the U.S government. Sales to the defense sector require us to comply with additional defense-specific regulations, including maintaining a compliant security program, obtaining security clearances for employees and passing various inspections. Failure to comply with applicable regulations and requirements could lead to our suspension or debarment from U.S. government contracting or subcontracting for a period of time as well as fines against the Company.
Any disruption or limitation in our ability to do business with the U.S. government or entities funded by the U.S. government could materially adversely affect our revenue and operating results.
Customer Concentration—A relatively small number of customers that purchase our products in large quantities have historically accounted for a significant portion of our revenues. If we are unable to maintain or replace our relationships with such customers and/or diversify our customer base, our revenue may fluctuate or decline and our growth may be limited.
Historically, a significant portion of our revenue has come from a limited number of customers. There can be no guarantee that we will be able to sustain our revenue levels from these customers. For the three months ended
March 25, 2016
, our top five customers worldwide accounted for approximately 49% of our total revenues, with various agencies of the U.S. government, excluding system integrators, accounting for approximately 6% of total revenue.
This customer concentration increases the risk of quarterly fluctuations in our revenues and operating results. The loss or reduction of business from one or a combination of our significant customers, for example as a result of a customer's capital expenditure budget reductions or U.S. government spending reductions, could materially adversely affect our revenues, financial condition and results of operations.
Strong Competition—We face competition from the leading enterprise computing companies in the world as well as from emerging companies. Some of our competitors have greater name recognition and capital resources than we do. If we are unable to compete effectively, we might not be able to achieve sufficient market penetration, revenue growth or profitability.
The markets for compute server products and storage products are highly competitive. In addition to intensely competitive smaller companies, we face challenges from some of the most established companies in the computer server market, such as Dell Inc., Hewlett-Packard Company ("HP"), International Business Machines Corporation, Cray, Inc. and Oracle Corporation. In the storage market, we compete primarily with EMC Corporation, HP, Hitachi Data Systems, Inc. and NetApp, Inc. Our largest competitors have several advantages over us, such as:
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substantially greater market presence and greater name recognition;
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substantially greater financial, technical, research and development, sales and marketing, manufacturing, distribution and other resources;
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longer operating histories;
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a broader offering of products and services;
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more established relationships with customers, suppliers and other technology companies; and
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the ability to acquire technologies or consolidate with other companies in the industry to compete more effectively.
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Because these competitors may have greater financial strength than we do and are able to offer a more diversified bundle of products and services, they may have the ability to severely undercut the pricing of our products or provide additional products or servicing at little or no cost, which would make us less competitive or force us to reduce our selling prices, negatively impacting our margins. We have had transactions where one or more competitors undercut our prices causing us to reduce our price, which negatively impacted our gross margin on that transaction and our overall gross margin. In addition, we have, on occasion, lost sales opportunities due to a competitor undercutting the pricing of our products or maintaining superior brand recognition. These competitors may be able to develop products that are superior to the commercially available components that we incorporate into our products, or may be able to offer products that provide significant price advantages over those we offer. For instance, a competitor could use its resources to develop proprietary motherboards with specifications and performance that are superior in comparison with the platforms that are currently available to the marketplace, which could give that competitor a distinct technological advantage. In addition, if our competitors' products become more widely accepted than our products, our competitive position will be impaired.
The intense competition we face in the sales of our products and services and general economic and business conditions can put pressure on us to change our prices. If our competitors offer deep discounts on certain products or services or develop products that the marketplace considers more valuable, we may need to lower prices or offer other favorable terms in order to compete successfully. Any such changes may reduce margins and could adversely affect operating results.
As the enterprise computing industry evolves, we expect to encounter additional competitors, including companies in adjacent technology businesses such as storage and networking infrastructure and management, companies providing technology that is complementary to ours in functionality, such as data center management software, contract manufacturers and other emerging companies that may announce server product offerings. Moreover, our current and potential competitors, including companies with whom we currently have strategic alliances, may establish cooperative relationships among themselves or with other third parties. If this occurs, new competitors or alliances may emerge that could negatively impact our competitive position.
Unproven Go-to-Market Strategy—We lack experience in marketing solutions to large enterprise customers. If we are not successful in increasing sales of our solutions into enterprise customers, our growth opportunities will be limited.
Despite our historical success in growing our revenue from certain agencies of the U.S. government as well as higher education, we have had limited success in broadening our base of enterprise customers. We have modified our go-to-market strategy and have invested in sales and marketing personnel and programs to increase penetration of our HPC, and High Performance Data Analytics solutions among enterprise customers, including original equipment manufacture (OEM) arrangements. If we are not successful in increasing sales of our solutions into enterprise customers, our growth opportunities may be limited.
Fluctuations in Operating Results—Among other things, the timing of our revenue is primarily dependent upon the funding and implementation schedules of our customers, particularly as it relates to large IT projects where we can have long sales cycles and long build-out and acceptance schedules. Our periodic operating results have fluctuated significantly in the past and will continue to fluctuate in the future, which could cause our stock price to decline.
Our quarterly and annual periodic operating results have fluctuated significantly in the past, and we believe that they will continue to fluctuate in the future, due to a number of factors, many of which are beyond our control. We expect that our revenue, gross margin and earnings per share will fluctuate on a periodic basis in future periods. Factors that may affect our periodic operating results include the following:
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fluctuations in the buying patterns and sizes of customer orders from one quarter to the next;
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increased competition causing us to sell our products or services at low margins;
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location and timing requirements for the delivery of our products and services;
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lengthy acceptance cycles of our products by certain customers;
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development or product delivery delays, delays in obtaining necessary components from our suppliers, or delays resulting from contractual provisions or other reasons;
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customer delays in the acceptance of our product once delivered;
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addition of new customers or loss of existing customers;
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gross margin pressures from the sales of products and services due to discounted pricing, especially to our largest customers;
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lack of reliability of our estimates to forecast sales and trends in our business to generate a sales pipeline;
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uncertainty regarding our sales pipeline and resulting customer contracts; our ability to align our product and service offerings and cost structure with customer needs;
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our ability to reduce operating expenses and total costs in procurement, which may involve delays in the anticipated timing of activities related to our cost savings plans and higher than expected or unanticipated costs to implement the plans;
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changes in the mix of products sold due to differences in profitability among our products;
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write-off of excess and obsolete inventory;
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impairment and shortening of the useful life of assets;
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unexpected changes in the price for, and the availability of, components from our suppliers;
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our ability to enhance our products with new and better designs and functionality;
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our ability to timely bring new capabilities to market combining our products and technologies with those produced by our strategic partners and original equipment manufacturers ("OEMs") to address new market opportunities;
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costs associated with obtaining components to satisfy customer demand;
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productivity and growth of our sales force;
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actions taken by our competitors, such as new product announcements or introductions or changes in pricing;
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market acceptance of newer products,
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technology regulatory compliance, certification and intellectual property issues associated with our products;
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the payment of unexpected legal fees and potential damages or settlements resulting from protecting or defending our intellectual property or other matters;
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the payment of significant damages, settlements or contractual penalties resulting from faulty or malfunctioning products or the provision of services unsatisfactory to our customers;
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compliance costs associated with new laws, rules and regulations, including environmental regulations;
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the payment of unexpected intellectual property licensing royalties to third parties who successfully assert that our product(s) infringe their intellectual property rights;
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the departure and acquisition of key management and other personnel; and
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general economic trends, including changes in information technology spending or geopolitical events such as war or incidents of terrorism.
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Lengthy Sales Cycle—Our sales cycle requires us to expend a significant amount of resources, and could have an adverse effect on the amount, timing and predictability of future revenue and cash collection.
The sales cycle of our products, beginning with our first customer contact to the closing of a sale, often ranges from six to nine months and it may be even longer before we are able to collect cash on our sales. We may expend significant resources during the sales cycle and ultimately fail to close the sale. The success of our product sales process is subject to factors over which we have little or no control, including:
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the timing of our customers' budget cycles and approval processes;
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our customers' existing use of, or willingness to adopt, open standard server products, or to replace their existing
servers or expand their processing capacity with our products;
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the announcement or introduction of competing products; and
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established relationships between our competitors and our potential customers.
We expend substantial time, effort and money educating our current and prospective customers as to the value of our products. Even if we are successful in persuading essential decision makers within our customers' organizations of the benefits of our products, senior management might nonetheless elect not to buy our products after months of sales efforts by our employees or resellers. If we are unsuccessful in closing sales after expending significant resources, our revenue, operating expenses and cash position may be adversely affected.
Even if we are successful in closing sales, several large transactions that we have entered into require us to invest cash up front to fund working capital without collecting cash for several quarters. Recently, we have found success in our strategy of focusing on large deals to help drive our revenue growth and have been awarded by customers a greater number of large installation programs. Such transactions require significant up-front capital investment. To further support our needs and to offset these declines in our cash position, we secured $70 million in term loan financing in January 2015. Nonetheless, during the
nine
months ended
March 25, 2016
, we generated approximately
$31.3 million
in cash from our operating activities. If we are unable to collect cash and negotiate more favorable cash collection terms in the future, or if we are unable to secure additional financing on acceptable terms, our liquidity and ability to fund our operations could be adversely affected.
International Sales and Operations—The global nature of our operations exposes us to increased risks and compliance obligations, which may adversely affect our business.
During the three months ended
March 25, 2016
, we derived approximately 62% of our revenue from sales outside of the United States. Our international business operations require us to recruit and retain qualified technical and managerial employees, manage multiple remote locations and ensure intellectual property protection outside of the United States. Our international operations subject us to increased risks, including:
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supporting multiple languages;
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recruiting sales and technical support personnel internationally with the skills to design, manufacture, sell and support our products;
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complying with governmental regulations, including obtaining required import or export approval for our products;
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increased complexity and costs of managing international operations;
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increased exposure to foreign currency exchange rate fluctuations;
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commercial laws and business practices that favor local competition;
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longer sales cycles and manufacturing lead times;
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financial risks such as longer payment cycles and difficulties in collecting accounts receivable;
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difficulties associated with repatriating cash generated or held abroad in a tax-efficient manner;
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ineffective legal protection of intellectual property rights;
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more complicated logistics and distribution arrangements;
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additional taxes and penalties;
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inadequate local infrastructure that could result in business disruptions;
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global political and economic instability; and
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other factors beyond our control such as natural disasters, terrorism, civil unrest, war and infectious diseases.
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If any of the foreign economies in which we do business deteriorate or if we fail to effectively manage our global operations, our business and results of operations would be harmed.
In addition, our global operations are subject to numerous U.S. and foreign laws and regulations, including those related to anti-corruption, tax, corporate governance, imports and exports, financial and other disclosures, privacy and labor relations. These laws and regulations are complex and may have differing or conflicting legal standards, making compliance difficult and costly. If we or our employees, contractors or agents violate these laws and regulations, we could be subject to fines, penalties or criminal sanctions and may be prohibited from conducting business in one or more countries. Any violation individually or in the aggregate could have a material adverse effect on our operations and financial condition.
Volatile Stock Price—Our stock price in the past has been volatile, and may continue to be volatile or may decline regardless of our operating performance, and investors may not be able to resell shares at or above the price at which they purchased the shares.
Our stock price has experienced high volatility. For example, during the
nine
months ended
March 25, 2016
, our stock price fluctuated from a high of $7.61 to a low of $3.93. Investors may not be able to sell shares at or above the price at which they purchased them. The market price of our common stock may fluctuate significantly in response to numerous factors, including without limitation:
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price and volume fluctuations in the overall stock market;
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the financial projections we may provide to the public, any changes in these projections or our failure to meet these projections;
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actual or anticipated fluctuations in our operating results;
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changes in operating performance and stock market valuations of other technology companies generally, or those that sell enterprise computing products in particular;
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changes in financial estimates by any securities analysts who follow our company, our failure to meet these estimates or failure of those analysts to initiate or maintain coverage of our stock;
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rating downgrades by any securities analysts who follow our company;
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the public's response to our press releases or other public announcements, including our filings with the SEC;
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increases in the total short position in our common stock;
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announcements by us or our competitors of significant technical innovations, customer wins or losses, acquisitions, strategic partnerships, joint ventures or capital commitments;
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introduction of technologies or product enhancements that reduce the need for our products;
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market conditions or trends in our industry or the economy as a whole;
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the loss of one or more key customers;
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the loss of key personnel;
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the development and sustainability of an active trading market for our common stock;
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lawsuits threatened or filed against us;
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future sales of our common stock by our officers, directors and significant stockholders; and
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other events or factors, including those resulting from war, incidents of terrorism or responses to these events.
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In addition, the stock markets, and in particular the NASDAQ Stock Market, have experienced extreme price and volume fluctuations that have affected and continue to affect the market prices of equity securities of many technology companies. Stock prices of many technology companies have fluctuated in a manner unrelated or disproportionate to the operating performance of those companies. In the past, stockholders have instituted securities class action litigation following periods of market volatility. We could become involved in securities litigation in the future, which could have substantial costs and divert resources and the attention of management from our business.
Due to these factors, sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell shares, could reduce the market price of our common stock.
Foreign Currency Fluctuations—We may experience foreign currency gains and losses.
We have significant exposure to revenues, expenses and certain asset and liability balances denominated in currencies other than the U.S. Dollar. Changes in the exchange rates of major foreign currencies, particularly the Japanese Yen, Euro, British Pound and Australian Dollar, relative to the U.S. Dollar, can significantly affect revenues and our operating results. Our revenues and operating results are adversely affected when the U.S. Dollar strengthens relative to other currencies and are positively affected when the U.S. Dollar weakens. Although we engage in foreign currency hedging activity, we may be unable to hedge all of our foreign currency risk, which could have a negative impact on our results of operations. For the three months ended
March 25, 2016
, our revenue from our EMEA and APJ regions was
$44.2 million
and
$33.3 million
, respectively. As of
March 25, 2016
, the balance in our foreign currency cash accounts was
$25.5 million
. An increase in the value of the U.S. Dollar relative to foreign currencies could make our products more expensive and, thus, not competitively priced in foreign markets. On the other hand, a decrease in the value of the U.S. Dollar relative to foreign currencies could increase our operating costs in foreign locations. In the future, a larger portion of our international revenue may be denominated in foreign currencies, which will subject us to additional risks associated with fluctuations in those foreign currencies. In addition, we may be unable to successfully hedge against any such fluctuations.
Our balance sheet hedging strategy is intended to mitigate our currency exposures related to remeasuring monetary assets and liabilities by entering into foreign currency forward contracts that have maturities generally of six months or less. These contracts are used to reduce our risk associated with exchange rate movements, as gains and losses on these contracts are intended to mitigate the effect of exchange rate fluctuations on certain foreign currency denominated balance sheet accounts. Additionally, our cash flow hedging strategy uses forward contracts designated as cash flow hedges to hedge a portion of future forecasted non-USD cash flows to further mitigate the effect of exchange rate fluctuations for these currencies.
Information Security—We maintain confidential and proprietary information on our computer networks and employ security measures designed to protect this information from unauthorized access. If our security measures are breached and unauthorized access is obtained, we may lose proprietary data and may suffer economic losses.
We maintain confidential information on our computer networks, including information and data that are proprietary to our customers and third parties, as well as to our company. Although we have designed and employed security measures to protect this information from unauthorized access, our security measures may be breached as a result of third-party action, including computer hackers, employee error, malfeasance or otherwise, and result in someone obtaining unauthorized access to our customers' data or our data, including our intellectual property and other confidential business information. Because the techniques employed by hackers to obtain unauthorized access or to sabotage systems change frequently, we may be unable to anticipate these techniques or to implement adequate preventative measures. Any security breach could result in disclosure of our trade secrets or disclosure of confidential customer, supplier or employee data. If this should happen, we could be exposed to potentially significant legal liability, harm to our reputation and other harm to our business.
Cost of Materials—Our products have incorporated or have been dependent upon, open standards, commoditized components and materials that we obtain in spot markets, and, as a result, our cost structure and our ability to respond in a timely manner to customer demand are sensitive to volatility of the market prices for these components and materials.
A significant portion of our cost of revenue is directly related to the pricing of commoditized materials and components utilized in the manufacture of our products, such as memory, hard drives, central processing units (“CPUs”), or power supplies. As part of our procurement model, we generally do not enter into long-term supply contracts for these materials and components, but instead purchase these materials and components in a competitive bid purchase order environment with suppliers or on the open market at spot prices. As a result, our cost structure is affected by the availability and price volatility in the marketplace for these components and materials, including new versions of hard drives and CPUs that are introduced by our suppliers. This volatility makes it difficult to predict expense levels and operating results and may cause them to fluctuate significantly. Further, if we are successful in growing our business, we may not be able to continue to procure components solely on the spot market, which would require us to enter into contracts with component suppliers to obtain these components.
In addition, because our procurement model involves our ability to maintain low inventory and to acquire materials and components as needed, and because we do not enter into long-term supply contracts for these materials and components, our ability to effectively and efficiently respond to customer orders may be constrained by the then-current availability or the terms and pricing of these materials and components. We may experience other shortages or delays of critical components as a result of strong demand, capacity constraints, supplier financial weaknesses, inability of suppliers to borrow funds in the credit markets, disputes with suppliers (some of whom are also customers), disruptions in the operations of component suppliers, natural disasters, other problems experienced by suppliers or problems faced during the transition to new suppliers.
The price of components may increase due to potential shortages or delays, and we may be exposed to quality issues or the components may not be available at all. We may therefore not be able to secure enough components at reasonable prices or of acceptable quality to build products or provide services in a timely manner in the quantities or according to the specifications needed. Accordingly, our revenue and gross margin could suffer as we could lose time-sensitive sales, incur additional freight costs or be unable to pass on price increases to our customers. If we cannot adequately address supply issues, we may have to reengineer some products or service offerings, resulting in further costs and delays.
In order to secure components for the provision of products or services, at times we may enter into non-cancelable commitments with vendors. In addition, we may purchase components strategically in advance of demand to take advantage of favorable pricing or to address concerns about the availability of future components. If we fail to anticipate customer demand properly, a temporary oversupply could result in excess or obsolete components. Further, we compete in an industry that is characterized by rapid technological advances in hardware with frequent introduction of new products. With new product introductions, we face risks in predicting customer demand for the new products as well as the transition from existing products. If we do not make an effective transition from existing products to future products, we could have an oversupply of components. For example, DRAM can represent a significant portion of our cost of revenue, and both the price and availability of various kinds of DRAM are subject to substantial volatility in the spot market. Additionally, if any of our suppliers of CPUs, such as Intel, or GPUs such as, NVIDIA were to increase the costs to us for components we use, we would either pass these price increases on to our customers, which could cause us to lose business from these customers, or we would need to absorb these price increases, which would cause our margins to decrease, either of which could adversely affect our business and financial results.
In addition to the component parts, we currently integrate application-specific integrate circuit ("ASIC") in many of our products. The development of an ASIC is costly and may take up to many months to develop. A large portion of these costs typically are expensed as incurred as research and development costs and will cause volatility in our operating results and may cause them to fluctuate significantly.
Supplier Relationships—If we fail to maintain or expand our relationships with our suppliers, in some cases single-source suppliers, we may not have adequate access to new or key technology necessary for our products, which may impair our ability to deliver leading-edge products.
In addition to the technologies we develop, our suppliers develop product innovations at our direction that are requested by our customers. In many cases, we retain the ownership of the intellectual property developed by these suppliers. Further, we rely heavily on our component suppliers, such as Intel and NVIDIA, to provide us with leading-edge components on time and in accordance with a product roadmap. If we are not able to maintain or expand our relationships with our suppliers or continue to leverage their research and development capabilities to develop new technologies desired by our customers, our ability to deliver leading-edge products in a timely manner may be impaired and we could be required to incur additional research and development expenses.
Channel Sales—We are continuing to develop and execute upon a channel strategy to generate additional sales and revenue, and the failure to successfully expand channel sales might affect our ability to sustain revenue growth and may harm our business and operations.
An increasing portion of our sales strategy is to develop our sales efforts through the use of resellers and other third parties to sell our systems, such as OEMs. We may not be successful in building or expanding relationships with these third parties. Further, even if we do develop and expand these relationships, they may conflict with our direct sales efforts in some territories. Ineffective marketing of our products by our resellers or disruptions in our distribution channels could lead to decreased sales or slower than expected growth in revenue and might harm our business and operations.
Term Loan—We are subject to a Term Loan that may limit our ability to engage in favorable business activities or finance future operations or capital needs; and we may have difficulty repaying such loan in the event of a default which could result in the acceleration of the indebtedness.
On January 27, 2015, we entered into a three and a half year term loan in the aggregate principal amount of $70.0 million. Pursuant to the terms of the agreement, certain of our subsidiaries have guaranteed or will guaranty our obligations under the loan. In addition, our obligations under the agreement are secured by a lien on substantially all of our assets and those of our subsidiary guarantors.
The Term Loan contains various covenants that limit our ability and the ability of our subsidiaries to, among other things, do the following:
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issue any preferred stock;
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incur or guarantee indebtedness;
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create, incur, assume, or permit liens to exist;
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consummate asset sales, acquisitions or mergers;
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pay dividends or repurchase stock;
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enter into transactions with affiliates; or
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enter into or permit certain types of other agreements to exist.
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The Term Loan also requires compliance with a minimum adjusted current ratio and a $10.0 million minimum unrestricted cash balance, calculated as set forth in the agreement, and contains customary events of default, including the following:
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failure to make required payments;
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material breaches of representations and warranties;
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failure to comply with certain agreements or covenants;
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failure to pay, or default under, certain other indebtedness;
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certain events of bankruptcy and insolvency;
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failure to pay certain judgments; and
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We may not prepay the loan during the first year and may only prepay the loan during the second year at a premium. After such time, we may prepay the loan without penalty. If we were unable to repay the loan, we could not terminate the facility and we would be subject to its covenants and conditions. As a result of these covenants we may be restricted in the manner in which we conduct our business. In addition, we may be unable to engage in favorable business activities or finance future operations or capital needs, including without limitation, funding acquisitions or repurchasing our stock. This indebtedness may also adversely affect our ability to access sources of capital or incur certain liens. Accordingly, these restrictions may limit our ability to successfully operate our business. A failure to comply with these restrictions could lead to an event of default, which could result in an acceleration of the indebtedness and could adversely affect our cash flow, working capital and operating results. If any of our indebtedness is accelerated, we may not have sufficient funds available to repay such indebtedness.
Dependence on Key Personnel—If we are unable to retain and attract adequate qualified personnel, we may not be able to execute on our business strategy.
During the past few fiscal years, we have experienced changes in our most senior managers. Our future success depends in large part upon the continued service and enhancement of our management team and our employees. If there are further changes in management, such changes could be disruptive and could negatively affect our operations, our culture and our strategic direction.
Our employees may terminate their employment with us at any time. Our U.S. employees are “at will,” while outside of the U.S., notice or severance may be required if we wish to terminate an employee. The failure of our management team to seamlessly manage employee transitions, or the loss of services of one or more members of our executive management or sales team or other key employees could seriously harm our business. Competition for qualified executives is intense and if we are unable to continue expanding our management team, or successfully integrate new additions to our management team in a manner that enables us to scale our business and operations effectively, our ability to operate effectively and efficiently could be limited or negatively impacted.
Additionally, to help attract, retain and motivate certain qualified employees, we use share-based incentive awards such as restricted stock units. If the value of such stock awards does not appreciate as measured by the performance of the price of our common stock, or if our share-based compensation otherwise ceases to be viewed as a valuable benefit, our ability to attract, retain and motivate employees could be weakened, which could harm our results of operations.
Contract Manufacturing—We are dependent on contract manufacturers and partners to assemble and test certain of our products, and our failure to successfully manage our relationships with these contract manufacturers and partners could impair our ability to deliver systems that meet our and/or our customers’ expectations, which could damage our relationships with our customers and decrease our revenue.
We have historically relied on a small number of contract manufacturers and partners to assemble and test certain of our products. None of these third-party contract manufacturers or partners are obligated to perform services or supply products to us for any specific period, or in any specific quantities, except as may be provided in a particular purchase order. For example, we design custom silicon chips for ASICs, but rely on a third-party to manufacture the ASICs for us. None of our contract manufacturers has provided contractual assurances to us that adequate capacity will be available to us to meet future demand for our products.
If we fail to properly manage our relationships with our contract manufacturers or partners, or if one or more of them are not able to meet our manufacturing or capacity requirements, maintain our high standards of quality or experience delays or disruptions in their service delivery, our ability to deliver quality products to our customers on a timely basis may decline, which would damage our relationships with customers, decrease our revenue and negatively impact our growth.
Acquisition Strategy—We may not be able to realize the potential financial or strategic benefits of acquisitions that we may complete in the future, or find suitable target businesses or technologies to acquire, which could impair our ability to grow our business, develop new products or sell our products.
If appropriate opportunities present themselves, we may consider acquiring or making investments in companies, assets or technologies that we believe are strategic. In addition, our Term Loan contains various covenants that limit our ability to acquire assets or make certain investments. Acquisitions are difficult, time consuming and pose a number of risks, including:
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the acquired products may fail to achieve projected sales or operating margin targets;
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the acquired business, asset or technology may not further our business strategy or we may not realize expected synergies or cost savings;
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we might overpay for the acquired business, asset or technology;
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we might experience difficulties integrating the acquired assets, technologies, operations or personnel or retaining the key personnel of the acquired company;
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disruption of ongoing business, including diversion of management's attention;
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we might experience difficulties entering and competing in new product or geographic markets in which we are not experienced;
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assumption of unknown liabilities, including tax and litigation or problems with product quality, and the related expenses and diversion of resources;
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potential downward pressure on operating margins due to lower operating margins of acquired businesses, increased headcount costs and other expenses associated with adding and supporting new products;
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potential negative impact on our relationships with customers, distributors and business partners; and
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potential negative impact on our earnings per share/negative impact on our earnings resulting from the application of ASC No. 805,
Business Combinations
, which became applicable to us in January 2009.
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In addition, if we were to proceed with one or more significant acquisitions or investments in which the consideration included cash, we could be required to use a substantial portion of our available cash. To the extent we issue shares of capital stock or other rights to purchase capital stock, including options and warrants, existing stockholders might be diluted and earnings per share might decrease. In addition, acquisitions and investments may result in the incurrence of debt, large one-time write-offs and restructuring charges.
If we do not appropriately manage these risks, any acquisitions that we complete may have an adverse effect on our business and financial condition. Additionally, if we determine that we cannot use or sell the acquired products or technology, we will be required to write down the associated intangible assets, which would negatively impact our operating results.
Financial Reporting Risks—We make estimates and assumptions in connection with the preparation of our consolidated financial statements, and any changes to those estimates and assumptions could have a material adverse effect on our results of operations. In addition, changes in accounting standards could also adversely affect our reported operating results.
In connection with the preparation of our consolidated financial statements, we use certain estimates and assumptions based on experience and other factors. Our most critical accounting estimates are described in “Management's Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K. While we believe that these estimates and assumptions are reasonable under the circumstances, they are subject to significant uncertainties, some of which are beyond our control. If these estimates and assumptions change or prove to have been incorrect, it could have a material adverse effect on our results of operations, and we may be required to restate our financial results for prior periods which could cause our stock price to decline.
We prepare our consolidated financial statements in conformity with U.S. Generally Accepted Accounting Principles ("GAAP"). These principles are subject to interpretation by the SEC, the Financial Accounting Standards Board (FASB) and various other bodies formed to interpret and create appropriate accounting principles and guidance. A change in existing principles or guidance can have a significant effect on our reported results and may retroactively affect previously reported results. Additionally, proposed accounting standards could have a significant impact on our operational processes, revenue and expenses, and could cause unexpected financial reporting fluctuations.
Environmental Laws and Liabilities—Unforeseen environmental costs could impact our future net earnings.
We are subject to various federal, state, local and foreign laws and regulations concerning environmental protection, including laws addressing the discharge of pollutants into the air and water, the management and disposal of hazardous substances and wastes, the cleanup of contaminated sites, the content of our products and the recycling, treatment and disposal of our products. In particular, we face increasing complexity in our product design and procurement operations as we adjust to new and future requirements relating to the chemical and materials composition of our products, their safe use, the energy consumption associated with those products, and climate change laws and regulations. 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. Our potential exposure includes fines and civil or criminal sanctions, third-party property damage, personal injury claims, compliance-related costs and clean-up costs. Further, liability under some environmental laws relating to contaminated sites can be imposed retroactively, on a joint and several basis, and without any finding of noncompliance or fault. The amount and timing of costs under environmental laws are difficult to predict and such costs could have a negative effect on our profitability. If we are found to be in violation of any environmental laws, costs associated with such liability may have an adverse effect on our financial results.
Geographic Business Concentrations—Business disruptions could affect our operating results.
A significant portion of our manufacturing, research and development activities and certain other critical business operations is concentrated in a few geographic areas. We are a highly automated business and a disruption or failure of our systems could cause delays in completing sales and providing services. A major earthquake, fire, tornado or other catastrophic event that results in the destruction or disruption of any of our critical business or information technology systems could severely affect our ability to conduct normal business operations and, as a result, our future operating results could be materially and adversely affected.
Further, we maintain a program of insurance coverage for various types of property, casualty and other risks. We place our insurance coverage with various carriers in numerous jurisdictions. However, there is a risk that a claim may go unpaid, such as in the event of a widespread catastrophic event that materially affects the resources of our insurer. The types and amounts of insurance that we obtain vary from time to time and from location to location, depending on availability, cost and our decisions with respect to risk retention. The policies are subject to deductibles and exclusions that result in our retention of a level of risk on a self-insurance basis. Losses not covered by insurance may be substantial and may increase our expenses, which could harm our results of operations and financial condition.
Tax Exposure—Unanticipated changes in our tax provisions or exposure to additional income tax liabilities could affect our profitability.
We are subject to income taxes in the United States and numerous foreign jurisdictions. Our tax liabilities are affected by the amounts we charge for inventory, services, funding and other items in intercompany transactions. We are subject to ongoing tax audits in various jurisdictions. Tax authorities may disagree with our intercompany charges, cross-jurisdictional transfer pricing or other matters and assess additional taxes, interest and penalties.
We regularly assess the likely outcomes of these audits in order to determine the appropriateness of our tax provision. However, there can be no assurance that we will accurately predict the outcomes of these audits, and the amounts ultimately paid upon resolution of audits could be materially different from the amounts previously included in our income tax expense and therefore could have a material impact on our tax provision, net income and cash flows.
In addition, our effective tax rate in the future could be adversely affected by changes to our operating structure, changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, changes in tax laws and the discovery of new information in the course of our tax return preparation process.
Export Controls—Our international sales may require export licenses and expose us to additional risks.
Our sales to customers outside the United States are subject to U.S. export regulations. Under these regulations, sales of many of our high-end products require approval and export licenses from the U.S. Department of Commerce. Our international sales would be adversely affected if these regulations were tightened, or if they are not adjusted over time, as technology changes, to reflect the increasing compute performance of our systems. Delay or denial in the approval of any required licenses could make it more difficult to sell to non-U.S. customers. In addition, we could be subject to regulations, fines and penalties for violations of import and export regulations if we were found in violation of these regulations. End users could circumvent end-user documentation requirements that are intended to aid in our compliance with export regulations, potentially causing us to violate these regulations. These violations could result in penalties, including prohibitions from exporting our products to one or more countries, and could materially harm our business, including our sales to the U.S. government.
Weak Global Economy—Weak or unstable global market and economic conditions may have serious adverse consequences on our business.
The global economy has experienced significant uncertainty, stock market volatility, tightened credit markets, concerns about both deflation and inflation, reduced demand for products, lower consumer confidence, reduced capital spending, liquidity concerns and business insolvencies. Declines and uncertainty about economic conditions could negatively impact our customers' businesses, causing our customers to postpone their decision-making or decrease their spending or affecting our customers' ability to pay for our products, which would harm our operating results. In addition, if one or more of our current service providers, manufacturers and other partners go out of business, it could directly affect our ability to attain our operating goals on schedule and on budget.
If the global economy experiences uncertainty, our ability to obtain credit on favorable terms could be jeopardized. Failure to secure any necessary financing in a timely manner and on favorable terms could have a material adverse effect on our financial performance and stock price and could require us to change our business plans. Furthermore, should any of our banking partners declare bankruptcy or otherwise default on their obligations, it could adversely affect our financial results and our business.
Intellectual Property Enforcement—If we are unable to protect our intellectual property adequately, we may not be able to compete effectively.
Our intellectual property is critical to our success and our ability to compete. If we fail to protect our intellectual property rights adequately, our competitors might gain access to our technology. Unauthorized parties may attempt to copy or otherwise obtain and use our proprietary technology despite our efforts to protect our intellectual property. In addition, we license our technology and intellectual property to third parties, including in some cases, our competitors, which could under some circumstances make our patent rights more difficult to enforce. Third parties could also obtain licenses to some of our intellectual property as a consequence of a merger or acquisition. Also, our participation in standard setting organizations or industry initiatives may require us to license our patents to other companies that adopt certain standards or specifications. As a result of such licensing, our patents might not be enforceable against others who might otherwise be infringing those patents and the value of our intellectual property may be impaired.
Monitoring unauthorized use of our technology is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as the laws of the United States. Any claims or litigation that we have initiated or that we may initiate in the future to protect our proprietary technology could be time consuming and expensive and divert the attention of our technical and management resources whether or not the claims or litigation are decided in our favor. Litigation is inherently uncertain, and there is no assurance that any litigation we initiate will have a successful outcome. Enforcing our rights could subject us to claims that the intellectual property right is invalid, is otherwise not enforceable, or is licensed to the party against whom we are asserting a claim. Also, assertion of our intellectual property rights could result in the other party seeking to assert alleged intellectual property rights of its own or assert other claims against us, which could harm our business.
We currently have numerous patents issued and a number of patent applications pending in the United States and other countries. These patents may be limited in value in asserting our intellectual property rights against more established companies in the computer technology sector that have sizable patent portfolios and greater capital resources. In addition, patents may not be issued from these patent applications, and even if patents are issued, they may not benefit us or give us adequate protection from competing products. For example, issued patents might be circumvented or challenged, and could be declared invalid or unenforceable. Moreover, if other companies develop unpatented proprietary technology similar to ours or competing technologies, our competitive position will be weakened.
Intellectual Property Risks—If we are found to have violated the intellectual property rights of others, we could be required to indemnify our customers, resellers or suppliers, redesign our products, pay significant royalties and enter into license agreements with third parties.
Our industry is characterized by a large number of patents, copyrights, trade secrets and trademarks and by frequent litigation based on allegations of infringement or other violation of intellectual property rights. As we continue our business, expand our product lines and our product functionality, and expand into new jurisdictions around the world, third parties may assert that our technology or products violate their intellectual property rights. Because of technological changes and the extent of issued patents in our industry, it is possible that certain components of our products and business methods may unknowingly infringe existing patents of others. Any claim, regardless of its merits, could be expensive and time consuming to defend against. Such claims would also divert the attention of our technical and management resources. Successful intellectual property claims against us could result in significant financial liability, impair our ability to compete effectively, or prevent us from operating our business or portions of our business. In addition, resolution of claims may require us to redesign our technology, to obtain licenses to use intellectual property belonging to third parties, which we may not be able to obtain on reasonable terms or at all, to cease using the technology covered by those rights, and to indemnify our customers, resellers or suppliers. Any of these events could result in unexpected expenses, negatively affect our competitive position and materially harm our business, financial condition and results of operations.
In addition, we are also subject to risks related to ownership of our patentable inventions as a result of recent changes in U.S. patent law under the America Invents Act (“AIA”). As a result of the AIA, the United States is now a “first-to-file” system. For any patent applications that are filed on or after March 16, 2013 and that do not otherwise properly claim the benefit of an application filed before that March 16, 2013 date, said applications will be subject to the new “first-to-file” requirements versus the “first-to-invent” standard of law that existed prior to that date. Accordingly, with respect to patent applications filed on or after March 16, 2013, even if we are the first to invent, we will not obtain ownership of an invention unless we are the first to file a patent application or can establish that such an earlier filing is derived from a previous public disclosure of our inventive work. If we are the first to invent but not the first to file a patent application, we will not be able to fully protect our intellectual property rights and may be found to have violated the intellectual property rights of others if we continue to operate in the absence of a patent issued to us. If we are not the first to file one or more patent applications to protect our intellectual property rights when the new patent regime becomes effective, we may be required to redesign our technology, cease using the related technology or attempt to license rights from another party, any of which could materially harm our business, financial condition and results of operations.
Open Source Software—Our use of open source and third-party software could limit our sales and growth opportunities and impose unanticipated conditions or restrictions on our ability to commercialize our products.
We incorporate open source software into our products. A majority of our server systems run on the Linux
®
operating system. Products based on the Linux operating system and sold by other software vendors have been the subject of intellectual property infringement litigation, including litigation by Microsoft Corporation. It is possible that a party could prove a claim for proprietary rights in the Linux operating system or other programs developed and distributed under the GNU General Public License or other open source software licenses. In addition, the GNU General Public License has itself been, and may be in the future, a subject of litigation, and it is possible that a court could hold these licenses to be unenforceable in that litigation. Any ruling by a court that the Linux operating system or significant portions of it may not be copied, modified or distributed, that users or distributors of Linux must pay royalties to Microsoft or others or that these licenses are not enforceable could also impede broader Linux adoption and materially harm our ability to sell our products based on the Linux operating system. Further, because potential customers have often invested significant capital and other resources in existing systems, many of which run mission-critical applications, customers may be hesitant to make dramatic changes to their data center systems. The failure of our customers and potential customers to purchase and adopt open standard-based technologies could have a material adverse impact on our ability to maintain or generate additional revenue.
In addition,
open source software is made available to us and to the public by its authors or other third parties under licenses that impose certain obligations on licensees in the event those licensees re-distribute or make derivative works of the open source software. The terms of many open source licenses have not been interpreted by United States or other courts, and these licenses could be construed in a manner that imposes unanticipated conditions or restrictions on our ability to commercialize our products. In this event, we could be required to seek licenses from third parties in order to continue offering our products, to make generally available, in source code form, proprietary code that links to certain open source modules, to re-engineer our products, or to discontinue the sale of our products if re-engineering could not be accomplished on a timely basis, any of which might harm our business, operating results and financial condition.
IT Infrastructure—Unsuccessful deployment of new transaction processing applications and other systems integration issues could disrupt our internal operations and any such disruption could reduce our expected revenue, increase our expenses and damage our reputation.
Portions of our IT infrastructure may experience interruptions, delays or cessations of service or produce errors in connection with systems integration and implementation of new transaction processing applications, including manufacturing and sales system. We may not be successful in implementing new systems and transitioning data, which could cause business disruptions and be more expensive, time consuming, disruptive and resource-intensive to remediate. Such disruptions could adversely impact our ability to fulfill orders and negatively impact our business or interrupt other processes. Delayed sales, lower margins or lost customers resulting from these disruptions have adversely affected us in the past, and in the future could adversely affect our financial results, public disclosures and reputation.
Litigation—Adverse litigation results could affect our business.
We may be subject to legal claims or regulatory matters involving consumer, stockholder, competition and other issues on a global basis. Litigation can be lengthy, expensive and disruptive to our operations, and results cannot be predicted with certainty. An adverse decision could include monetary damages or, in cases for which injunctive relief is sought, an injunction prohibiting us from manufacturing or selling one or more of our products. If we were to receive an unfavorable ruling on a matter, our business, operating results or financial condition could be materially harmed. Additional information regarding legal matters is discussed under "Legal Proceedings" in Part II, Item 1 of this Quarterly Report on Form 10-Q.
Global Cost Reduction Efforts—We may not fully realize the anticipated positive impacts to future financial results from our cost reduction efforts.
We have taken in the past and may continue to take cost reduction efforts to streamline operations and reduce operating expenses. Our ability to achieve the anticipated cost savings and other benefits from our cost reduction measures within expected time frames is subject to many estimates and assumptions, and may vary materially based on many factors. These estimates and assumptions are subject to significant economic, competitive and other uncertainties, some of which are beyond our control. There can be no assurance that we will fully realize the anticipated positive impacts to future financial results from our current or future cost reduction measures. If our estimates and assumptions are incorrect or if other unforeseen events occur, we may not achieve the cost savings expected from such actions, and our business and results of operations could be adversely affected.
Internal Controls—If we are unable to maintain effective internal control over financial reporting in the future, the accuracy and timeliness of our financial reporting may be adversely affected.
Effective internal controls over financial reporting are necessary for us to provide reliable financial reports and effectively prevent fraud. As a publicly traded company we must maintain effective disclosure controls and procedures and internal control over financial reporting, which can be difficult to do. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
A failure to have effective internal controls and procedures for financial reporting in place could result in a restatement of our financial statements, impact our ability to accurately report financial information on a timely basis, make it difficult or impossible to obtain an audit of our financial statements or result in a qualification of any such audit. Any such event could lead to a loss of market confidence in our financial statements, delisting from the NASDAQ Global Select Market, loss of financing sources and litigation, any of which could adversely affect our stock price.
Corporate Governance—We are subject to evolving corporate governance and public disclosure regulations that have increased both our compliance costs and the risk of noncompliance, which could have an adverse effect on our stock price.
We are subject to changing rules and regulations promulgated by a number of governmental and self-regulated organizations, including the SEC, the NASDAQ Global Select Market and the FASB. These rules and regulations continue to evolve in scope and complexity and many new requirements have been created in response to laws enacted by Congress, making compliance more difficult and uncertain. Our efforts to comply with new regulations have resulted in, and are likely to continue to result in, increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities.
Anti-takeover Provisions—Some provisions in our certificate of incorporation and bylaws may deter third parties from acquiring us.
Our certificate of incorporation and bylaws contain provisions that may make the acquisition of our company more difficult without the approval of our board of directors, including the following:
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limitations on persons authorized to call a special meeting of stockholders;
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our stockholders may take action only at a meeting of stockholders and not by written consent;
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our certificate of incorporation authorizes undesignated preferred stock, the terms of which may be established and shares of which may be issued without stockholder approval; and
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advance notice procedures required for stockholders to nominate candidates for election as directors or to bring matters before an annual meeting of stockholders.
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These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors of their choosing and cause us to take other corporate actions they desire.
Conflict Minerals Risks—We are subject to the SEC's rules regarding the use and disclosure of conflict minerals, which we expect will increase our operating and compliance costs and could potentially harm our reputation, causing a decline in our stock price.
The SEC adopted its final rule implementing Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act concerning conflict minerals in August 2012. The objective of the rule is to reduce funding for armed groups that are abusing human rights in the "conflict region" as defined in the final rule. This new rule requires us to: (1) determine whether conflict minerals (tin, tantalum, tungsten, gold or similar derivatives) are used in our products and, if so, determine if the minerals originated from the Democratic Republic of Congo (DRC) or its immediately adjoining countries; and (2), if so, conduct due diligence regarding the source and chain of custody of these conflict minerals to determine whether the conflict minerals financed or benefited armed groups. The rule requires us to submit forms and reports to the SEC annually that disclose our determinations and due diligence measures. We are currently conducting conflict minerals due diligence with our supply chain partners. Presently, we have not determined how many of our supply chain partners use conflict minerals or how much expense our due diligence exercise will add to our operational cost. If we do not properly assess supply chain partners and appropriately control costs and budget for conflict minerals compliance, our results of operations and profitability in the future could suffer, our reputation could be harmed and our stock price could suffer as a result.