QUANTUM CORP /DE/ - Quarter Report: 2012 September (Form 10-Q)

Form 10-Q
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Commission File Number 1-13449
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QUANTUM CORPORATION
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Incorporated Pursuant to the Laws of the State of Delaware

IRS Employer Identification Number 94-2665054

1650 Technology Drive, Suite 800, San Jose, California 95110

(408) 944-4000
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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934, during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by checkmark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

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

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

As of the close of business on November 2, 2012, 240,765,014 shares of Quantum Corporation’s common stock were issued and outstanding.

QUANTUM CORPORATION
INDEX

PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

QUANTUM CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
(Unaudited)

See accompanying notes to Condensed Consolidated Financial Statements.

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QUANTUM CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)

See accompanying notes to Condensed Consolidated Financial Statements.

2

QUANTUM CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands)
(Unaudited)

See accompanying notes to Condensed Consolidated Financial Statements.

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QUANTUM CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

See accompanying Notes to Condensed Consolidated Financial Statements.

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QUANTUM CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1: BASIS OF PRESENTATION

Quantum Corporation (“Quantum”, the “Company”, “us” or “we”), founded in 1980, is a global expert in data protection and big data management. We provide solutions for storing and protecting information in physical, virtual, cloud and big data environments that are designed to help customers be certain they are maximizing the value of their data over its entire lifecycle. With our solutions, customers can better adapt in a world of continuing change by keeping and protecting more data for a longer period of time while reducing costs and increasing return on investment. We work closely with a broad network of distributors, value-added resellers (“VARs”), direct marketing resellers (“DMRs”), original equipment manufacturers (“OEMs”) and other suppliers to meet customers’ evolving data protection and big data management needs. Our stock is traded on the New York Stock Exchange under the symbol QTM.

The accompanying unaudited Condensed Consolidated Financial Statements include the accounts of Quantum and our wholly-owned subsidiaries. On June 13, 2011, we acquired Pancetera Software, Inc. (“Pancetera”), and Pancetera’s results of operations are included in our Condensed Consolidated Statements of Operations from that date. All intercompany balances and transactions have been eliminated. The interim financial statements reflect all adjustments, consisting of normal recurring adjustments that, in the opinion of management, are necessary for a fair statement of the results for the periods shown. The results of operations for such periods are not necessarily indicative of the results expected for the full fiscal year. The Condensed Consolidated Balance Sheet as of March 31, 2012 has been derived from the audited financial statements at that date. However, it does not include all of the information and notes required by accounting principles generally accepted in the United States for complete financial statements. The accompanying financial statements should be read in conjunction with the audited Consolidated Financial Statements for the fiscal year ended March 31, 2012 included in our Annual Report on Form 10-K, as filed with the Securities and Exchange Commission on June 14, 2012.

Recent Accounting Pronouncements

In July 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2012-02, Intangibles — Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment (“ASU 2012-02”). ASU 2012-02 provides entities the option to perform a qualitative assessment to determine whether it is more likely than not an indefinite-lived asset is impaired, similar to the goodwill impairment testing guidance. If an entity determines the fair value of the indefinite-lived asset is not more likely than not impaired, then no additional testing is required. ASU 2012-02 also provides examples of changes in events and circumstances that an entity should consider for impairment indicators in interim periods. ASU 2012-02 is effective for fiscal years, and interim periods within those years, beginning after September 15, 2012 and may be early adopted. We plan to early adopt in the fourth quarter of fiscal 2013 and do not anticipate adoption will impact our statements of financial position or results of operations.

NOTE 2: FAIR VALUE

The assets measured and recorded at fair value on a recurring basis consist of money market funds which are valued using quoted market prices (level 1 fair value measurements) at the respective balance sheet dates (in thousands):

We did not record impairments to any non-financial assets in the second quarter and first six months of fiscal 2013 or 2012. We do not have any non-financial liabilities measured and recorded at fair value on a non-recurring basis.

We had $184.5 million in long-term debt at September 30, 2012, and the estimated fair value of our long-term debt was approximately $179.7 million, based on market prices in less active markets and current interest rates (level 2 fair value measurements).

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NOTE 3: INVENTORIES

Manufacturing inventories and service parts inventories consisted of the following (in thousands):

NOTE 4: INTANGIBLE ASSETS AND GOODWILL

Intangible assets are evaluated for impairment whenever indicators of impairment are present. During the second quarter of fiscal 2013 and 2012, we considered whether there were any indicators of impairment for both our goodwill and our long-lived assets, including amortizable and indefinite-lived intangible assets, and determined there were none.

The following provides a summary of the carrying value of amortizable intangible assets (in thousands):

Total intangible amortization expense was $3.7 million and $8.3 million for the three and six months ended September 30, 2012, respectively, and was $5.4 million and $11.3 million for the three and six months ended September 30, 2011, respectively.

We evaluate goodwill for impairment annually during the fourth quarter of our fiscal year, or more frequently when indicators of impairment are present. There were no changes to goodwill balances during the second quarter of fiscal 2013. The following table provides a summary of the goodwill balance at both September 30, 2012 and March 31, 2012 (in thousands):

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NOTE 5: ACCRUED WARRANTY

The quarterly and year-to-date changes in the accrued warranty balance were (in thousands):

We generally warrant our products against defects for 1 to 3 years. A provision for estimated future costs and estimated returns for credit relating to warranty is recorded when products are shipped and revenue recognized. Our estimate of future costs to satisfy warranty obligations is primarily based on historical trends and, if believed to be significantly different from historical trends, estimates of future failure rates and future costs of repair including materials consumed in the repair, labor and overhead amounts necessary to perform the repair. If future actual failure rates differ from our estimates, we record the impact in subsequent periods. If future actual costs to repair were to differ significantly from our estimates, we record the impact of these unforeseen cost differences in subsequent periods.

NOTE 6: LONG-TERM DEBT

Our outstanding borrowings under the Wells Fargo credit agreement (“WF credit agreement”) were $49.5 million at September 30, 2012, at an interest rate of 2.46%. In addition, we have letters of credit totaling $0.3 million, reducing the amount available to borrow on the revolver to $24.2 million at September 30, 2012.

On June 28, 2012, the WF credit agreement was amended in order to allow the assignment of $25 million of the total revolver commitment to Silicon Valley Bank. This amendment also made certain other conforming and related modifications, including changes to the average liquidity requirements. The average liquidity covenant requirement was amended to be at least $15 million for the most recently completed month through December 31, 2012, increasing to $20 million on January 1, 2013. The average liquidity requirement to avoid triggering mandatory field audits was amended to be at least $20 million through March 31, 2013, increasing to $25 million on April 1, 2013. As of September 30, 2012, we were in compliance with all debt covenants.

NOTE 7: RESTRUCTURING CHARGES

In fiscal 2012, restructuring actions to consolidate operations supporting the business were the result of strategic management decisions. We had no restructuring expense for the three or six months ending September 30, 2012. The types of restructuring expense for the three and six months ended September 30, 2011 were (in thousands):

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During the second quarter and first six months of fiscal 2012, we accrued severance charges for various positions eliminated worldwide. Facility restructuring charges for both the second quarter and first six months of fiscal 2012 were due to estimated charges for a facility in India that we vacated in the second quarter of fiscal 2012. The other restructuring reversal for the first six months of fiscal 2012 was due to actual payments lower than estimated on a supplier relationship.

Accrued Restructuring

The following tables show the activity and the estimated timing of future payouts for accrued restructuring (in thousands):

NOTE 8: STOCK INCENTIVE PLANS AND SHARE-BASED COMPENSATION

Overview

Our stock incentive plans (“Plans”) are broad-based, long-term retention programs that are intended to attract and retain talented employees and align stockholder and employee interests. The Plans provide for the issuance of stock options, stock appreciation rights, stock purchase rights and long-term performance awards to our employees, officers and affiliates. We also have an employee stock purchase plan (“Purchase Plan”) that allows for the purchase of stock at a 15% discount to fair market value at the date of grant or the exercise date, whichever value is less.

The Black-Scholes option pricing model is used to estimate the fair value of options granted under our Plans and rights to acquire stock granted under our Purchase Plan.

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Share-Based Compensation

The following table summarizes share-based compensation (in thousands):

Stock Options

No stock options were granted in the second quarter or in the first six months of fiscal 2013. No stock options were granted in the second quarter of fiscal 2012; however, stock options were granted in the first six months of fiscal 2012. The weighted-average grant date fair values of employee stock option grants, as well as the weighted-average assumptions used in calculating these values for the first six months of fiscal 2012 were based on estimates at the date of grant as follows:

Restricted Stock

The fair value of the restricted stock units granted is the intrinsic value as of the respective grant date since the restricted stock units are granted at no cost to the employees. The weighted-average grant date fair values of restricted stock units granted during the second quarter and first six months of fiscal 2013 were $1.99 and $2.00, respectively. The weighted-average grant date fair values of restricted stock units granted during the second quarter and first six months of fiscal 2012 were $3.25 and $3.19, respectively.

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Stock Purchase Plan

Under the Stock Purchase Plan, rights to purchase shares are typically granted during the second and fourth quarter of each fiscal year. The value of rights to purchase shares granted in the second quarter and first six months of fiscal 2013 and fiscal 2012, respectively, was estimated at the date of the grant. The weighted-average grant date fair values and the assumptions used in calculating fair values for the three and six month periods ended September 30, 2012 and 2011 are as follows:

Stock Activity

Stock Options

A summary of activity relating to our stock options follows (options and aggregate intrinsic value in thousands):

Restricted Stock

A summary of activity relating to our restricted stock follows (shares in thousands):

NOTE 9: INCOME TAXES

Income tax provisions for the second quarter and first six months of fiscal 2013 were $0.4 million and $0.9 million, respectively, and were $0.3 million and $0.9 million for the second quarter and first six months of fiscal 2012, respectively. Income tax provisions for each of these periods reflect expenses for foreign income taxes and state taxes.

We have provided a full valuation allowance against our U.S. net deferred tax assets due to our history of net losses, difficulty in predicting future results and our conclusion that we cannot rely on projections of future taxable income to realize the deferred tax assets. Significant management judgment is required in determining our deferred tax assets and liabilities and valuation allowances for purposes of assessing our ability to realize any future benefit from our net deferred tax assets. We intend to maintain this valuation allowance until sufficient positive evidence exists to support a reversal or decrease in this allowance. Future income tax expense will be reduced to the extent that we have sufficient positive evidence to support a reversal of, or decrease in, our valuation allowance.

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NOTE 10: NET INCOME (LOSS) PER SHARE

The following is our computation of basic and diluted net income (loss) per share (in thousands, except per share data):

The computations of diluted net income (loss) per share for the periods presented exclude the following because the effect would have been anti-dilutive:

• For all periods presented, 31.2 million weighted equivalent shares of 3.50% convertible subordinated notes issued in November 2010 were excluded.
   
• For the second quarter and first six months of fiscal 2013, options to purchase 17.6 million and 18.3 million weighted average shares, respectively, were excluded. For the second quarter and first six months of fiscal 2012, options to purchase 9.6 million and 21.8 million weighted average shares, respectively, were excluded.
   
• Unvested restricted stock and restricted stock units of 10.7 million and 9.7 million weighted average shares for the second quarter and first six months of fiscal 2013, respectively, were excluded. Unvested restricted stock units for 5.9 million and 8.3 million weighted average shares for the second quarter and first six months of fiscal 2012, respectively, were excluded.

NOTE 11: LEGAL PROCEEDINGS

On June 28, 2012, Overland Storage, Inc. (“Overland”) filed a patent infringement lawsuit against Quantum and Venture Corporation Limited in the U.S. District Court for the Southern District of California, alleging that certain automated tape libraries of the defendants fall within the scope of patents 6,328,766 and 6,353,581. Overland is seeking injunctive relief, as well as the recovery of unspecified monetary damages, including treble damages for willful infringement. We do not believe we infringe the Overland patents and we will defend ourselves and will do so vigorously. Due to the inherent uncertainty of litigation, we cannot identify probable or estimable damages related to the lawsuit at this time.

On August 28, 2012, we filed a lawsuit against Overland in the U.S. District Court for the Southern District of California, for patent infringements of our patents 6,542,787; 6,498,771; 5,925,119 and 5,491,812 by the products in Overland’s NEO tape library and SnapServer product lines. We are seeking injunctive relief and the recovery of monetary damages. Due to the inherent uncertainty of litigation, we cannot identify probable or estimable awards related to the lawsuit at this time.

On September 12, 2011, Compression Technology Solutions LLC (“CTS”) filed a patent infringement lawsuit against a group of companies, consisting of Quantum, CA., Inc., EMC Corporation, Hewlett-Packard Company, International Business Machines Corp., NetApp, Inc. and Quest Software, Inc., in the U.S. District Court for the Eastern District of Missouri, alleging that certain unspecified products of the defendants, characterized as “deduplication software systems,” and, in the case of Quantum, including Quantum’s “DXi Series Deduplication software,” fall within the scope of patent 5,414,650. CTS is seeking injunctive relief, as well as the recovery of monetary damages, including treble damages for willful infringement. We do not believe we infringe the CTS patent; we believe that the CTS patent is invalid, and we intend to defend ourselves vigorously. In April 2012, our motion to transfer venue was granted and the lawsuit was transferred to the U.S. District Court for the Northern District of California. Due to the inherent uncertainty of litigation, we cannot identify probable or estimable damages related to the lawsuit at this time.

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NOTE 12: SUBSEQUENT EVENTS

On October 31, 2012, we issued $60.0 million aggregate principal amount of 4.50% convertible senior subordinated notes due November 15, 2017, and on November 6, 2012 we issued an additional $10.0 million aggregate principal amount of 4.50% convertible senior subordinated notes due November 15, 2017 pursuant to an over-allotment provision (“4.50% notes”). These notes are convertible into shares of our common stock at a conversion rate of 607.1645 shares per $1,000 principal amount of notes, a conversion price of approximately $1.65 per share. We may not redeem the notes prior to their maturity date although investors may convert the 4.50% notes into Quantum common stock until November 14, 2017 at their option. In addition, since purchasers are qualified institutional investors, as defined in Rule 144A under the Securities Act of 1933 (“Securities Act”), the 4.50% notes have not been registered under the Securities Act. We will pay 4.50% interest per annum on the principal amount of the notes semi-annually on May 15 and November 15 of each year beginning in May 2013. Interest began to accrue on October 31, 2012. The terms of the 4.50% notes are governed by an agreement dated October 31, 2012 between Quantum and U.S. Bank National Association. The 4.50% notes are subordinated to any existing indebtedness and other liabilities.

We repaid all outstanding borrowings under the WF credit agreement with $49.5 million of the proceeds from the 4.50% notes on October 31, 2012.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENT

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements in this report usually contain the words “will,” “estimate,” “anticipate,” “expect,” “believe,” “project” or similar expressions and variations or negatives of these words. All such forward-looking statements including, but not limited to, (1) our goals for future operating performance, including increasing revenue in higher margin areas of our business; (2) our expectation that we will continue to derive a substantial portion of our revenue from products based on tape technology; (3) our belief that our existing cash and capital resources will be sufficient to meet all currently planned expenditures, debt service and sustain our operations for at least the next 12 months; (4) our expectations regarding our ongoing efforts to control our cost structure and our plans to reduce spending; (5) our belief that customers delayed tape library and tape drive purchases due to the anticipated release of LTO-6 tape drives and tape automation libraries and (6) our business goals, objectives, key focuses, opportunities and prospects which are inherently uncertain as they are based on management’s expectations and assumptions concerning future events, and they are subject to numerous known and unknown risks and uncertainties. Readers are cautioned not to place undue reliance on these forward-looking statements, about which we speak only as of the date hereof. As a result, our actual results may differ materially from the forward-looking statements contained herein. Factors that could cause actual results to differ materially from those described herein include, but are not limited to: (1) the amount of orders received in future periods; (2) our ability to timely ship our products; (3) uncertainty regarding information technology spending and the corresponding uncertainty in the demand for our products and services; (4) our ability to maintain supplier relationships; (5) general economic, political and fiscal conditions in the U.S. and internationally, particularly in light of EU sovereign debt concerns and the uncertainty in the U.S. regarding fiscal and tax policies; (6) our ability to successfully introduce new products; (7) our ability to capitalize on market demand; (8) our ability to achieve anticipated gross margin levels; (9) customers not adopting LTO-6 tape drives and tape automation libraries in numbers consistent with past technology introductions and (10) those factors discussed under “Risk Factors” in Part II, Item 1A. Our forward-looking statements are not guarantees of future performance. We disclaim any obligation to update information in any forward-looking statement.

OVERVIEW

Quantum Corporation (“Quantum”, the “Company”, “us” or “we”), founded in 1980, is a global expert in data protection and big data management. We provide solutions for storing and protecting information in physical, virtual, cloud and big data environments that are designed to help customers be certain they are maximizing the value of their data over its entire lifecycle. With our solutions, customers can better adapt in a world of continuing change by keeping and protecting more data for a longer period of time while reducing costs and increasing return on investment. We work closely with a broad network of distributors, value-added resellers (“VARs”), direct marketing resellers (“DMRs”), original equipment manufacturers (“OEMs”) and other suppliers to meet customers’ evolving data protection and big data management needs. Our stock is traded on the New York Stock Exchange under the symbol QTM.

We offer a comprehensive range of solutions for data protection and big data management challenges that provide performance and value to end user customers of all sizes, from small businesses to multinational enterprises. We believe our combination of expertise, innovation and platform independence enables us to solve data protection and big data management issues more easily, cost-effectively and securely. We earn our revenue from the sale of products, systems and services through an array of channel partners and our sales force to reach end user customers of all sizes. Our products are sold under both the Quantum brand name and the names of various OEM customers. They include DXi^® deduplication systems for high speed recovery and reliability, Scalar^® tape automation products for disaster recovery and long-term data retention, StorNext^® data management software and appliances for high-performance big data file sharing and archiving and vmPRO^™ solutions for protecting virtual machine data. We also offer cloud solutions for cloud-based backup, fast restore, data recovery and business continuity. In addition, we have the global scale and scope to support our worldwide customer base.

For the second quarter of fiscal 2013, we believe our focus on closing transactions earlier in the quarter, qualifying orders earlier in the process and making contact with senior level decision makers at end users helped us improve our revenue results for disk systems and software solutions. We continued to acquire new customers which we believe was due in part to increased end user awareness as a result of our recent marketing and advertising campaigns. In addition, we introduced several new products during the second quarter of fiscal 2013, including our Q-Cloud backup and disaster recovery subscription service and StorNext 4.3. During the quarter, we also continued to expand our partnerships and routes to market.

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During the second quarter of fiscal 2013, we believe there was weakness and reduced demand in the market for tape automation products. In addition, we believe there were some customers that delayed making tape library and tape drive purchases in the second quarter of fiscal 2013, and to a lesser extent in prior quarters, due to the anticipated release of LTO-6 tape drives and tape automation libraries in the upcoming quarter. Historically, we have seen declines in our tape automation systems revenue prior to the release of new technology due to customers delaying purchases until the new technology becomes available. Global economic conditions also continued to be volatile and uncertain, especially in Europe, and companies continued to be cautious with their purchasing decisions.

In an effort to return to generating positive cash flow from operations, we plan to implement various cost controls and spending reductions. We continue to be focused on building the long-term growth areas of the business and supporting our strategic initiatives. In addition, between October 31 and November 6, 2012, we issued $70 million of convertible senior subordinated notes due November 15, 2017 to improve our capital structure, strengthen our balance sheet and provide greater flexibility in our business operations. These initiatives are intended to improve profitability and increase shareholder value.

Results

We had total revenue of $147.3 million in the second quarter of fiscal 2013, an 11% decrease from the second quarter of fiscal 2012. Revenue was lower than expected for tape automation systems and tape devices, and royalty revenue decreased as expected. Our product revenue from OEM customers decreased 19% and revenue from branded products decreased 11% both primarily due to lower than expected tape automation systems revenue. As noted above, we believe tape automation systems revenue decreases reflected reduced market demand. Our continued efforts to increase revenue from disk systems and software solutions resulted in record quarterly revenue and a 14% increase in this revenue category. Service revenue was slightly lower than the second quarter of fiscal 2012. Our continued focus on growing our branded business is reflected in the greater proportion of non-royalty revenue from branded business, at 84% in the second quarter of fiscal 2013, compared to 82% in the second quarter of fiscal 2012.

Our gross margin percentage decreased 320 basis points from the second quarter of fiscal 2012 to 40.2% primarily due to the decrease in product revenue in addition to a decrease in high-margin royalty revenue. Operating expenses increased $3.0 million, or 5% from the second quarter of fiscal 2012, primarily from increased sales and marketing expenses, largely due to growing our sales force and marketing team. We also continued our expanded marketing programs in the second quarter of fiscal 2013 to generate greater awareness and future demand for Quantum products and services. We had a $10.0 million loss from operations in the second quarter of fiscal 2013 compared to operating income of $6.9 million in the second quarter of fiscal 2012.

Interest expense decreased 36% to $1.8 million primarily due to principal payments in the prior fiscal year. We had a net use of cash from operating activities of $13.4 million in the second quarter of fiscal 2013 compared to net cash provided by operating activities of $5.6 million in the second quarter of fiscal 2012.

RESULTS OF OPERATIONS

Revenue

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Total revenue decreased in the second quarter of fiscal 2013, largely due to lower than expected tape automation systems revenue and an expected decrease in royalty revenue. Total revenue in the first six months of fiscal 2013 decreased from the first six months of fiscal 2012, reflecting economic weakness in Europe, a decrease in large orders, or orders over $200,000, and potential delayed purchases from customers waiting for LTO-6 technology. Revenue from branded data protection products and services decreased $13.0 million, or 12% from the second quarter of fiscal 2012 and decreased 10% from the first six months of fiscal 2012. Data protection products include our tape automation systems, disk systems and devices and media offerings. Revenue from branded big data and archive products and services increased $3.2 million, or 27% from the second quarter of fiscal 2012 and increased 35% from the first six months of fiscal 2012. Big data and archive products include StorNext software and StorNext and Q-Series appliances. In addition, OEM product and service revenue decreased $5.4 million and $9.2 million from the second quarter and first six months of fiscal 2012, respectively. Royalty revenue decreased $2.5 million and $6.0 million from the second quarter and first six months of fiscal 2012, respectively.

Product Revenue

Our product revenue, which includes sales of our hardware and software products sold through both our Quantum branded and OEM channels, decreased $15.1 million and $23.5 million in the second quarter and first six months of fiscal 2013, respectively, compared to the prior year periods primarily due to decreased revenue from sales of tape automation systems across most all product lines. These decreases were partially offset by the addition of revenue from our new StorNext appliances that resulted in increased disk systems and software solutions revenue for both the second quarter and first six months of fiscal 2013. Revenue from sales of branded products decreased 11% and 9%, respectively, and sales of products to our OEM customers decreased 19% and 16%, respectively, in the second quarter and first six months of fiscal 2013 compared to the prior year periods.

Our disk systems and software solutions revenue increased 14% and 10%, respectively, from the second quarter and first six months of fiscal 2012 primarily due to the addition of revenue from our StorNext appliances and Q-Series disk. The first StorNext appliance was introduced in the second quarter of fiscal 2012. As noted above, we had record quarterly revenue for disk systems and software solutions. In addition, enterprise disk systems revenue increased 30% from the second quarter of fiscal 2012 mainly due to increased large orders, or orders over $200,000. The 30% revenue growth in enterprise disk systems revenue from the second quarter of fiscal 2012 did not fully offset the 44% decrease from the first quarter of fiscal 2012, resulting in a 7% decrease in enterprise disk systems revenue for the first six months of fiscal 2013 compared to the prior year period. 

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The decrease in tape automation systems revenue in the second quarter of fiscal 2013 compared to the second quarter of fiscal 2012 was primarily due to decreased branded tape automation system sales and, to a lesser extent, from decreased OEM tape automation system sales. Contributing to the decrease in branded tape automation systems revenue was a decline in sales to agencies and departments of the U.S. federal government compared to the second quarter of fiscal 2012. Tape automation systems revenue from midrange products decreased the most in the second quarter of fiscal 2013 followed by decreased revenue for enterprise and entry level products. For the first six months of fiscal 2013, enterprise and midrange tape automation systems had the largest decreases compared to the prior year period. As noted above, tape automation system revenue in the second quarter and first six months of fiscal 2013 may have been negatively impacted by reduced demand in the market, including customers delaying tape library and tape drive purchases due to the anticipated release of LTO-6 tape technology.

Product revenue from devices, which includes tape drives and removable hard drives, and non-royalty media sales decreased from the second quarter and first six months of fiscal 2012 largely due to decreased media sales in addition to lower revenue from devices. The second quarter and first six months of fiscal 2012 had higher than usual media sales due to customers increasing their media inventories in response to concerns of supply disruptions following the March 2011 earthquake and tsunami in Japan. Revenue from devices decreased primarily due to overall market declines and may have also been impacted by the pending availability of LTO-6 tape technology.

Service Revenue

Service revenue includes revenue from sales of hardware service contracts, product repair, installation and professional services. Sales of hardware service contracts are typically purchased by our customers to extend the warranty or to provide faster service response time, or both. Service revenue decreased 1% from both the second quarter and first six months of fiscal 2012 primarily due to a decreased volume of OEM product repair services, mostly offset by growth in revenue from branded service contracts associated with our StorNext appliances.

Royalty Revenue

Tape media royalties decreased 18% and 21% from the second quarter and first six months of fiscal 2012 due to lower media unit sales sold by media licensees. The decrease was primarily due to higher than typical media sales during the second quarter and first six months of fiscal 2012 due to inventories being increased in the second quarter and first half of fiscal 2012 in response to concerns of supply disruptions following the March 2011 earthquake and tsunami in Japan.

Gross Margin

*Gross margin for the six months ended September 30, 2011 includes $0.3 million of restructuring benefit related to cost of revenue.

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The 320 basis point decrease in gross margin percentage compared to the second quarter of fiscal 2012 was primarily due to decreased product revenue. Some of our costs of goods sold are relatively fixed in the short term; therefore, revenue increases or decreases can have a material impact on the gross margin rate. In addition, approximately 100 basis points of the decrease was due to the $2.5 million decrease in royalty revenue. Approximately half of the 240 basis point decrease in gross margin percentage for the first six months of fiscal 2013 was due to a $6.0 million decrease in royalty revenue and the other half was largely due to decreased product revenue.

Product Margin

Product gross margin dollars decreased $10.6 million, or 25%, compared to the second quarter of fiscal 2012, and our product gross margin rate decreased 500 basis points primarily due to a 13% decrease in product revenue. For the first six months of fiscal 2013, product gross margin decreased $15.3 million, or 20%, and our product gross margin rate decreased 360 basis points primarily due to an 11% decrease in product revenue. Some of our product costs of goods sold are relatively fixed in the short term; therefore, product revenue increases or decreases impact the product gross margin rate. The change in the mix of products sold also contributed to decreased product margins in the second quarter and first six months of fiscal 2013. In addition, we had an increase in the inventory allowance in the second quarter and first six months of fiscal 2013 compared to the prior year periods largely due to more products nearing end of life than in the second quarter and first six months of fiscal 2012. Partially offsetting this decrease was lower intangible amortization in both the second quarter and first six months of fiscal 2013 due to certain intangible assets becoming fully amortized in fiscal 2012 and the second quarter of fiscal 2013.

Service Margin

Service gross margin dollars increased $0.7 million, or 5%, compared to the second quarter of fiscal 2012, and service gross margin percentage increased 220 basis points despite a decrease in service revenue of $0.2 million. For the first six months of fiscal 2013 service gross margin dollars increased $1.8 million, or 6%, and service gross margin percentage increased 300 basis points despite a decrease in service revenue of $0.8 million compared to the first half of fiscal 2012. These service margin increases were primarily due to reduced costs across our service delivery model in part due to bringing repair of certain product lines in-house and from a decreased volume of repairs. In addition, our service activities continue to reflect a larger proportion of branded products under contract, which have relatively higher margins than margins for OEM repair services.

The more significant cost decreases in the second quarter of fiscal 2013 compared to the second quarter of fiscal 2012 were for external service providers and third party warehouse expenses. For the first six months of fiscal 2013, the more significant cost decreases compared to the prior year period were for third party warehouse, external service providers and service materials. Third party warehouse expenses decreased due to reduced usage as a result of bringing repair of certain product lines in-house. External service provider expense decreased due to a combination of bringing repair of certain product lines in-house and negotiating lower rates on the renewals of contracts with certain service providers. Service material decreases were primarily due to decreased volumes of repairs compared to the prior year.

Research and Development Expenses

The increase in research and development expenses compared to the second quarter and first six months of fiscal 2012 was primarily due to an increase in use of external service providers largely for next generation LTO product development.

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Sales and Marketing Expenses

The increase in sales and marketing expense for the second quarter and first six months of fiscal 2013 was primarily due to a $1.7 million and $4.2 million increase, respectively, in compensation and benefits from growing our branded sales force and marketing team. We also had increases of $0.6 million and $2.4 million compared to the second quarter and first six months of fiscal 2012, respectively, in marketing and advertising expenses due to expanded marketing programs to generate greater awareness of Quantum and increase future demand for our products and services.

General and Administrative Expenses

The increase in general and administrative expenses for the first six months of fiscal 2013 compared to the first six months of fiscal 2012 was primarily due to a $0.6 million increase in facility expenses due to a higher proportion of facility costs attributable to general corporate operations as a result of reducing facilities utilized for manufacturing, service and research and development over the past year.

Gain on Sale of Patents

In the second quarter of fiscal 2012, we had a $1.5 million gain on the sale of certain patents. Under the patent sale agreement, we retain a royalty-free license for these patents. We may enter into similar transactions in the future.

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Interest Expense

Interest expense decreased from the second quarter of fiscal 2012 primarily due to principal payments in the prior fiscal year that reduced the outstanding balance of senior debt, decreasing interest expense. In addition, refinancing our senior debt in March 2012 decreased interest rates and debt amortization expense compared to the prior credit agreement. For the first six months of fiscal 2013, interest expense decreased primarily due to refinancing our senior debt in March 2012. In addition, principal payments in the prior fiscal year reduced the outstanding balance of senior debt, decreasing interest expense compared to the first half of fiscal 2012.

Income Taxes

The income tax provision for the second quarter and first six months of fiscal 2013 and 2012 reflects expenses for foreign income taxes and state taxes. We have provided a full valuation allowance against our U.S. net deferred tax assets due to our history of net losses, difficulty in predicting future results and our conclusion that we cannot rely on projections of future taxable income to realize the deferred tax assets.

Significant management judgment is required in determining our deferred tax assets and liabilities and valuation allowances for purposes of assessing our ability to realize any future benefit from our net deferred tax assets. We intend to maintain this valuation allowance until sufficient positive evidence exists to support a reversal or decrease in this allowance. Future income tax expense will be reduced to the extent that we have sufficient positive evidence to support a reversal of, or decrease in, our valuation allowance.

Amortization of Intangible Assets

The following tables detail intangible asset amortization expense within our Condensed Consolidated Statements of Operations (in thousands):

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The decrease in intangible expense in the second quarter and first six months of fiscal 2013 compared to the second quarter and first six months of fiscal 2012 was primarily due to certain intangibles becoming fully amortized during fiscal 2012 and the first six months of fiscal 2013. For further information regarding amortizable intangible assets, refer to Note 4: “Intangible Assets and Goodwill.”

Share-based Compensation

The following table summarizes share-based compensation within our Condensed Consolidated Statements of Operations (in thousands):

The increase in share-based compensation for the first six months of fiscal 2013 was primarily due to restricted stock unit awards granted in the second quarter of fiscal 2013, largely due to merit increases for our workforce.

LIQUIDITY AND CAPITAL RESOURCES

Following is a summary of cash flows from operating, investing and financing activities (in thousands):

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Six Months Ended September 30, 2012

The $15.2 million difference between reported net loss and cash used in operating activities during the six months ended September 30, 2012 was primarily due to $28.0 million in non-cash items, the largest of which were amortization, depreciation, share-based compensation and service parts lower of cost or market adjustment. In addition, we had an $11.3 million decrease in accounts receivable primarily due to decreased sales in the second quarter of fiscal 2013 compared to the fourth quarter of fiscal 2012. These were partially offset by cash uses from a $13.3 million decrease in accounts payable and an $11.1 million decrease in deferred revenue. Accounts payable decreased due to decreased purchases in addition to the timing of payments. The decrease in deferred revenue was largely due to a typical seasonal decline in service contract volumes. The majority of our service contracts renew in our third and fourth fiscal quarters.

Cash used in investing activities was primarily due to $6.7 million of property and equipment purchases and $2.2 million used to purchase other investments. Equipment purchases were primarily for engineering equipment and testing hardware to support product development activities, and we made leasehold improvements to a facility in the first quarter of fiscal 2013. Other investments were from investments we made in private technology companies with products or features complementary to Quantum products.

Six Months Ended September 30, 2011

The $18.7 million difference between reported net loss and cash provided by operating activities during the six months ended September 30, 2011 was primarily due to $28.4 million in non-cash items, the largest of which were amortization, depreciation, share-based compensation and service parts lower of cost or market adjustment. In addition, we had a $6.3 million decrease in accounts receivable primarily due to the timing of billings. These were partially offset by cash uses from a $6.0 million increase in manufacturing inventories, a $5.6 million decrease in deferred revenue and a $4.5 million decrease in accrued compensation. The increase in manufacturing inventories was the net result of lower inventory allowances, increased finished goods and decreased raw materials. The decrease in deferred revenue was largely due to a typical seasonal decline in service contract volumes. Accrued compensation decreased primarily due to the timing of payroll payments.

Cash used in investing activities reflects $8.2 million of cash paid, net of cash acquired, for our acquisition of Pancetera and $6.0 million of equipment purchases during the first six months of fiscal 2012. Equipment purchases were primarily for engineering equipment and testing hardware to support product development activities.

Cash used in financing activities during the first six months of fiscal 2012 was primarily due to $35.5 million of principal payments on the senior term debt, partially offset by $7.0 million in proceeds received from the exercise of stock options and issuance of shares under the employee stock purchase plan.

Capital Resources and Financial Condition

We continue to focus on improving our operating performance, including increasing revenue in higher margin areas of the business and continuing efforts to improve margins, return to consistent profitability and to generate positive cash flows from operating activities. We believe that our existing cash and capital resources will be sufficient to meet all currently planned expenditures, debt service, contractual obligations and sustain operations for at least the next 12 months. This belief is dependent upon our ability to achieve revenue and gross margin projections and to control operating expenses in order to provide positive cash flow from operating activities. Should any of the above assumptions prove incorrect, either in combination or individually, it would likely have a material negative effect on our cash balances and capital resources.

The following is a description of our existing capital resources including outstanding balances, funds available to borrow, and primary repayment terms including interest rates.

We have $135 million aggregate principal amount outstanding of 3.50% convertible subordinated notes due November 15, 2015. Semi-annual interest payments are required on these notes.

On October 31, 2012, we issued $60.0 million aggregate principal amount of 4.50% convertible senior subordinated notes due November 15, 2017, and on November 6, 2012 we issued an additional $10.0 million aggregate principal amount of 4.50% convertible senior subordinated notes due November 15, 2017 pursuant to an over-allotment provision (“4.50% notes”). These notes are convertible into shares of our common stock at a conversion rate of 607.1645 shares per $1,000 principal amount, a conversion price of approximately $1.65 per share. We may not redeem the notes prior to their maturity date although investors may convert the 4.50% notes into Quantum common stock until November 14, 2017 at their option. In addition, since purchasers are qualified institutional investors, as defined in Rule 144A under the Securities Act of 1933 (“Securities Act”), the 4.50% notes have not been registered under the Securities Act. We will pay 4.50% interest per annum on the principal amount of the 4.50% notes semi-annually on May 15 and November 15 of each year beginning in May 2013. Interest began to accrue on October 31, 2012. The terms of the 4.50% notes are governed by an agreement dated October 31, 2012 between Quantum and U.S. Bank National Association. The 4.50% notes are subordinated to any existing indebtedness and other liabilities.

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Under the Wells Fargo credit agreement (“WF credit agreement”), we have the ability to borrow up to $75 million under a senior secured revolving credit facility. The maximum principal amount that may be borrowed is the lesser of $75 million, reduced by $1.0 million per quarter commencing July 1, 2012, or the amount of the monthly borrowing base. The WF credit agreement matures March 29, 2017, or on August 16, 2015 if our 3.50% convertible subordinated notes remain outstanding on that date.

Our outstanding borrowings under the WF credit agreement were $49.5 million at September 30, 2012, at an interest rate of 2.46%, which was subsequently reset to 2.61% on October 1, 2012. In addition, we have letters of credit totaling $0.3 million, reducing the amount available to borrow on the revolver to $24.2 million at September 30, 2012. Quarterly, we are required to pay a 0.375% commitment fee on undrawn amounts under the revolving credit facility. There is a blanket lien on all of our assets under the WF credit agreement in addition to certain financial and reporting covenants. On October 31, 2012, we repaid all outstanding borrowings under the WF credit agreement with $49.5 million of the proceeds from the 4.50% notes.

On June 28, 2012, the WF credit agreement was amended in order to allow the assignment of $25 million of the total revolver commitment to Silicon Valley Bank. This amendment also made certain other conforming and related modifications, including changes to the average liquidity requirements. The average liquidity covenant requirement was amended to be at least $15 million for the most recently completed month through December 31, 2012, increasing to $20 million on January 1, 2013. The average liquidity requirement to avoid triggering mandatory field audits was amended to be at least $20 million through March 31, 2013, increasing to $25 million on April 1, 2013. As of September 30, 2012, we were in compliance with all debt covenants.

Generation of positive cash flow from operating activities has historically been, and will continue to be, an important source of cash to fund operating needs and meet our current and long-term obligations. We have taken many actions in recent years to offset the negative impact of the recession and slow economic recovery and their impact on the data protection and big data and archive markets. We are planning to implement cost reduction initiatives beginning in the third quarter of fiscal 2013 in an effort to better align spending with current revenue levels. We cannot provide assurance that the actions we are currently undertaking, have taken in the past or any actions we may take in the future will ensure a consistent, sustainable and sufficient level of net income and positive cash flow from operating activities to fund, sustain or grow our business. Certain events that are beyond our control, including prevailing economic, competitive and industry conditions, as well as various legal and other disputes, may prevent us from achieving these financial objectives. Any inability to achieve consistent and sustainable net income and cash flow could result in:

Any of the above mentioned items, individually or in combination, could have a material and adverse effect on our results of operations, available cash and cash flows, financial condition, access to capital and liquidity.

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CRITICAL ACCOUNTING ESTIMATES AND POLICIES

Our discussion and analysis of the financial condition and results of operations is based on the accompanying unaudited Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these statements requires us to make significant estimates and judgments about future uncertainties that affect reported assets, liabilities, revenues and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions believed to be reasonable under the circumstances. In the event that estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current information. The accounting estimates requiring our most difficult, subjective or complex judgments because these matters are inherently uncertain are unchanged. These critical accounting estimates and policies have been disclosed in our Annual Report on Form 10-K for the year ended March 31, 2012 filed with the Securities and Exchange Commission on June 14, 2012.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Changes in interest rates affect interest income earned on our cash equivalents and interest expense on our borrowings under the WF credit agreement. Our outstanding convertible subordinated notes have fixed interest rates, thus a hypothetical 100 basis point increase in interest rates would not impact interest expense on these borrowings.

Our cash equivalents consisted solely of money market funds during the three months ended September 30, 2012. During the first six months of fiscal 2013, interest rates on these funds were under 1.0% and we earned negligible amounts in interest income.

The interest rate on amounts borrowed on our WF credit agreement is based on an election by us of an annual rate equal to (1) a base rate established by Wells Fargo plus an applicable margin of 1.0% to 1.5%, based on availability levels under the WF credit agreement or (2) the LIBOR rate plus an applicable margin ranging from 2.0% and 2.5%, based on availability levels under the WF credit agreement. A hypothetical 100 basis point increase in interest rates would increase interest expense $0.2 million for the six months ended September 30, 2012.

ITEM 4. CONTROLS AND PROCEDURES

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On June 28, 2012, Overland Storage, Inc. (“Overland”) filed a patent infringement lawsuit against Quantum and Venture Corporation Limited in the U.S. District Court for the Southern District of California, alleging that certain automated tape libraries of the defendants fall within the scope of patents 6,328,766 and 6,353,581. Overland is seeking injunctive relief, as well as the recovery of unspecified monetary damages, including treble damages for willful infringement. We do not believe we infringe the Overland patents and we will defend ourselves vigorously. Due to the inherent uncertainty of litigation, we cannot identify probable or estimable damages related to the lawsuit at this time.

On August 28, 2012, we filed a lawsuit against Overland in the U.S. District Court for the Southern District of California, for patent infringements of our patents 6,542,787; 6,498,771; 5,925,119 and 5,491,812 by the products in Overland’s NEO tape library and SnapServer product lines. We are seeking injunctive relief and the recovery of monetary damages. Due to the inherent uncertainty of litigation, we cannot identify probable or estimable awards related to the lawsuit at this time.

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On September 12, 2011, Compression Technology Solutions LLC (“CTS”) filed a patent infringement lawsuit against a group of companies, consisting of Quantum, CA., Inc., EMC Corporation, Hewlett-Packard Company, International Business Machines Corp., NetApp, Inc. and Quest Software, Inc., in the U.S. District Court for the Eastern District of Missouri, alleging that certain unspecified products of the defendants, characterized as “deduplication software systems,” and, in the case of Quantum, including Quantum’s “DXi Series Deduplication software,” fall within the scope of patent 5,414,650. CTS is seeking injunctive relief, as well as the recovery of monetary damages, including treble damages for willful infringement. We do not believe we infringe the CTS patent; we believe that the CTS patent is invalid, and we intend to defend ourselves vigorously. In April 2012, our motion to transfer venue was granted and the lawsuit was transferred to the U.S. District Court for the Northern District of California. Due to the inherent uncertainty of litigation, we cannot identify probable or estimable damages related to the lawsuit at this time.

ITEM 1A. RISK FACTORS

YOU SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW, TOGETHER WITH ALL OF THE OTHER INFORMATION INCLUDED IN THIS QUARTERLY REPORT ON FORM 10-Q. THE RISKS AND UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES FACING QUANTUM. ADDITIONAL RISKS AND UNCERTAINTIES NOT PRESENTLY KNOWN TO US OR THAT ARE CURRENTLY DEEMED IMMATERIAL MAY ALSO IMPAIR OUR BUSINESS AND OPERATIONS. THIS QUARTERLY REPORT ON FORM 10-Q CONTAINS “FORWARD-LOOKING” STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. PLEASE SEE “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” FOR ADDITIONAL DISCUSSION OF THESE FORWARD-LOOKING STATEMENTS.

We continue to face risks related to the slow economic recovery.

The economic crisis in the U.S. and global financial markets in 2008 and 2009 and the continuing slow recovery has had a material and adverse impact on our business and our financial condition, including reduced demand for IT products and services overall and data protection and big data management specifically. We continue to face risks related to the slow economic recovery, including risks related to economic conditions in Europe. In addition, concerns about the potential default of various national bonds and debt backed by individual countries as well the politics impacting these, could negatively impact the U.S. and global economies and adversely affect our financial results. Uncertainty about economic conditions poses a risk as businesses may further reduce or postpone spending in response to reduced budgets, tight credit, negative financial news and declines in income or asset values which could adversely affect our business, financial condition and results of operations. In addition, our ability to access capital markets may be restricted which could have an impact on our ability to react to changing economic and business conditions and could also adversely affect our results of operations and financial condition.

We rely on indirect sales channels to market and sell our branded products. Therefore, the loss of or deterioration in our relationship with one or more of our resellers or distributors, or our inability to establish new indirect sales channels to drive growth of our branded revenue, especially for disk systems and software solutions, could negatively affect our operating results.

We sell the majority of our branded products to value-added resellers, or VARs, and to direct marketing resellers such as CDW Corporation, who in turn sell our products to end users, and to distributors such as Ingram Micro, Inc. and others. The success of these sales channels is hard to predict, particularly over time, and we have no purchase commitments or long-term orders from them that assure us of any baseline sales through these channels. Several of our resellers carry competing product lines that they may promote over our products. A reseller might not continue to purchase our products or market them effectively, and each reseller determines the type and amount of our products that it will purchase from us and the pricing of the products that it sells to end user customers. Establishing new indirect sales channels is an important part of our strategy to drive growth of our branded revenue.

As we introduce new products and solutions, we could negatively impact our relationship with channel partners that historically have sold other products and solutions that now compete with our new offerings. For example, we introduced various StorNext appliance solutions in fiscal 2012 causing us to more directly compete for hardware sales with channel partners that sold other hardware products in conjunction with our StorNext software.

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Certain of our contracts with customers contain “most favored nation” pricing provisions mandating that we offer our products to these customers at the lowest price offered to other similarly situated customers. In addition, sales of our enterprise products, and the revenue associated with the on-site service of those products, are somewhat concentrated in specific customers, including government agencies and government-related companies. Our operating results could be adversely affected by any number of factors including:

• A change in competitive strategy that adversely affects a reseller’s willingness or ability to distribute our products;
• The reduction, delay or cancellation of orders or the return of a significant amount of products;
• Our inability to gain traction in developing new indirect sales channels for our branded products;
• The loss of one or more of such distributors or resellers;
• Any financial difficulties of such distributors or resellers that result in their inability to pay amounts owed to us; or
• Changes in requirements or programs that allow our products to be sold by third parties to government customers.

A large percentage of our sales come from a few customers, some of which are also competitors, and these customers generally have no minimum or long-term purchase commitments. The loss of, or a significant reduction in demand from, one or more key customers could materially and adversely affect our business, financial condition and operating results.

Our sales have been and continue to be concentrated among a few customers because under our business model, we sell to OEMs, distributors, VARs and DMRs to reach end user customers. Furthermore, customers are not obligated to purchase any minimum product volume and our relationships with customers are terminable at will. Revenue from OEM customers has decreased in recent years. If we experience further declines in revenue from OEM customers or any of our other large customers, we could be materially and adversely affected. In addition, certain of our large customers are also our competitors, and such customers could decide to reduce or terminate their purchases of our products for competitive reasons.

Some of our tape and disk products are incorporated into larger storage systems or solutions that are marketed and sold to end users by large OEM customers as well as VARs, channel partners and other distributors. Because of this, we have limited market access to these end users, limiting our ability to reach and influence their purchasing decisions. These market conditions further our reliance on these OEM and other large customers such as distributors and VARs. Thus if they were to significantly reduce, cancel or delay their orders with us, our results of operations could be materially and adversely affected.

A portion of our sales are to various agencies and departments of the U.S. federal government. The U.S. Congress passed an Omnibus bill that requires across-the-board automatic spending cuts effective January 1, 2013 if a budget agreement is not reached by December 31, 2012. The potential automatic spending cuts could decrease revenue from sales to the federal government that could materially and adversely affect our results of operations.

Our operating results depend on a limited number of products and on new product introductions, which may not be successful, in which case our business, financial condition and operating results may be materially and adversely affected.

A limited number of products comprise a significant majority of our sales, and due to rapid technological change in the industry, our future operating results depend on our ability to develop and successfully introduce new products. To compete effectively, we must continually improve existing products and introduce new ones. We have devoted and expect to continue to devote considerable management and financial resources to these efforts. We cannot provide assurance that:

• We will introduce new products in the timeframe we are forecasting;
• We will not experience technical, quality, performance-related or other difficulties that could prevent or delay the introduction and market acceptance of new products;
• Our new products will achieve market acceptance and significant market share, or that the markets for these products will continue or grow as we have anticipated;
• Our new products will be successfully or timely qualified with our customers by meeting customer performance and quality specifications which must occur before customers will place large product orders; or
• We will achieve high volume production of these new products in a timely manner, if at all.

If we are not successful in timely completion of our new product qualifications and then ramping sales to our key customers, our revenue and results of operations could be adversely impacted. In addition, if the quality of our products is not acceptable to our customers, this could result in customer dissatisfaction, lost revenue and increased warranty and repair costs.

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Competition may intensify in the data protection market as a result of competitors introducing products based on new technology standards and merger and acquisition activity, which could materially and adversely affect our business, financial condition and results of operations.

Our competitors in the data protection market for disk systems and virtual machine solutions are aggressively trying to advance and develop new technologies and products to compete against our technologies and products, and we face the risk that customers could choose competitor products over ours. Competition in our markets is characterized by technological innovation and advancement. As a result of competition and new technology standards, our sales or gross margins could decline, which could materially and adversely affect our business, financial condition and results of operations.

Technological developments and competition over the years in the tape automation market has resulted in decreased prices for tape automation products and product offerings. Pricing pressure is more pronounced in the tape automation market for entry-level products and least pronounced for enterprise products. Similar to our competitors, our products may be priced lower and often incorporate new and/or different features and technologies than prior years. We face risks that customers could choose competitor products over ours due to these features and technologies or due to pricing differences. We have managed pricing pressure by reducing production costs and/or adding features to increase value to maintain a certain level of gross margin for our tape automation systems. If competition further intensifies, or if there is additional industry consolidation, our sales and gross margins for tape automation systems could decline, which could materially and adversely affect our business, financial condition and results of operations.

Industry consolidation and competing technologies with device products, which include tape drives and removable hard drives, have resulted in decreased prices and increasingly commoditized device products. Our response has been to manage our device business at the material margin level and we have chosen not to compete for sales in intense price-based situations or if we would be unable to maintain a certain gross margin level. Our focus has shifted to higher margin opportunities in other product lines. Although revenue from devices has decreased in recent years, our material margins have remained relatively stable over this period. We have exited certain portions of the device market and have anticipated decreased sales of devices. We face risk of reduced shipments of our devices beyond our plans, and could have reduced margins on these products, which could adversely impact our business, financial condition and results of operations.

Additionally, the competitive landscape could change due to merger and acquisition activity in the data protection market. Such transactions may impact us in a number of ways. For instance, they could result in:

• Competitors decreasing in number but having greater resources and becoming more competitive with us;
• Companies that we have not historically competed against entering into one or more of our primary markets and increasing competition in that market(s); and
• Customers that are also competitors becoming more competitive with us and/or reducing their purchase of our products.

These transactions also create uncertainty and disruption in the market because whether a pending transaction will be completed, the timing of such a transaction and its degree of impact are often unknown. Given these factors and others, such merger and acquisition activity may materially and adversely impact our business, financial condition and results of operations.

Competition may intensify in the big data and archive market as a result of competitors introducing products based on new technology standards and merger and acquisition activity, which could materially and adversely affect our business, financial condition and results of operations.

Competition in the big data and archive market is characterized by technological innovation and advancement, including performance and scale features, and our competitors are aggressively trying to advance and develop new technologies and solutions. We face the risk that customers could choose competitor solutions over ours due to these features and technologies. As a result of competition and new technology standards, our sales from software solutions and appliances could decline, which could materially and adversely affect our business, financial condition and results of operations.

Additionally, the competitive landscape could change due to merger and acquisition activity. Transactions such as these may impact us in a number of ways. For instance, they could result in:

• Competitors decreasing in number but having greater resources and becoming more competitive with us;
• Companies that we have not historically competed against entering into one or more of our primary markets and increasing competition in that market(s); and
• Customers that are also competitors becoming more competitive with us and/or reducing their purchase of our products.

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These transactions also create uncertainty and disruption in the market, because whether a pending transaction will be completed, the timing of such a transaction and its degree of impact are often unknown. Given these factors and others, such merger and acquisition activity may materially and adversely impact our business, financial condition and results of operations.

A significant decline in royalty, branded software or OEM deduplication software revenues could materially and adversely affect our business, financial condition and operating results.

Our royalties, branded software and OEM deduplication software revenues are relatively profitable and can significantly impact total company profitability. We receive royalty revenue based on tape media cartridges sold by various tape media manufacturers and resellers. Under our license agreements with these companies, each of the licensees determines the pricing and number of units of tape media cartridges that it sells. Our royalty revenue varies depending on the level of sales of the various media cartridge offerings sold by the licensees and other factors, including:

• The size of the installed base of devices and similar products that use tape media cartridges; 
• The performance of our strategic licensing partners, which sell tape media cartridges; 
• The relative growth in units of newer device products, since the associated media cartridges for newer products typically sell at higher prices than the media cartridges associated with older products; 
• The media consumption habits and rates of end users; 
• The pattern of device retirements; and 
• The level of channel inventories.

Our media royalties depend on royalty rates and the quantity of media consumed in the market. We do not control licensee sales of these tape media cartridges. Reduced royalty rates, or a reduced installed device base using tape media cartridges, would result in further reductions in our royalty revenue and could reduce gross margins. This could materially and adversely affect our business, financial condition and results of operations.

Our branded software revenues are also dependent on many factors, including the success of competitive offerings, our ability to execute on our product roadmap and our effectiveness at marketing and selling our branded software solutions directly or through our channel partners. Disruptions to any one of these factors could reduce our branded software revenues which could adversely affect our business, financial condition and operating results.

Our OEM deduplication software revenues also depend on many factors, including the success of competitive offerings, our ability to execute on our product roadmap with our OEM deduplication software partners, the effort of our OEM deduplication software partners in marketing and selling the resulting products, the market acceptance of the resulting products and changes in the competitive landscape such as that which occurred with EMC’s purchase of Data Domain. Our relationship with EMC changed from partner to competitor in deduplication as a result of their acquisition of Data Domain. Following this acquisition, except for the first quarter of fiscal 2011 when significant revenue was recognized in accordance with contractual requirements, our OEM deduplication software revenue has significantly declined, which has negatively impacted our results. Any further disruptions to the factors on which our OEM deduplication software revenues depends could adversely affect our business, financial condition and operating results.

We derive the majority of our revenue from products incorporating tape technology. If we are unable to compete with new or alternative storage technologies, our business, financial condition and operating results could be materially and adversely affected.

We derive the majority of our revenue from products that incorporate some form of tape technology and we expect to continue to derive significant revenue from these products in the next several years. As a result, our future operating results depend in part on continued market acceptance and use of products employing tape technology. Disk products as well as various software solutions and alternative technologies continue to gain broader market acceptance. We face risks that our tape customers migrate toward these products and solutions.

We are addressing this risk through our own targeted investment in disk systems and other alternative technologies; however, these markets are characterized by rapid innovation, evolving customer demands and strong competition, including competition with several companies who are also significant customers. If we are not successful in our efforts, our business, financial condition and operating results could be materially and adversely affected.

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If our products fail to meet our or our customers’ specifications for quality and reliability, our results of operations may be adversely impacted and our competitive position may suffer.

Although we place great emphasis on product quality, we may from time to time experience problems with the performance of our products, which could result in one or more of the following:

• Increased costs related to fulfillment of our warranty obligations; 
• The reduction, delay or cancellation of orders or the return of a significant amount of products; 
• Focused failure analysis causing distraction of the sales, operations and management teams; or 
• The loss of reputation in the market and customer goodwill.

These factors could cause our business, financial condition and results of operations to be materially and adversely affected.

We have taken considerable steps towards reducing our cost structure and may take further cost reduction actions. The steps we have taken and may take in the future may not reduce our cost structure to a level appropriate in relation to our future sales and therefore, these anticipated cost reductions may be insufficient to result in consistent profitability.

In the last several years, we have recorded significant restructuring charges and made cash payments in order to reduce our cost of sales and operating expenses to rationalize our operations following past acquisitions, to respond to adverse economic and industry conditions and from strategic management decisions. We may take future steps to further reduce our operating costs, including future cost reduction steps or restructurings in response to strategic decisions, adverse changes in our business or industry or future acquisitions. We may be unable to reduce our cost of sales and operating expenses at a rate and to a level appropriate in relation to our future sales, which may adversely affect our business, financial condition and operating results.

If we are unable to attract and retain skilled employees, our business could be adversely impacted.

We may be subject to increased turnover in our employee base or the inability to fill open headcount requisitions due to competition, concerns about our operational performance or other factors. In addition, we may rely on the performance of employees whose skill sets are not sufficiently developed to fulfill their expected job responsibilities. Either of these situations could impair or delay our ability to realize operational and strategic objectives and cause increased expenses and lost sales opportunities.

Economic or other business factors may lead us to write down the carrying amount of our goodwill or long-lived assets, such as the goodwill impairment charge in fiscal 2009, which could have a material and adverse effect on our results of operations.

We evaluate our goodwill for impairment annually during the fourth quarter of our fiscal year, or more frequently when indicators of impairment are present. Long-lived assets are reviewed for impairment whenever events or circumstances indicate impairment might exist. We continue to monitor relevant market and economic conditions, including the price of our stock, and perform appropriate impairment reviews when conditions deteriorate such that we believe the value of our goodwill could be further impaired or an impairment exists in our long-lived assets. It is possible that conditions could deteriorate due to economic or other factors that affect our business, resulting in the need to write down the carrying amount of our goodwill or long-lived assets to fair value at the time of such assessment. As a result, our operating results could be materially and adversely affected.

Third party intellectual property infringement claims could result in substantial liability and significant costs, and, as a result, our business, financial condition and operating results may be materially and adversely affected.

From time to time, third parties allege our infringement of and need for a license under their patented or other proprietary technology, such as our current litigation with CTS Solutions and Overland Storage described in Legal Proceedings. While we currently believe the amount of ultimate liability, if any, with respect to any such actions will not materially affect our financial position, results of operations or liquidity, the ultimate outcome of any license discussion or litigation is uncertain. Adverse resolution of any third party infringement claim could subject us to substantial liabilities and require us to refrain from manufacturing and selling certain products. In addition, the costs incurred in intellectual property litigation can be substantial, regardless of the outcome. As a result, our business, financial condition and operating results could be materially and adversely affected.

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In addition, certain products or technologies acquired or developed by us may include “open source” software. Open source software is typically licensed for use at no initial charge. Certain open source software licenses, however, require users of the open source software to license to others any software that is based on, incorporates or interacts with, the open source software under the terms of the open source license. Although we endeavor to comply fully with such requirements, third parties could claim that we are required to license larger portions of our software than we believe we are required to license under open source software licenses. If such claims were successful, they could adversely impact our competitive position and financial results by providing our competitors with access to sensitive information that may help them develop competitive products. In addition, our use of open source software may harm our business and subject us to intellectual property claims, litigation or proceedings in the future because:

• Open source license terms may be ambiguous and may subject us to unanticipated obligations regarding our products, technologies and intellectual property; 
• Open source software generally cannot be protected under trade secret law; and
• It may be difficult for us to accurately determine the origin of the open source code and whether the open source software infringes, misappropriates or violates third party intellectual property or other rights.

As a result of our global manufacturing and sales operations, we are subject to a variety of risks that are unique to businesses with international operations of a similar scope, any of which could, individually or in the aggregate have a material adverse effect on our business.

A significant portion of our manufacturing and sales operations and supply chain occurs in countries other than the U.S. We also have sales outside the U.S. We utilize contract manufacturers to produce certain of our products and have suppliers for various components, several of which have operations located in foreign countries including China, Hungary, Japan, Malaysia, Singapore and Thailand. Because of these operations, we are subject to a number of risks including:

• Shortages in component parts and raw materials;
• Import and export and trade regulation changes that could erode our profit margins or restrict our ability to transport our products; 
• The burden and cost of complying with foreign and U.S. laws governing corporate conduct outside the U.S.; 
• Adverse movement of foreign currencies against the U.S. dollar (the currency in which our results are reported) and global economic conditions generally;
• Inflexible employee contracts and employment laws that may make it difficult to terminate or change the compensation structure for employees in some foreign countries in the event of business downturns;
• Potential restrictions on the transfer of funds between countries; 
• Political, military, social and infrastructure risks, especially in emerging or developing economies; 
• Import and export duties and value-added taxes; and 
• Natural disasters, including earthquakes, flooding, typhoons and tsunamis. 

Any or all of these risks could have a material adverse effect on our business.

Our quarterly operating results could fluctuate significantly, and past quarterly operating results should not be used to predict future performance.

Our quarterly operating results have fluctuated significantly in the past and could fluctuate significantly in the future. As a result, our quarterly operating results should not be used to predict future performance. Quarterly operating results could be materially and adversely affected by a number of factors, including, but not limited to:

• Failure to complete shipments in the last month of a quarter during which a substantial portion of our products are typically shipped;
• Customers canceling, reducing, deferring or rescheduling significant orders as a result of excess inventory levels, weak economic conditions or other factors; 
• Customer fiscal year-ends and budget availability impacting customer demand for our products; 
• Declines in large orders, or orders greater than $200,000; 
• Declines in royalty revenues;

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• Declines in software revenues; 
• Product development and ramp cycles and product performance or quality issues; 
• Poor execution of and performance against expected sales and marketing plans and strategies; 
• Reduced demand from our OEM or distribution, VAR, DMR and other large customers; and 
• Increased competition.

For instance, for the first quarter of fiscal 2013, our financial results were below our guidance for the period in part because we were unable to close a number of larger transactions. After we reported this on July 9, 2012, our share price declined by 28%. If we fail to meet our projected quarterly results, our business, financial condition and results of operations may be materially and adversely affected.

If we fail to protect our intellectual property or if others use our proprietary technology without authorization, our competitive position may suffer.

Our future success and ability to compete depends in part on our proprietary technology. We rely on a combination of copyright, patent, trademark, and trade secrets laws and nondisclosure agreements to establish and protect our proprietary technology. However, we cannot provide assurance that patents will be issued with respect to pending or future patent applications that we have filed or plan to file or that our patents will be upheld as valid or will prevent the development of competitive products or that any actions we have taken will adequately protect our intellectual property rights. We generally enter into confidentiality agreements with our employees, consultants, customers, potential customers and others as required, in which we strictly limit access to, and distribution of, our software, and further limit the disclosure and use of our proprietary information.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain or use our products or technology. Enforcing our intellectual property rights can sometimes only be accomplished through the use of litigation. Our competitors may also independently develop technologies that are substantially equivalent or superior to our technology. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the U.S.

Because we may order components from suppliers in advance of receipt of customer orders for our products which include these components, we could face a material inventory risk, which could have a material and adverse effect on our results of operations and cash flows.

Although we use third parties to manufacture certain of our products, we also manufacture products in-house. Managing our in-house manufacturing capabilities presents a number of risks that could materially and adversely affect our financial condition. For instance, as part of our component planning, we place orders with or pay certain suppliers for components in advance of receipt of customer orders. We occasionally enter into negotiated orders with vendors early in the manufacturing process of our products to ensure that we have sufficient components for our products to meet anticipated customer demand. Because the design and manufacturing process for these components can be complicated, it is possible that we could experience a design or manufacturing flaw that could delay or even prevent the production of the components for which we previously committed to pay. We also face the risk of ordering too many components, or conversely, not enough components, since supply orders are generally based on forecasts of customer orders rather than actual customer orders. In addition, in some cases, we make non-cancelable order commitments to our suppliers for work-in-progress, supplier’s finished goods, custom sub-assemblies, discontinued (end-of-life) components and Quantum-unique raw materials that are necessary to meet our lead times for finished goods. If we cannot change or be released from supply orders, we could incur costs from the purchase of unusable components, either due to a delay in the production of the components or other supplies or as a result of inaccurately predicting supply orders in advance of customer orders. These same risks exist with our third party contract manufacturing partners. Our business and operating results could be materially and adversely affected if we incur increased costs, or are unable to fulfill customer orders.

In addition, several of our disk drive suppliers as well as suppliers of other components for our tape automation products with operations in Thailand were impacted by flooding in October 2011, which has affected those suppliers’ ability to manufacture a sufficient number of drives and components in order to meet the demands of their customers, including us. Certain suppliers have also announced anticipated price increases for available drives. Continued supply shortages and pricing complexities could materially and adversely affect our supply chain, customer relationships and results of operations. Although we have purchased a supply of hard disk drives to meet estimated demand for the near term, our business and operating results could be materially and adversely affected if we incur increased costs or are unable to meet customer demand.

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Some of our manufacturing, component production and service repair are outsourced to third party contract manufacturers, component suppliers and service providers. If we cannot obtain products, parts and services from these third parties in a cost effective and timely manner that meets our customers’ expectations, this could materially and adversely impact our business, financial condition and results of operations.

Many aspects of our supply chain and operational results are dependent on the performance of third party business partners. We face a number of risks as a result of these relationships, including, among others:

• Sole source of product supply
  In many cases, our business partner may be the sole source of supply for the products or parts they manufacture, or the services they provide, for us. Because we are relying on one supplier, we are at greater risk of experiencing shortages, reduced production capacity or other delays in customer deliveries that could result in customer dissatisfaction, lost sales and increased expenses, each of which could materially damage customer relationships and result in lost revenue.
   
• Cost and purchase commitments
  We may not be able to control the costs for the products our business partners manufacture for us or the services they provide to us. They procure inventory to build our products based upon a forecast of customer demand that we provide. We could be responsible for the financial impact on the contract manufacturer, supplier or service provider of any reduction or product mix shift in the forecast relative to materials that they had already purchased under a prior forecast. Such a variance in forecasted demand could require us to pay them for finished goods in excess of current customer demand or for excess or obsolete inventory and generally incur higher costs. As a result, we could experience reduced gross margins and operating losses based on these purchase commitments. With respect to service providers, although we have contracts for most of our third party repair service vendors, the contract period may not be the same as the underlying service contract with our customer. In such cases, we face risks that the third party service provider may increase the cost of providing services over subsequent periods contracted with our customer.
   
• Financial condition and stability
  Our third party business partners may suffer adverse financial or operational results or may be negatively impacted by global and local economic conditions. Therefore, we may face interruptions in the supply of product components or service as a result of financial or other volatility affecting our supply chain. We could suffer production downtime or increased costs to procure alternate products or services as a result of the possible inadequate financial condition of one or more of our business partners.
   
• Quality and supplier conduct
  We have limited control over the quality of products and components produced and services provided by our supply chain business partners. Therefore, the quality of the products, parts or services may not be acceptable to our customers and could result in customer dissatisfaction, lost revenue and increased warranty costs. In addition, we have limited control over the manner in which our business partners conduct their business. Sub-tier suppliers selected by the primary third party could have process control issues or could select components with latent defects that manifest over a longer period of time. Therefore, we may face negative consequences or publicity as a result of a third party’s failure to comply with applicable compliance, trade, environmental or employment regulations.

Any or all of these risks could have a material adverse effect on our business. In the past we have successfully transitioned products or component supply from one supplier to another existing supplier of different products or to our own facilities without significant financial or operational impact, but there is no guarantee of our continued ability to do so.

If we do not successfully manage the changes that we have made and may continue to make to our infrastructure and management, our business could be disrupted, and that could adversely impact our results of operations and financial condition.

Managing change is an important focus for us. In recent years, we have implemented several significant initiatives involving our sales and marketing, engineering and operations organizations, aimed at increasing our efficiency and better aligning these groups with our corporate strategy. In addition, we have reduced headcount to streamline and consolidate our supporting functions as appropriate following past acquisitions and in response to market or competitive conditions. Our inability to successfully manage the changes that we implement, and detect and address issues as they arise could disrupt our business and adversely impact our results of operations and financial condition.

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Our stock price could become more volatile if certain institutional investors were to increase or decrease the number of shares they own. In addition, there are other factors and events that could affect the trading prices of our common stock.

A small number of institutional investors have owned a significant portion of our common stock at various times in recent years. If any or all of these investors were to decide to purchase significant additional shares or to sell significant amounts or all of the common shares they currently own, or if there is a perception that those sales may occur, that may cause our stock price to be more volatile. For example, there have been instances in the past where a shareholder with a significant equity position began to sell shares, putting downward pressure on our stock price for the duration of their selling activity. In these situations, selling pressure outweighed buying demand and our stock price declined. This situation has occurred due to our stock price falling below institutional investors’ price thresholds and our volatility increasing beyond investors’ volatility parameters causing even greater sell pressure.

Trading prices of our common stock may fluctuate in response to a number of other events and factors, such as:

• General economic conditions; 
• Changes in interest rates; 
• Fluctuations in the stock market in general and market prices for technology companies in particular; 
• Quarterly variations in our operating results; 
• New products, services, innovations and strategic developments by our competitors or us, or business combinations and investments by our competitors or us; 
• Changes in financial estimates by us or securities analysts and recommendations by securities analysts;
• Changes in our capital structure, including issuance of additional debt or equity to the public; and
• Strategic acquisitions.

Any of these events and factors may cause our stock price to rise or fall and may adversely affect our business and financing opportunities.

If the average closing price of our common stock were to drop below $1.00 per share over a consecutive thirty trading-day period, we would be out of compliance with NYSE Euronext (“NYSE”) rules, and our common stock could be delisted from trading on the NYSE, which could materially and adversely impair the liquidity and value of our common stock.