QUANTUM CORP /DE/ - Quarter Report: 2013 September (Form 10-Q)

Form 10-Q

QUANTUM CORPORATION

Incorporated Pursuant to the Laws of the State of Delaware

IRS Employer Identification Number 94-2665054

224 Airport Parkway, San Jose, California 95110

(408) 944-4000

Former Address: 1650 Technology Drive, Suite 700, San Jose, California, 95110

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

Indicate by 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 ¨

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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨       Accelerated filer x       Non-accelerated filer ¨       Smaller reporting company ¨

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

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.

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QUANTUM CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE 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. All intercompany balances and transactions have been eliminated. We reclassified the long-term portion of accrued restructuring from current accrued restructuring charges to other long-term liabilities in the March 31, 2013 Condensed Consolidated Balance Sheet to conform to current period presentation. In the Condensed Consolidated Statements of Cash Flows prior period income taxes payable has been reclassified into other assets and liabilities to conform to current period presentation. These reclassifications had no impact on total assets, total liabilities, income (loss) from operations, net loss or net cash used in operating activities. 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, 2013 has been derived from the audited financial statements at that date, but it does not include all disclosures 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, 2013 included in our Annual Report on Form 10-K, as filed with the Securities and Exchange Commission on June 7, 2013.

Recent Accounting Pronouncements

In July 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (“ASU 2013-11”). ASU 2013-11 requires an entity to present an unrecognized tax benefit as a reduction of a deferred tax asset for an net operating loss (“NOL”) carryforward, or similar tax loss or tax credit carryforward, rather than as a liability when (1) the uncertain tax position would reduce the NOL or other carryforward under the tax law of the applicable jurisdiction and (2) the entity intends to use the deferred tax asset for that purpose. ASU 2013-11 does not require new recurring disclosures. ASU 2013-11 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. We will adopt ASU 2013-11 prospectively in the first quarter of fiscal 2015 and do not anticipate adoption will impact our statements of financial position or results of operations.

NOTE 2: REVISION OF PRIOR PERIOD FINANCIAL STATEMENTS

During the first quarter of fiscal 2014, we identified an error related to certain allowances recorded for estimated future price adjustments on products and services sold to our customers that had accumulated over a significant number of years, resulting in a $1.5 million cumulative overstatement of revenue and accounts receivable at April 1, 2013. Revenue for fiscal 2013, 2012 and 2011 was $0.1 million overstated, $0.1 million understated and $0.1 million overstated, respectively, for this error. In addition, we identified a $0.7 million under accrual of sales commission expense for the fourth quarter of fiscal 2013 that was not recorded in fiscal 2013. The cumulative effect of recording these two items in the first quarter of fiscal 2014 would have been a $2.2 million reduction in net income.

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In addition, we had previously identified the following items:

• A $0.7 million overstatement of DXi OEM software revenue in fiscal 2010 that was corrected as an out-of-period adjustment in fiscal 2011;
• A $0.5 million understatement of royalty revenue in fiscal 2011 that was corrected as an out-of-period adjustment in fiscal 2012; and
• A $0.9 million understatement of payroll tax expense on commissions that was corrected as an out-of-period adjustment in fiscal 2013. Of the cumulative adjustment, $0.3 million related to fiscal 2012 and $0.6 million related to periods prior to fiscal 2011.

We evaluated these errors in accordance with the Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 99 and determined that the errors were not material to our results of operations, financial position or cash flows in our previously issued financial statements, and therefore amendments of previously filed reports are not required. However, if the entire correction of the error was recorded during the first quarter of fiscal 2014, the impact would be significant to the quarter ended June 30, 2013. As a result, we have determined that it is appropriate to revise our prior period financial statements in accordance with the SEC's Staff Accounting Bulletin No. 108 for the items discussed above. The revisions to correct these items in the applicable prior periods are reflected in the financial information herein and will be reflected in future filings containing such financial information. The revisions had no net impact on our Consolidated Statements of Cash Flows or net income (loss) per diluted share for any prior period.

The impact of these revisions to our Consolidated Balance Sheets at March 31, 2013 and 2012; our Consolidated Statements of Operations for the years ended March 31, 2013, 2012 and 2011; and our Condensed Consolidated Statements of Operations for each quarter of fiscal 2013 and 2012 and the six months ended September 30, 2013 and 2012 is summarized as follows (in thousands, except per share amounts):

Consolidated Balance Sheets

The As Reported column includes certain reclassifications to conform to the current presentation.

Consolidated Statements of Operations – Annual

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Consolidated Statements of Operations – Quarterly – Fiscal 2013

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Consolidated Statements of Operations – Quarterly – Fiscal 2012

These revisions impacted our Consolidated Statements of Comprehensive Income (Loss) for each period by an amount equal to the impact to net income (loss) for the applicable period.

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NOTE 3: FAIR VALUE

The assets measured and recorded at fair value on a recurring basis consist of money market funds, which are included in cash and cash equivalents in our Condensed Consolidated Balance Sheets, and 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 2014 or 2013. We do not have any non-financial liabilities measured and recorded at fair value on a non-recurring basis.

We had $205.0 million in convertible subordinated debt at September 30, 2013, and the estimated fair value of our convertible subordinated debt was approximately $206.3 million, based on quoted market prices in less active markets (level 2 fair value measurements). We transferred the fair value level of the convertible subordinated debt to level 2 from level 1 at September 30, 2013 due to our assessment that the convertible subordinated notes were not actively traded during the second quarter of fiscal 2014.

NOTE 4: INVENTORIES

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

NOTE 5: INTANGIBLE ASSETS AND GOODWILL

We evaluate our amortizable and indefinite-lived intangible assets (“long-lived assets”) for impairment whenever indicators of impairment exist and concluded the carrying amount of our long-lived assets was recoverable and there was no impairment in the second quarter or first six months of fiscal 2014 and 2013. The following provides a summary of the carrying value of intangible assets (in thousands):

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Total intangible amortization expense was $2.2 million and $4.4 million for the three and six months ended September 30, 2013, respectively, and was $3.7 million and $8.3 million for the three and six months ended September 30, 2012, 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 or first six months of fiscal 2014. The following table provides a summary of the goodwill balance at both September 30, 2013 and March 31, 2013 (in thousands):

NOTE 6: 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.

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NOTE 7: RESTRUCTURING CHARGES

In the second quarter of fiscal 2014, restructuring actions were primarily the result of continued implementation efforts to further consolidate manufacturing and service activities with contract manufacturers that were initiated the first quarter of fiscal 2014. We had no restructuring expense in the second quarter or first six months of fiscal 2013. The types of restructuring expense for the three and six months ended September 30, 2013 were (in thousands):

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Accrued Restructuring

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

The $0.5 million of severance and benefit restructuring costs for the three months ended September 30, 2013 was primarily due to further consolidation of sales territories to improve utilization of our global sales team, and the $3.5 million severance and benefit restructuring costs for the six months ended September 30, 2013 was primarily the result of deciding to outsource our manufacturing operations and further consolidate production and service activities. The restructuring charge reversal was primarily due to actual costs being lower than estimated, followed by employees transferring from eliminated positions to fill other staffing needs during the second quarter and first six months of fiscal 2014. Other restructuring expenses were comprised of incremental retention bonuses for certain key employees whose positions are being eliminated, freight charges and travel costs as a result of transitioning toward an outsource model.

We anticipate the $3.1 million and $0.1 million severance and benefits and other restructuring accruals, respectively, will be substantially paid by the end of fiscal 2014. Facility restructuring accruals will be paid in accordance with the respective facility lease terms. The $1.6 million of lease payments scheduled to occur between October 2014 and February 2021 is included in other long-term liabilities in the Condensed Consolidated Balance Sheets.

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NOTE 8: STOCK INCENTIVE PLANS AND SHARE-BASED COMPENSATION

Share-Based Compensation

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

Stock Options

No stock options were granted during the second quarter or first six months of fiscal 2014 or 2013. The Black-Scholes option pricing model is used to estimate the fair value of stock options.

Restricted Stock

The fair value of restricted stock units (“RSUs”) 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 RSUs granted during the second quarter and first six months of fiscal 2014 were $1.41 and $1.40, respectively. The weighted-average grant date fair values of RSUs granted during the second quarter and first six months of fiscal 2013 were $1.99 and $2.00, respectively.

During the second quarter of fiscal 2014, we granted 0.8 million RSUs with market conditions (“market RSUs”) and estimated the fair value of these market RSUs using a Monte Carlo simulation model. The number of market RSUs is dependent on Quantum’s common stock achieving certain 60-day average stock price targets as of specified dates, which vest immediately to two years after the specified dates.

The Monte Carlo model requires the input of assumptions including expected volatility, risk-free interest rate and expected term in order to simulate a large number of possible outcomes to provide an estimated fair value of the market RSUs. We used an expected volatility of 66%, a risk free interest rate of 0.5% and expected terms of ten months, twenty two months and thirty four months that mirrors the various vesting dates of the awards. The estimated fair value of the market RSUs was $0.7 million which will be recognized over the respective vesting periods of the awards.

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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 2014 and fiscal 2013, 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, 2013 and 2012 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 2014 were $0.5 million and $0.9 million, respectively, and were $0.4 million and $0.9 million for the second quarter and first six months of fiscal 2013, 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 LOSS PER SHARE

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

The computations of diluted net 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 the 3.50% convertible subordinated notes were excluded. For the second quarter and first six months of fiscal 2014, 42.5 million weighted equivalent shares of the 4.50% convertible subordinated notes were excluded.
• For the second quarter and first six months of fiscal 2014, options to purchase 13.9 million and 14.9 million weighted average shares, respectively, 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.
• Unvested RSUs of 10.9 million and 10.4 million weighted average shares for the second quarter and first six months of fiscal 2014, respectively, were excluded. Unvested RSUs 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.

NOTE 11: LEGAL PROCEEDINGS

Overland

On June 28, 2012, Overland Storage, Inc. (“Overland”) filed a patent infringement lawsuit against Quantum in the U.S. District Court for the Southern District of California, alleging that certain of its automated tape libraries 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. We do not believe there is a reasonable possibility that we will pay material damages related to this lawsuit.

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.

On April 12, 2013, we filed a lawsuit against Overland in the U.S. District Court for the Southern District of California, for patent infringements of our patent 7,263,596 by the products in Overland’s SnapScale product lines. We are seeking injunctive relief and the recovery of monetary damages.

Compression Technology Solutions

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 was 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 defended 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. On May 29, 2013, our motion for summary judgment was granted, with all of the asserted claims held invalid by the District Court, and the lawsuit against Quantum and the other defendants has been dismissed with prejudice. On July 10, 2013, CTS appealed the decision of the District Court to the United States Court of Appeals for the Federal Circuit.

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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, investing wisely in our business, having operating profit and generating cash from operations; (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; (5) our expectations regarding the outcome of any litigation in which we are involved and (6) our business goals, objectives, key focuses, opportunities and prospects 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; (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 and (9) 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 proven global expert in data protection and big data management. We provide solutions for storing and protecting information in physical, virtual and cloud environments and for enabling high performance sharing of content. These solutions are designed to help customers be certain they are maximizing the value of their data over its entire lifecycle. With our products, customers can better adapt in a world of continuing change by keeping and protecting more data for a longer period of time and leveraging it more effectively to meet their business or organizational objectives, while at the same time 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. Our data protection solutions include DXi^® deduplication systems and Scalar^® automated tape libraries that optimize backup and recovery, simplify management and lower cost and our vmPRO^TM virtual server backup and disaster recovery offerings that protect virtual environments while minimizing the impact to servers and storage. In addition, we also offer software for cloud backup and disaster recovery of physical and virtual servers. For big data environments, we provide StorNext^® tiered storage and Lattus^TM object storage solutions designed to help maximize revenue and results by enabling customers to extract the full value from their digital assets. We have a full range of services and the global scale and scope to support our worldwide customer base.

Our goals for fiscal 2014 are to continue to capitalize on market opportunities to balance the cash flow and operating profit against revenue growth associated with potential opportunities and go-to-market strategies, with an emphasis on delivering results that we expect to be more predictable and controllable. In some cases, as was the case in the second quarter of fiscal 2014, this means we may generate lower overall revenue but more cash flow and profit in order to provide greater operating leverage for future revenue increases. Our revenue growth strategy is focused on leveraging our StorNext and Lattus solutions to drive deeper into big data vertical markets and extend their reach into the data center and the cloud in addition to expanding relationships with our partners and gaining additional access to end users through existing and new channel partners. We continue our efforts to further leverage our tape automation and DXi expertise, our installed product base and our broad data protection product portfolio in order to gain market share in the data center.

During the second quarter of fiscal 2014, we had record quarterly revenue from our big data solutions, largely from object storage solutions and StorNext appliance revenue contributions. We plan to further expand and improve our product and solution offerings in fiscal 2014, with emphasis on software solutions, branded disk systems, next generation object storage, virtual offerings and cloud solutions. New products announced during the second quarter of fiscal 2014 included StorNext 5 software, and we launched Lattus-D, an object storage system for the data center. In addition, we expanded our strategic partnerships to combine our Lattus-D offering with a partner’s software to expand data center environment solutions and provide an object storage based private cloud solution.

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Results

We had total revenue of $131.4 million in the second quarter of fiscal 2014, an 11% decrease from the second quarter of fiscal 2013, primarily due to lower than expected revenue from sales outside of North America and to the U.S. federal government. Our gross margin percentage increased 270 basis points from the second quarter of fiscal 2013 to 42.9% primarily due to improvements in our service delivery model, partially offset by reduced high-margin royalty revenue. Operating expenses decreased $7.8 million, or 11% from the second quarter of fiscal 2013, primarily from cost controls and spending reductions that we began implementing in the third quarter of fiscal 2013. The largest spending decrease compared to the second quarter of fiscal 2013 was for compensation and benefits as a result of reduced staffing to right-size our workforce in order to align spending with revenue expectations. These cost reductions impacted sales and marketing expenses the most compared to the second quarter of fiscal 2013. Despite the 11% decrease in revenue, we had a $5.0 million loss from operations in the second quarter of fiscal 2014 compared to an operating loss of $10.0 million in the second quarter of fiscal 2013.

Interest expense increased 34% to $2.4 million primarily due to refinancing our revolving debt balance in the third quarter of fiscal 2013 with 4.50% convertible subordinated notes. We generated $8.2 million of cash from operating activities in the first six months of fiscal 2014 compared to a net use of cash from operating activities of $14.5 million in the first half of fiscal 2013.

RESULTS OF OPERATIONS

Revenue

Total revenue decreased in the second quarter of fiscal 2014 primarily due to lower than expected revenue from sales outside of North America and sales to the U.S. federal government. We believe decreased sales in Europe were largely due to economic uncertainty and its impact on the European business climate, especially in September, which is typically our highest revenue month of the second fiscal quarter. We believe sales to the U.S. federal government were also negatively impacted in September by the pending U.S. federal government shut down, causing delays and cancelations of orders. Total revenue in the first six months of fiscal 2014 decreased from the first six months of fiscal 2013, reflecting decreased sales in Europe and to the U.S. federal government, partially offset by a $15.0 million royalty received in connection with finalizing an intellectual property agreement in the first quarter of fiscal 2014.

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Revenue from branded data protection products and services decreased $14.3 million, or 14%, from the second quarter of fiscal 2013 and decreased $19.9 million, or 10%, from the first six months of fiscal 2013, largely due to a decrease in disk systems revenue followed by a tape automation systems revenue decrease. 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 $1.0 million, or 6% from the second quarter of fiscal 2013 and increased 10% from the first six months of fiscal 2013 largely due to increased sales of our big data appliance offerings and Lattus object storage solutions. Big data and archive products include StorNext software, StorNext and Q-Series appliances and Lattus object storage solutions. In addition, OEM product and service revenue decreased $1.6 million and $4.9 million from the second quarter and first six months of fiscal 2013, respectively. Royalty revenue decreased $1.0 million from the second quarter of fiscal 2013 and increased $13.5 million from the first six months of fiscal 2013.

Product Revenue

Our product revenue, which includes sales of our hardware and software products sold through both our Quantum branded and OEM channels, decreased $15.3 million and $23.2 million in the second quarter and first six months of fiscal 2014, respectively, compared to the prior year periods, largely due to decreased revenue from sales of enterprise disk systems and slightly larger than expected decreases in revenue from tape automation systems. As noted above, total revenue decreased largely due to lower than expected revenue from sales in Europe and to the U.S. federal government, and these were also the primary drivers of decreased product revenue. Revenue from sales of branded products decreased 17% and 12%, respectively, and sales of products to our OEM customers decreased 7% and 10%, respectively, in the second quarter and first six months of fiscal 2014 compared to the prior year periods.

Our disk systems and software solutions revenue decreased 26% and 18%, respectively, from the second quarter and first six months of fiscal 2013 primarily due to decreased sales of enterprise disk systems worldwide. We had fewer large orders, or orders over $200,000, in the second quarter and first six months of fiscal 2014 which negatively impacted enterprise disk systems revenue. Partially offsetting this decrease was increased revenue from certain of our big data offerings, notably our StorNext archive enabled libraries and server-based appliances and our Lattus object storage solutions, compared to the second quarter and first half of fiscal 2013.

The decrease in tape automation systems revenue in the second quarter and first six months of fiscal 2014 compared to the prior year periods was primarily due to decreased branded enterprise tape automation system sales as a result of a decline in large orders. Sales of branded tape automation systems decreased more than revenue from OEM product sales in both the second quarter and first half of fiscal 2014 from the prior year periods. As noted above, the largest branded revenue decrease was in enterprise products, followed by entry level then midrange products. Branded midrange tape automation sales were slightly above our expectations in the second quarter of fiscal 2014. For the second quarter of fiscal 2014, OEM tape automation revenue decreased from the second quarter of fiscal 2013 primarily due to reduced midrange tape automation sales and decreased from the first six months of fiscal 2013 primarily due to decreased enterprise sales.

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Product revenue from devices, which includes tape drives and removable hard drives, and non-royalty media sales increased from the second quarter and first six months of fiscal 2013. The increase in the second quarter of fiscal 2014 was primarily due to increased revenue from devices while the increase in the first half of fiscal 2014 was primarily due to increased media sales.

Service Revenue

Service revenue includes revenue from sales of hardware service contracts and product repairs. 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 increased 1% from both the second quarter and first six months of fiscal 2013 primarily due to increased revenue from branded service contracts associated with our StorNext appliances, partially offset by lower revenue from a decreased volume of OEM product repair services.

Royalty Revenue

Tape media royalties decreased 9% from the second quarter of fiscal 2013 primarily due to expected decreases of media unit sales sold by media licensees. For the first six months of fiscal 2014, royalty revenue increased 60% primarily due to the receipt of a one-time cash payment of $15 million from Microsoft Corporation pursuant to an intellectual property agreement entered into in May which was partially offset by expected sales decreases of media sold by media licensees.

Gross Margin

* The second quarter and first six months of fiscal 2014 includes $0.1 million of restructuring charges related to cost of revenue.

The 270 basis point increase in gross margin percentage compared to the second quarter of fiscal 2013 was primarily due to improvements in our service delivery model, partially offset by reduced royalty revenue. For the first six months of fiscal 2014, approximately half of the 530 basis point increase in gross margin percentage compared to the prior year period was attributable to the improvements in our service delivery model and the other half was due to the $13.5 million net increase in royalty revenue.

Product Margin

Product gross margin dollars decreased $5.3 million, or 17%, compared to the second quarter of fiscal 2013, and our product gross margin rate decreased 40 basis points. For the first six months of fiscal 2014, product gross margin decreased $7.2 million, or 12%, and our product gross margin rate was the same as the first six months of fiscal 2013. The decreased product revenue was mostly offset in the second quarter and first six months of fiscal 2014 by decreased costs as a result of several items. Product material costs decreased the most, commensurate with the decrease in product revenue, followed by reduced expenses as a result of cost reduction initiatives that began in the second half of fiscal 2013, lower intangible amortization from certain intangible assets becoming fully amortized in fiscal 2013 and a decrease in warranty expense from a reduced number of products under warranty compared to the second quarter and first six months of fiscal 2013. The most significant decreased cost as a result of cost reduction initiatives was compensation and benefits expense from reduced staffing levels.

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Service Margin

Service gross margin dollars increased $3.6 million, or 23%, compared to the second quarter of fiscal 2013, and service gross margin percentage increased 940 basis points on a slight increase in service revenue. For the first six months of fiscal 2014 service gross margin dollars increased $5.1 million, or 16%, and service gross margin percentage increased 650 basis points on a slight increase in service revenue compared to the first half of fiscal 2013. These increases in service gross margin rate were primarily due to reduced compensation and benefits from lower staffing levels as a result of implementing improvements in our service delivery model, including outsourcing geographies with lower service and repair volumes and improving utilization of our service team. 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.

Research and Development Expenses

The decrease in research and development expenses compared to the second quarter and first six months of fiscal 2013 was primarily due to cost controls that resulted in a $1.7 million and $3.0 million decrease, respectively, in compensation and benefits from reduced staffing levels. In addition, we had decreases of $0.7 million and $1.0 million, respectively, in external service provider expense and had decreases of $0.4 million and $0.6 million, respectively, in project materials expense related to the nature of projects under development and specific development activities in the prior year periods that were not repeated at the same levels this quarter.

Sales and Marketing Expenses