VMWARE, INC. - Quarter Report: 2014 September (Form 10-Q)
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended September 30, 2014
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File Number 001-33622
_______________________________________________________
VMWARE, INC.
(Exact name of registrant as specified in its charter)
_______________________________________________________
Delaware | 94-3292913 |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification Number) |
3401 Hillview Avenue Palo Alto, CA | 94304 |
(Address of principal executive offices) | (Zip Code) |
(650) 427-5000
(Registrant’s telephone number, including area code)
_____________________________________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer | x | Accelerated filer | ¨ | |
Non-accelerated filer | o | (Do not check if a smaller reporting company) | 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
As of October 31, 2014, the number of shares of common stock, par value $0.01 per share, of the registrant outstanding was 430,484,596 of which 130,484,596 shares were Class A common stock and 300,000,000 were Class B common stock.
TABLE OF CONTENTS
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Item 2. | ||
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Item 1A. | ||
Item 2. | ||
Item 3. | ||
Item 4. | ||
Item 5. | ||
Item 6. | ||
VMware, VMworld, vSphere, vCloud, vCenter, VMware View, vCloud Suite, Horizon Suite, VMware NSX, Virtual SAN, vCloud Air, CloudVolumes, AirWatch, vShield, Desktone, Dynamic Ops, Nicira, Wanova and Virsto are registered trademarks or trademarks of VMware or its subsidiaries in the United States and other jurisdictions. All other marks and names mentioned herein may be trademarks of their respective companies.
2
PART I
FINANCIAL INFORMATION
ITEM 1. | FINANCIAL STATEMENTS |
VMware, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(amounts in millions, except per share amounts, and shares in thousands)
(unaudited)
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Revenues: | |||||||||||||||
License | $ | 639 | $ | 564 | $ | 1,814 | $ | 1,583 | |||||||
Services | 876 | 725 | 2,519 | 2,141 | |||||||||||
Total revenues | 1,515 | 1,289 | 4,333 | 3,724 | |||||||||||
Operating expenses (1): | |||||||||||||||
Cost of license revenues | 46 | 51 | 143 | 163 | |||||||||||
Cost of services revenues | 196 | 132 | 519 | 375 | |||||||||||
Research and development | 327 | 266 | 936 | 797 | |||||||||||
Sales and marketing | 529 | 449 | 1,550 | 1,308 | |||||||||||
General and administrative | 169 | 103 | 498 | 298 | |||||||||||
Realignment charges | 6 | 1 | 4 | 64 | |||||||||||
Operating income | 242 | 287 | 683 | 719 | |||||||||||
Investment income | 11 | 7 | 28 | 21 | |||||||||||
Interest expense with EMC | (7 | ) | (1 | ) | (18 | ) | (3 | ) | |||||||
Other income (expense), net | (2 | ) | 15 | (2 | ) | 29 | |||||||||
Income before income taxes | 244 | 308 | 691 | 766 | |||||||||||
Income tax provision | 50 | 47 | 131 | 87 | |||||||||||
Net income | $ | 194 | $ | 261 | $ | 560 | $ | 679 | |||||||
Net income per weighted-average share, basic for Class A and Class B | $ | 0.45 | $ | 0.61 | $ | 1.30 | $ | 1.58 | |||||||
Net income per weighted-average share, diluted for Class A and Class B | $ | 0.45 | $ | 0.60 | $ | 1.29 | $ | 1.57 | |||||||
Weighted-average shares, basic for Class A and Class B | 430,463 | 429,709 | 430,408 | 428,690 | |||||||||||
Weighted-average shares, diluted for Class A and Class B | 434,118 | 433,182 | 434,656 | 432,916 | |||||||||||
__________ | |||||||||||||||
(1) Includes stock-based compensation as follows: | |||||||||||||||
Cost of license revenues | $ | 1 | $ | 1 | $ | 2 | $ | 2 | |||||||
Cost of services revenues | 11 | 7 | 31 | 21 | |||||||||||
Research and development | 61 | 52 | 187 | 165 | |||||||||||
Sales and marketing | 43 | 37 | 128 | 106 | |||||||||||
General and administrative | 17 | 16 | 51 | 42 | |||||||||||
Realignment charges | — | — | — | 6 |
The accompanying notes are an integral part of the condensed consolidated financial statements.
3
VMware, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions)
(unaudited)
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Net income | $ | 194 | $ | 261 | $ | 560 | $ | 679 | |||||||
Other comprehensive income: | |||||||||||||||
Changes in market value of available-for-sale securities: | |||||||||||||||
Unrealized gains (losses), net of taxes of $(2), $3, $1 and $(2) | (3 | ) | 5 | 2 | (3 | ) | |||||||||
Reclassification of (gains) realized during the period, net of taxes of $(1), $0, $(2) and $(1) | (1 | ) | — | (2 | ) | (1 | ) | ||||||||
Net change in market value of available-for-sale securities | (4 | ) | 5 | — | (4 | ) | |||||||||
Changes in market value of effective foreign currency forward exchange contracts: | |||||||||||||||
Unrealized (losses), net of $0 taxes for all periods | (3 | ) | (1 | ) | (3 | ) | (1 | ) | |||||||
Reclassification of (gains) losses realized during the period, net of $0 taxes for all periods | (1 | ) | 1 | — | — | ||||||||||
Net change in market value of effective foreign currency forward exchange contracts | (4 | ) | — | (3 | ) | (1 | ) | ||||||||
Total other comprehensive income (loss) | (8 | ) | 5 | (3 | ) | (5 | ) | ||||||||
Total comprehensive income, net of taxes | $ | 186 | $ | 266 | $ | 557 | $ | 674 |
The accompanying notes are an integral part of the condensed consolidated financial statements.
4
VMware, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS
(amounts in millions, except per share amounts, and shares in thousands)
(unaudited)
September 30, | December 31, | ||||||
2014 | 2013 | ||||||
ASSETS | |||||||
Current assets: | |||||||
Cash and cash equivalents | $ | 2,293 | $ | 2,305 | |||
Short-term investments | 4,801 | 3,870 | |||||
Accounts receivable, net of allowance for doubtful accounts of $2 | 957 | 1,220 | |||||
Deferred tax assets | 232 | 190 | |||||
Other current assets | 249 | 96 | |||||
Total current assets | 8,532 | 7,681 | |||||
Property and equipment, net | 969 | 845 | |||||
Other assets, net | 155 | 107 | |||||
Deferred tax assets | 156 | 60 | |||||
Intangible assets, net | 772 | 607 | |||||
Goodwill | 3,935 | 3,027 | |||||
Total assets | $ | 14,519 | $ | 12,327 | |||
LIABILITIES AND STOCKHOLDERS’ EQUITY | |||||||
Current liabilities: | |||||||
Accounts payable | $ | 150 | $ | 109 | |||
Accrued expenses and other | 779 | 608 | |||||
Due to related parties, net | 17 | 18 | |||||
Unearned revenues | 2,725 | 2,558 | |||||
Total current liabilities | 3,671 | 3,293 | |||||
Notes payable to EMC | 1,500 | 450 | |||||
Unearned revenues | 1,650 | 1,534 | |||||
Other liabilities | 262 | 234 | |||||
Total liabilities | 7,083 | 5,511 | |||||
Contingencies (see Note I) | |||||||
Stockholders’ equity: | |||||||
Class A common stock, par value $.01; authorized 2,500,000 shares; issued and outstanding 131,103 and 130,349 shares | 1 | 1 | |||||
Class B convertible common stock, par value $.01; authorized 1,000,000 shares; issued and outstanding 300,000 shares | 3 | 3 | |||||
Additional paid-in capital | 3,553 | 3,496 | |||||
Accumulated other comprehensive income | 1 | 4 | |||||
Retained earnings | 3,872 | 3,312 | |||||
Total VMware, Inc.'s stockholders’ equity | 7,430 | 6,816 | |||||
Non-controlling interests | $ | 6 | $ | — | |||
Total stockholders' equity | $ | 7,436 | $ | 6,816 | |||
Total liabilities and stockholders’ equity | $ | 14,519 | $ | 12,327 |
The accompanying notes are an integral part of the condensed consolidated financial statements.
5
VMware, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
(unaudited)
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Operating activities: | |||||||||||||||
Net income | $ | 194 | $ | 261 | $ | 560 | $ | 679 | |||||||
Adjustments to reconcile net income to net cash provided by operating activities: | |||||||||||||||
Depreciation and amortization | 91 | 82 | 255 | 261 | |||||||||||
Stock-based compensation | 133 | 113 | 399 | 332 | |||||||||||
Excess tax benefits from stock-based compensation | (8 | ) | (12 | ) | (34 | ) | (60 | ) | |||||||
Deferred income taxes, net | (36 | ) | 32 | (115 | ) | 41 | |||||||||
Non-cash realignment charges | — | — | — | 15 | |||||||||||
Gain on disposition of certain lines of business and other, net | — | (12 | ) | — | (31 | ) | |||||||||
Other | — | 4 | — | 3 | |||||||||||
Changes in assets and liabilities, net of acquisitions: | |||||||||||||||
Accounts receivable | 163 | 152 | 293 | 360 | |||||||||||
Other assets | (27 | ) | 4 | (70 | ) | (72 | ) | ||||||||
Due to/from related parties, net | 57 | 49 | 25 | 84 | |||||||||||
Accounts payable | 49 | (2 | ) | 41 | 16 | ||||||||||
Accrued expenses | (60 | ) | (69 | ) | (4 | ) | (91 | ) | |||||||
Income taxes receivable from EMC | — | — | — | 15 | |||||||||||
Income taxes payable | 65 | (2 | ) | 178 | (4 | ) | |||||||||
Unearned revenues | (15 | ) | 37 | 237 | 300 | ||||||||||
Net cash provided by operating activities | 606 | 637 | 1,765 | 1,848 | |||||||||||
Investing activities: | |||||||||||||||
Additions to property and equipment | (100 | ) | (94 | ) | (254 | ) | (247 | ) | |||||||
Purchases of available-for-sale securities | (998 | ) | (573 | ) | (2,974 | ) | (2,227 | ) | |||||||
Sales of available-for-sale securities | 610 | 253 | 1,551 | 1,072 | |||||||||||
Maturities of available-for-sale securities | 162 | 227 | 483 | 597 | |||||||||||
Proceeds from disposition of certain lines of business | — | 6 | — | 37 | |||||||||||
Purchase of strategic investments | (1 | ) | (7 | ) | (41 | ) | (7 | ) | |||||||
Business acquisitions, net of cash acquired | (44 | ) | — | (1,112 | ) | (184 | ) | ||||||||
Increase in restricted cash | — | (1 | ) | (76 | ) | (3 | ) | ||||||||
Other investing | — | — | (10 | ) | (1 | ) | |||||||||
Net cash used in investing activities | (371 | ) | (189 | ) | (2,433 | ) | (963 | ) | |||||||
Financing activities: | |||||||||||||||
Proceeds from issuance of common stock | 59 | 70 | 158 | 185 | |||||||||||
Proceeds from issuance of notes payable to EMC | — | — | 1,500 | — | |||||||||||
Repayment of note payable to EMC | — | — | (450 | ) | — | ||||||||||
Reduction in capital from EMC | — | — | (24 | ) | — | ||||||||||
Proceeds from non-controlling interests | 7 | — | 7 | — | |||||||||||
Repurchase of common stock | (43 | ) | (90 | ) | (450 | ) | (392 | ) | |||||||
Excess tax benefits from stock-based compensation | 8 | 12 | 34 | 60 | |||||||||||
Shares repurchased for tax withholdings on vesting of restricted stock | (27 | ) | (17 | ) | (119 | ) | (84 | ) | |||||||
Net cash provided by (used in) financing activities | 4 | (25 | ) | 656 | (231 | ) | |||||||||
Net increase (decrease) in cash and cash equivalents | 239 | 423 | (12 | ) | 654 | ||||||||||
Cash and cash equivalents at beginning of the period | 2,054 | 1,840 | 2,305 | 1,609 | |||||||||||
Cash and cash equivalents at end of the period | $ | 2,293 | $ | 2,263 | $ | 2,293 | $ | 2,263 | |||||||
Non-cash items: | |||||||||||||||
Changes in capital additions, accrued but not paid | $ | (14 | ) | $ | (3 | ) | $ | (3 | ) | $ | (8 | ) | |||
Changes in tax withholdings on vesting of restricted stock, accrued but not paid | 3 | (2 | ) | 4 | (1 | ) | |||||||||
Fair value of stock options assumed in acquisition | 1 | — | 25 | — |
The accompanying notes are an integral part of the condensed consolidated financial statements.
6
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
A. Overview and Basis of Presentation
Company and Background
VMware, Inc. (“VMware” or the “Company”) is the leader in virtualization infrastructure solutions utilized by organizations to help them transform the way they build, deliver and consume information technology (“IT”) resources. VMware’s virtualization infrastructure solutions, which include a suite of products and services designed to deliver a software-defined data center, run on industry-standard desktop computers and servers and support a wide range of operating system and application environments, as well as networking and storage infrastructures.
Accounting Principles
The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).
Unaudited Interim Financial Information
These accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. In the opinion of management, these unaudited condensed consolidated financial statements include all adjustments, consisting of normal recurring adjustments and accruals, for a fair statement of VMware’s condensed consolidated results of operations, financial position and cash flows for the periods presented. Results of operations are not necessarily indicative of the results that may be expected for the full year 2014. Certain information and footnote disclosures typically included in annual consolidated financial statements have been condensed or omitted. Accordingly, these unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in VMware’s 2013 Annual Report on Form 10-K.
As of September 30, 2014, EMC Corporation ("EMC") held approximately 79.6% of VMware’s outstanding common stock and 97.2% of the combined voting power of VMware’s outstanding common stock, including 43 million shares of VMware’s Class A common stock and all of VMware’s Class B common stock. VMware is a majority-owned and controlled subsidiary of EMC, and its results of operations and financial position are consolidated with EMC’s financial statements.
Management believes the assumptions underlying the condensed consolidated financial statements are reasonable. However, the amounts recorded for VMware’s intercompany transactions with EMC and Pivotal Software, Inc. (“Pivotal,” previously known as “GoPivotal, Inc.”) may not be considered arm’s length with an unrelated third party. Therefore, the financial statements included herein may not necessarily reflect the financial position, results of operations and cash flows had VMware engaged in such transactions with an unrelated third party during all periods presented. Accordingly, VMware’s historical financial information is not necessarily indicative of what the Company’s financial position, results of operations and cash flows will be in the future if and when VMware contracts at arm’s length with unrelated third parties for the services the Company receives from and provides to EMC and Pivotal.
Principles of Consolidation
The condensed consolidated financial statements include the accounts of VMware and subsidiaries in which VMware has a controlling financial interest. Non-controlling interests are presented as a separate component within total stockholders' equity and represent the equity and cumulative pro-rata share of the results of operations attributable to the non-controlling interests. Net earnings attributable to the non-controlling interests are eliminated within other income (expense), net in the condensed consolidated statements of income and are not presented separately as they were not material for the periods presented. All intercompany transaction and account balances between VMware and its subsidiaries have been eliminated in consolidation. Transactions with EMC and Pivotal are generally settled in cash. Changes in the intercompany balances with EMC and Pivotal are presented as a component of cash flows from operating, investing and financing activities.
Use of Accounting Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the reported amounts of revenues and expenses during the reporting periods, and the disclosure of contingent liabilities at the date of the financial statements. Estimates are used for, but not limited to trade receivable valuation, marketing rebates, useful lives assigned to fixed assets and intangible assets, valuation of goodwill and definite-lived intangibles, income taxes, stock-based compensation and contingencies. Actual results could differ from those estimates.
7
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
New Accounting Pronouncements
During May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606). The updated revenue standard establishes principles for recognizing revenue and develops a common revenue standard for all industries. Upon adoption, entities will be required to recognize the amount of revenue that they expect to be entitled to for the transfer of promised goods or services to their customers. The updated standard is effective for the Company in the first quarter of 2017 and permits the use of either the retrospective or cumulative effect transition method. Early adoption is not permitted.
The Company has not selected a transition method and is currently evaluating the effect that the updated standard will have on its consolidated financial statements and related disclosures.
B. Business Combinations, Joint Venture, Definite-Lived Intangible Assets, Net and Goodwill
Business Combinations
Acquisition of CloudVolumes, Inc.
On August 20, 2014, VMware acquired all of the outstanding shares of CloudVolumes, Inc. ("CloudVolumes") for approximately $45 million of cash. CloudVolumes is a provider of real-time application delivery technology that enables enterprises to deliver native applications to virtualized environments on-demand. VMware acquired CloudVolumes to expand VMware's end-user computing group. The preliminary purchase price primarily included $9 million of identifiable intangible assets and approximately $37 million of goodwill that is expected to be non-deductible for tax purposes. The impact of this acquisition was not material to VMware's consolidated financial statements.
Acquisition of AirWatch LLC
On February 24, 2014, VMware acquired for cash all of the outstanding membership units of A.W.S. Holding, LLC (“AirWatch Holding”), the sole member and equity holder of AirWatch LLC (“AirWatch”). AirWatch is a leader in enterprise mobile management and security solutions. VMware acquired AirWatch to expand VMware's solutions within the enterprise mobile and security space. The total preliminary purchase price of $1,128 million included cash of $1,104 million and the fair value of assumed unvested equity attributed to pre-combination services totaling $24 million.
Merger consideration totaling $300 million, including $75 million being held in escrow, is payable to certain employees of AirWatch subject to specified future employment conditions and will be recognized as expense over the requisite service period on a straight-line basis. Compensation expense of $41 million and $101 million was recognized during the three and nine months ended September 30, 2014, respectively.
VMware assumed all of AirWatch's unvested stock options and restricted stock outstanding at the completion of the acquisition with an estimated fair value of $134 million. Of the total fair value, $24 million was allocated to the purchase price and $110 million was allocated to future services and will be expensed over the remaining requisite service periods on a straight-line basis. The estimated fair value of the stock options assumed by the Company was determined using the Black-Scholes option pricing model. Pursuant to the purchase agreement, AirWatch's outstanding stock awards were converted into shares of VMware's common stock at the conversion ratio of 0.4.
The following table summarizes the initial preliminary allocation of the consideration to the fair value of the assets acquired and liabilities assumed (table in millions):
Cash | $ | 36 | |
Other current assets | 60 | ||
Intangible assets | 250 | ||
Goodwill | 879 | ||
Other acquired assets | 17 | ||
Total assets acquired | 1,242 | ||
Unearned revenues | (45 | ) | |
Other assumed liabilities | (69 | ) | |
Total liabilities assumed | (114 | ) | |
Fair value of assets acquired and liabilities assumed | $ | 1,128 |
8
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The excess of the purchase consideration over the fair value of net tangible and identifiable intangible assets acquired was recorded as goodwill. The estimated fair value assigned to the tangible assets, identifiable intangible assets, and assumed liabilities were based on management's estimates and assumptions. The preliminary allocation of the purchase price was based on a preliminary valuation and assumptions and is subject to change within the purchase price allocation period. Additionally, indirect taxes, income taxes payable and deferred taxes may continue to be subject to change as additional information is received and tax returns are finalized. VMware expects to finalize the allocation of purchase consideration as soon as practicable and no later than one year from the acquisition date.
Subsequent adjustments made to the initial preliminary allocation of the consideration primarily relate to deferred taxes and the liability for employer related taxes. As a result, goodwill decreased $4 million in connection with these adjustments.
Management expects that the majority of goodwill and identifiable intangible assets will be deductible for U.S. income tax purposes.
The following table summarizes the components of the identifiable intangible assets acquired and their estimated useful lives by VMware in conjunction with the acquisitions of AirWatch (amounts in table in millions):
Useful Lives (in years) | Weighted-Average Useful Lives (in years) | Fair Value Amount | |||||
Purchased technology | 2 – 6 | 5.9 | $ | 118 | |||
Customer relationships and customer lists | 2 – 8 | 7.9 | 78 | ||||
Trademarks and tradenames | 8 | 8 | 40 | ||||
Other | 2 – 8 | 3.2 | 14 | ||||
Total identifiable intangible assets | $ | 250 |
The following net income pro forma financial information summarizes the combined net income for VMware and AirWatch, which was significant for purposes of the unaudited pro forma financial information disclosure, as though the companies were combined at the beginning of the Company’s fiscal year 2013. The amount of revenue of AirWatch was not considered material, and as such, has not been included in the unaudited pro forma financial information disclosure below.
Supplemental information on an unaudited pro forma basis, as if AirWatch had been acquired on January 1, 2013, is presented as follows (table in millions):
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Pro forma adjusted net income | $ | 194 | $ | 200 | $ | 523 | $ | 500 |
Joint Venture
During the three months ended September 30, 2014, VMware established a joint venture intended to expand the VMware vCloud Air services (formerly vCloud Hybrid Service) in Japan. Cash contributions of $8 million and $7 million were made by VMware and the non-controlling interest, respectively, in proportion to their respective ownership interest. At September 30, 2014, VMware had a controlling interest in the joint venture and approximately 51% of the ownership. Accordingly, VMware consolidated the financial results of the joint venture. The non-controlling interest's share of the earnings in the joint venture was not material during the three months ended September 30, 2014.
9
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Definite-Lived Intangible Assets, Net
As of September 30, 2014, definite-lived intangible assets consisted of the following (amounts in table in millions):
September 30, 2014 | |||||||||||||
Weighted-Average Useful Lives (in years) | Gross Carrying Amount | Accumulated Amortization | Net Book Value | ||||||||||
Purchased technology | 6.5 | $ | 702 | $ | (232 | ) | $ | 470 | |||||
Leasehold interest | 34.9 | 145 | (14 | ) | 131 | ||||||||
Customer relationships and customer lists | 8.3 | 153 | (49 | ) | 104 | ||||||||
Trademarks and tradenames | 8.4 | 65 | (11 | ) | 54 | ||||||||
Other | 2.9 | 18 | (5 | ) | 13 | ||||||||
Total definite-lived intangible assets | $ | 1,083 | $ | (311 | ) | $ | 772 |
As of December 31, 2013, definite-lived intangible assets consisted of the following (amounts in table in millions):
December 31, 2013 | |||||||||||||
Weighted-Average Useful Lives (in years) | Gross Carrying Amount | Accumulated Amortization | Net Book Value | ||||||||||
Purchased technology | 6.6 | $ | 580 | $ | (163 | ) | $ | 417 | |||||
Leasehold interest | 34.9 | 145 | (11 | ) | 134 | ||||||||
Customer relationships and customer lists | 8.7 | 75 | (37 | ) | 38 | ||||||||
Trademarks and tradenames | 9.1 | 24 | (7 | ) | 17 | ||||||||
IPR&D | 1 | — | 1 | ||||||||||
Total definite-lived intangible assets | $ | 825 | $ | (218 | ) | $ | 607 |
Amortization expense for definite-lived intangible assets was $37 million and $104 million during the three and nine months ended September 30, 2014, respectively and $25 million and $81 million during the three and nine months ended September 30, 2013, respectively.
As of September 30, 2014, the remaining estimated annual amortization expense of the definite-lived intangibles is expected to be as follows (table in millions):
Remainder of 2014 | $ | 37 | |
2015 | 142 | ||
2016 | 124 | ||
2017 | 117 | ||
2018 | 105 | ||
Thereafter | 247 | ||
Total | $ | 772 |
10
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Goodwill
The following table summarizes the changes in the carrying amount of goodwill during the nine months ended September 30, 2014 (table in millions):
Balance, January 1, 2014 | $ | 3,027 | |
Increase in goodwill related to AirWatch business combination | 875 | ||
Increase in goodwill related to CloudVolumes business combination | 37 | ||
Other | (4 | ) | |
Balance, September 30, 2014 | $ | 3,935 |
C. Realignment Charges
During the three months ended September 30, 2014, VMware eliminated approximately 90 positions across all major functional groups and geographies to streamline its operations. As a result of these actions, $7 million of realignment charges was recognized during the three months ended September 30, 2014 on the condensed consolidated statements of income, which consisted of workforce reduction charges. An immaterial credit was also recognized during the three months ended September 30, 2014. As of September 30, 2014, $5 million remained in accrued expenses and other on the condensed consolidated balance sheet and is expected to be paid by the end of 2014.
During January 2013, VMware approved and initiated a business realignment plan to streamline its operations. The realignment plan included the elimination of approximately 710 positions and personnel across all major functional groups and geographies. During the nine months ended September 30, 2013, $64 million of realignment charges were recorded on the condensed consolidated statements of income, which consisted of workforce reduction charges and asset impairments. As of December 31, 2013, the plan had been completed.
11
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
D. Net Income per Share
Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted-average number of common shares outstanding and potentially dilutive securities outstanding during the period, as calculated using the treasury stock method. Potentially dilutive securities primarily include unvested restricted stock units, stock options and purchase options under VMware’s employee stock purchase plan. Securities are excluded from the computations of diluted net income per share if their effect would be anti-dilutive. VMware uses the two-class method to calculate earnings per share as both classes share the same rights in dividends, therefore basic and diluted earnings per share are the same for both classes.
The following table sets forth the computations of basic and diluted net income per share during the three and nine months ended September 30, 2014 and 2013 (net income in millions, shares in thousands):
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Net income | $ | 194 | $ | 261 | $ | 560 | $ | 679 | |||||||
Weighted-average shares, basic for Class A and Class B | 430,463 | 429,709 | 430,408 | 428,690 | |||||||||||
Effect of dilutive securities | 3,655 | 3,473 | 4,248 | 4,226 | |||||||||||
Weighted-average shares, diluted for Class A and Class B | 434,118 | 433,182 | 434,656 | 432,916 | |||||||||||
Net income per weighted-average share, basic for Class A and Class B | $ | 0.45 | $ | 0.61 | $ | 1.30 | $ | 1.58 | |||||||
Net income per weighted-average share, diluted for Class A and Class B | $ | 0.45 | $ | 0.60 | $ | 1.29 | $ | 1.57 |
The following table sets forth the weighted-average common share equivalents of Class A common stock that were excluded from the diluted earnings per share calculations because their effect would have been anti-dilutive (shares in thousands):
Three Months Ended | Nine Months Ended | ||||||||||
September 30, | September 30, | ||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||
Anti-dilutive securities: | |||||||||||
Employee stock options | 1,180 | 1,181 | 1,244 | 892 | |||||||
Restricted stock units | 107 | 2,357 | 37 | 919 | |||||||
Total | 1,287 | 3,538 | 1,281 | 1,811 |
12
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
E. Investments
Investments as of September 30, 2014 and December 31, 2013 consisted of the following (tables in millions):
September 30, 2014 | |||||||||||||||
Cost or Amortized Cost | Unrealized Gains | Unrealized Losses | Aggregate Fair Value | ||||||||||||
U.S. government and agency obligations | $ | 556 | $ | — | $ | — | $ | 556 | |||||||
U.S. and foreign corporate debt securities | 3,045 | 5 | (3 | ) | 3,047 | ||||||||||
Foreign governments and multi-national agency obligations | 32 | — | — | 32 | |||||||||||
Municipal obligations | 930 | 3 | — | 933 | |||||||||||
Asset-backed securities | 28 | — | — | 28 | |||||||||||
Mortgage-backed securities | 206 | — | (1 | ) | 205 | ||||||||||
Total investments | $ | 4,797 | $ | 8 | $ | (4 | ) | $ | 4,801 |
December 31, 2013 | |||||||||||||||
Cost or Amortized Cost | Unrealized Gains | Unrealized Losses | Aggregate Fair Value | ||||||||||||
U.S. government and agency obligations | $ | 537 | $ | — | $ | — | $ | 537 | |||||||
U.S. and foreign corporate debt securities | 2,351 | 6 | (3 | ) | 2,354 | ||||||||||
Foreign governments and multi-national agency obligations | 37 | — | — | 37 | |||||||||||
Municipal obligations | 811 | 3 | — | 814 | |||||||||||
Mortgage-backed securities | 129 | — | (1 | ) | 128 | ||||||||||
Total investments | $ | 3,865 | $ | 9 | $ | (4 | ) | $ | 3,870 |
VMware evaluated its fixed income investments as of September 30, 2014 and December 31, 2013 to determine whether or not any security had experienced an other-than-temporary decline in fair value. As of September 30, 2014 and December 31, 2013, VMware did not consider any of its fixed income investments to be other-than-temporarily impaired. The realized gains and realized losses on fixed income investments during the three and nine months ended September 30, 2014 and 2013 were not material.
Unrealized losses on investments as of September 30, 2014 and December 31, 2013, which have been in a net loss position for less than twelve months, were classified by investment category as follows (table in millions):
September 30, 2014 | December 31, 2013 | ||||||||||||||
Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | ||||||||||||
U.S. and foreign corporate debt securities | $ | 1,208 | $ | (3 | ) | $ | 750 | $ | (3 | ) | |||||
Mortgage-backed securities | 61 | — | 91 | (1 | ) | ||||||||||
Total | $ | 1,269 | $ | (3 | ) | $ | 841 | $ | (4 | ) |
Unrealized losses on investments, which have been in a net loss position for twelve months or greater, were not material as of September 30, 2014 and December 31, 2013.
13
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Strategic Investments
VMware evaluated the strategic investments in its portfolio that are accounted under the cost method, to assess whether any of its strategic investments were other-than-temporarily impaired. VMware uses Level 3 inputs as part of its impairment analysis, including, pre- and post-money valuations of recent financing events and the impact of those on its fully diluted ownership percentages, as well as other available information regarding the issuer’s historical and forecasted performance. The estimated fair value of these investments is considered in VMware's impairment review if any events or changes in circumstances occur that might have a significant adverse effect on their value. During the nine months ended September 30, 2013, VMware recognized an other-than-temporary impairment charge of $13 million for a non-recoverable strategic investment. Strategic investments are included in other assets, net on the condensed consolidated balance sheets.
Contractual Maturities
The contractual maturities of investments held at September 30, 2014 consisted of the following (table in millions):
Amortized Cost Basis | Aggregate Fair Value | ||||||
Due within one year | $ | 1,296 | $ | 1,297 | |||
Due after 1 year through 5 years | 3,261 | 3,264 | |||||
Due after 5 years | 240 | 240 | |||||
Total investments | $ | 4,797 | $ | 4,801 |
F. Fair Value Measurements
Certain financial assets and liabilities are measured at fair value on a recurring basis.
VMware’s Level 1 classification of the fair value hierarchy includes money market funds and certain available-for-sale fixed income securities because these securities are valued using quoted prices in active markets for identical assets. Fixed income available-for-sale securities consist of high quality, investment-grade securities from diverse issuers.
VMware’s Level 2 classification includes the remainder of the available-for-sale fixed income securities because these securities are priced using inputs other than quoted prices that are observable either directly or indirectly. The valuation techniques used to measure the fair value of financial instruments having Level 2 inputs were derived from non-binding market consensus prices that are corroborated by observable market data, quoted market prices for similar instruments, or pricing models such as discounted cash flow techniques. VMware’s procedures include controls to ensure that appropriate fair values are recorded such as comparing prices obtained from multiple independent sources.
Additionally, VMware’s Level 2 classification includes foreign currency forward contracts and notes payable to EMC as the valuation inputs for these are based upon quoted prices, quoted pricing intervals from public data sources, observable market data and discounted cash flow techniques. The fair value of the foreign currency forward contracts was not material for any period presented. As of September 30, 2014, the fair value of the notes payable to EMC approximated the carrying value.
VMware does not have any material assets or liabilities that fall into Level 3 of the fair value hierarchy as of September 30, 2014 and December 31, 2013, and there have been no transfers between fair value measurement levels during both the three and nine months ended September 30, 2014 and 2013.
14
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The following tables set forth the fair value hierarchy of VMware’s money market funds and available-for-sale securities, including those securities classified within cash and cash equivalents on the condensed consolidated balance sheets, that were required to be measured at fair value as of September 30, 2014 and December 31, 2013 (tables in millions):
September 30, 2014 | |||||||||||
Level 1 | Level 2 | Total | |||||||||
Money-market funds | $ | 1,686 | $ | — | $ | 1,686 | |||||
U.S. government and agency obligations | 403 | 153 | 556 | ||||||||
U.S. and foreign corporate debt securities | — | 3,077 | 3,077 | ||||||||
Foreign governments and multi-national agency obligations | — | 32 | 32 | ||||||||
Municipal obligations | — | 934 | 934 | ||||||||
Asset-backed securities | — | 28 | 28 | ||||||||
Mortgage-backed securities | — | 205 | 205 | ||||||||
Total | $ | 2,089 | $ | 4,429 | $ | 6,518 |
December 31, 2013 | |||||||||||
Level 1 | Level 2 | Total | |||||||||
Money-market funds | $ | 1,808 | $ | — | $ | 1,808 | |||||
U.S. government and agency obligations | 385 | 152 | 537 | ||||||||
U.S. and foreign corporate debt securities | — | 2,366 | 2,366 | ||||||||
Foreign governments and multi-national agency obligations | — | 37 | 37 | ||||||||
Municipal obligations | — | 816 | 816 | ||||||||
Mortgage-backed securities | — | 128 | 128 | ||||||||
Total | $ | 2,193 | $ | 3,499 | $ | 5,692 |
G. Derivatives and Hedging Activity
VMware conducts business in multiple foreign currencies and has international sales and expenses denominated in foreign currencies, subjecting the Company to foreign currency risk. To mitigate this risk, VMware enters into hedging activities as described below. The counterparties to VMware’s foreign currency forward contracts are multi-national commercial banks considered to be credit-worthy. VMware does not enter into speculative foreign exchange contracts for trading purposes.
Cash Flow Hedging Activities
To mitigate its exposure to foreign currency fluctuations resulting from operating expenses denominated in certain foreign currencies, VMware enters into foreign currency forward contracts. The Company designates these forward contracts as cash flow hedging instruments as the accounting criteria for such designation has been met. Therefore, the effective portion of gains or losses resulting from changes in the fair value of these hedges is initially reported in accumulated other comprehensive income on the condensed consolidated balance sheet and is subsequently reclassified to the related operating expense line item in the condensed consolidated statements of income in the same period that the underlying expenses are incurred. During the three and nine months ended September 30, 2014 and 2013, the effective portion of gains or losses reclassified to the condensed consolidated statements of income was not material. Interest charges or “forward points” on VMware’s forward contracts are excluded from the assessment of hedge effectiveness and are recorded in other income (expense), net in the condensed consolidated statements of income as incurred.
VMware generally enters into cash flow hedges semi-annually with maturities of six months or less. As of September 30, 2014 and December 31, 2013, VMware had forward contracts to purchase foreign currency designated as cash flow hedges with a total notional value of $62 million and $82 million, respectively. The notional value represents the gross amount of foreign currency that will be bought or sold upon maturity of the forward contract. The fair value of these forward contracts was immaterial as of September 30, 2014 and December 31, 2013 and therefore excluded from the fair value tables above. During the three and nine months ended September 30, 2014 and 2013, all cash flow hedges were considered effective.
15
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Balance Sheet Hedging Activities
In order to manage exposure to foreign currency fluctuations, VMware enters into foreign currency forward contracts to hedge a portion of its net outstanding monetary assets and liabilities against fluctuations in certain foreign exchange rates. These forward contracts are not designated as hedging instruments under applicable accounting guidance, and therefore all changes in the fair value of the forward contracts are reported in other income (expense), net in the condensed consolidated statements of income.
VMware’s foreign currency forward contracts are generally traded on a monthly basis with a typical contractual term of one month. As of September 30, 2014 and December 31, 2013, VMware had outstanding forward contracts with a total notional value of $453 million and $498 million, respectively. The notional value represents the gross amount of foreign currency that will be bought or sold upon maturity of the forward contract. The fair value of these forward contracts was immaterial as of September 30, 2014 and December 31, 2013 and therefore excluded from the fair value tables above.
During the three and nine months ended September 30, 2014, VMware recognized a gain of $29 million and $24 million, respectively, relating to the settlement of foreign forward contracts. During the three months ended September 30, 2013 VMware recognized a loss of $16 million. During the nine months ended September 30, 2013 the impact on its consolidated statements of income was not material.
The combined gains and losses derived from the settlement of foreign forward contracts and the underlying foreign-currency denominated assets and liabilities resulted in a net loss of $3 million and net gain of $1 million during the three months ended September 30, 2014 and September 30, 2013, respectively. The combined gains and losses derived from the settlement of foreign forward contracts and underlying foreign-currency denominated assets and liabilities resulted in a net loss of $4 million and $5 million during the nine months ended September 30, 2014 and September 30, 2013, respectively.
H. Unearned Revenues
Unearned revenues as of September 30, 2014 and December 31, 2013 consisted of the following (table in millions):
September 30, 2014 | December 31, 2013 | ||||||
Unearned license revenues | $ | 428 | $ | 465 | |||
Unearned software maintenance revenues | 3,558 | 3,304 | |||||
Unearned professional services revenues | 389 | 323 | |||||
Total unearned revenues | $ | 4,375 | $ | 4,092 |
Unearned license revenues are generally recognized upon delivery of existing or future products or services, or they are otherwise recognized ratably over the term of the arrangement. Future products include, in some cases, emerging products that are offered as part of product promotions where the purchaser of an existing product is entitled to receive the future product at no additional charge. To the extent the future product has not been delivered and vendor-specific objective evidence (“VSOE”) of fair value cannot be established, the revenue for the entire order is deferred until such time as all product delivery obligations have been fulfilled. In the event the arrangement does not include professional services, unearned license revenue may also be recognized ratably, if the customer is granted the right to receive unspecified future products or VSOE of fair value on the software maintenance element of the arrangement does not exist. Total unearned license revenues may vary over periods for a variety of factors, including the type and level of promotions offered, and the timing of when the products are delivered upon general availability.
Unearned software maintenance revenues are attributable to VMware’s maintenance contracts and are generally recognized ratably, typically over terms of one to five years with a weighted-average remaining term at September 30, 2014 of approximately two years. Unearned professional services revenues result primarily from prepaid professional services, including training, and are generally recognized as the services are delivered.
I. Contingencies
Litigation
VMware and the U.S. General Services Administration ("GSA") and the Department of Justice ("DOJ") are in ongoing discussions regarding VMware’s government sales practices covering the period between 2006 and 2013. $11 million has been accrued for this matter and is included in accrued expenses and other in the condensed consolidated balance sheet. The amount accrued as of September 30, 2014 is considered both probable and reasonably estimable. VMware is cooperating with both the GSA and DOJ inquiries. VMware believes a loss in excess of the estimated $11 million liability is currently not determinable.
16
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
VMware is also subject to other legal, administrative and regulatory proceedings, claims, demands and investigations in the ordinary course of business, including claims with respect to commercial, product liability, intellectual property, employment, class action, whistleblower and other matters. From time to time, VMware also receives inquiries from and has ongoing discussions with government entities on various matters. VMware accrues for a liability when a determination has been made that a loss is both probable of occurrence and the amount of the loss can be reasonably estimated. Significant judgment is required in both the determination of probability and the determination as to whether a loss is reasonably estimable. In making such judgments, VMware considers the impact of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular matter. Legal costs are generally recognized as expense when incurred. As of September 30, 2014 and December 31, 2013, amounts accrued relating to these other matters arising as part of the ordinary course of business were considered immaterial. To the extent there is a reasonable possibility that the losses could exceed the amounts already accrued, VMware believes that the amount of any such additional loss would also be immaterial to VMware’s condensed consolidated financial position, results of operations and cash flows.
J. Stockholders’ Equity
VMware Stock Repurchases
The following table summarizes stock repurchase authorizations that remain open as of September 30, 2014 (amounts in table in millions):
Authorization Date | Amount Authorized | Expiration Date | Status | |||
August 6, 2014 | $1,000 | December 31, 2016 | Open | |||
August 7, 2013 | $700 | December 31, 2015 | Open |
From time to time, future stock repurchases may be made pursuant to the August 2014 and 2013 authorizations in open market transactions or privately negotiated transactions as permitted by securities laws and other legal requirements. VMware is not obligated to purchase any shares under its stock repurchase programs. The timing of any repurchases and the actual number of shares repurchased will depend on a variety of factors, including VMware’s stock price, cash requirements for operations and business combinations, corporate and regulatory requirements and other market and economic conditions. Purchases can be discontinued at any time that VMware feels additional purchases are not warranted. All shares repurchased under VMware’s stock repurchase programs are retired. As of September 30, 2014, the cumulative authorized amount remaining for repurchase was $1,209 million.
The following table summarizes stock repurchase activity during the three and nine months ended September 30, 2014 and 2013 (aggregate purchase price in millions, shares in thousands):
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Aggregate purchase price | $ | 43 | $ | 90 | $ | 450 | $ | 392 | |||||||
Class A common shares repurchased | 436 | 1,228 | 4,691 | 5,228 | |||||||||||
Weighted-average price per share | $ | 98.94 | $ | 73.63 | $ | 95.56 | $ | 75.06 |
The amount of repurchased shares includes commissions and is classified as a reduction to additional paid-in capital.
VMware Stock Options
The following table summarizes option activity since January 1, 2014 (shares in thousands):
Number of Shares | Weighted- Average Exercise Price (per share) | |||||
Outstanding, January 1, 2014 | 5,756 | $ | 44.12 | |||
Granted | 2,323 | 45.81 | ||||
Exercised | (2,119 | ) | 36.45 | |||
Forfeited | (144 | ) | 41.52 | |||
Outstanding, September 30, 2014 | 5,816 | 47.66 |
17
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The above table includes stock options substituted for unvested stock options in connection with business combinations. As a result, the weighted-average exercise price per share may be less than the VMware stock price at time of grant.
The stock options outstanding as of September 30, 2014 had an aggregate intrinsic value of $271 million based on VMware’s closing price as of September 30, 2014.
VMware Restricted Stock
VMware restricted stock primarily consists of restricted stock unit (“RSU”) awards granted to employees. RSUs are valued based on the VMware stock price on the date of grant, and shares underlying RSU awards are not issued until the RSUs vest. Upon vesting, each RSU converts into one share of VMware Class A common stock.
VMware restricted stock also includes performance stock unit (“PSU”) awards, which have been granted to certain of VMware's executives and employees. The PSU awards include performance conditions and, in certain cases, a time-based vesting component. Upon vesting, each PSU award will convert into VMware’s Class A common stock at various ratios ranging from 0.5 to 3.0 shares per PSU, depending upon the degree of achievement of the performance target designated by each individual award. If minimum performance thresholds are not achieved, then no shares will be issued.
The following table summarizes restricted stock activity since January 1, 2014 (shares in thousands):
Number of Units | Weighted- Average Grant Date Fair Value (per unit) | |||||
Outstanding, January 1, 2014 | 12,856 | $ | 85.85 | |||
Granted | 4,629 | 95.64 | ||||
Vested | (3,647 | ) | 94.85 | |||
Forfeited | (915 | ) | 86.55 | |||
Outstanding, September 30, 2014 | 12,923 | 89.12 |
As of September 30, 2014, the 12.9 million units outstanding included 12.2 million of RSUs, 0.6 million of PSUs and 0.1 million of restricted stock. The above table includes RSUs issued for outstanding unvested RSUs in connection with business combinations.
The total fair value of VMware RSUs, PSUs, and restricted stock that vested during the nine months ended September 30, 2014 was $348 million. As of September 30, 2014, restricted stock representing 12.9 million shares of VMware’s Class A common stock were outstanding, with an aggregate intrinsic value of $1,213 million based on VMware’s closing price as of September 30, 2014.
Accumulated Other Comprehensive Income
The changes in components of accumulated other comprehensive income during the nine months ended September 30, 2014 were as follows (table in millions):
Unrealized Gains on Available-for-Sale Securities | Loss on Cash Flow Hedges | Total | |||||||||
Balance, January 1, 2014 | $ | 4 | $ | — | $ | 4 | |||||
Other comprehensive gain (loss) before reclassifications, net of taxes of $1, $0 and $1 | 2 | (3 | ) | (1 | ) | ||||||
Amounts reclassified from accumulated other comprehensive income to the condensed consolidated statement of income, net of taxes of $(2), $0 and $(2) | (2 | ) | — | (2 | ) | ||||||
Other comprehensive income (loss), net | — | (3 | ) | (3 | ) | ||||||
Balance, September 30, 2014 | $ | 4 | $ | (3 | ) | $ | 1 |
Gains on VMware’s available-for-sale securities are reclassified to investment income on the condensed consolidated statements of income in the same period that they are realized.
18
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
K. Related Parties
EMC Reseller Arrangement, Other Services and Notes Payable
VMware and EMC engaged in the following ongoing intercompany transactions, which resulted in revenues and receipts and unearned revenues for VMware:
• | Pursuant to an ongoing reseller arrangement with EMC, EMC bundles VMware's products and services with EMC's products and sells them to end-users. |
• | EMC purchases products and services from VMware for internal use. |
• | VMware recognizes revenues for professional services based upon such contractual agreements with EMC. |
• | From time to time, VMware and EMC enter into agreements to collaborate on technology projects, and EMC pays VMware for services that VMware provides to EMC in connection with such projects. |
Information about VMware's revenues and receipts from such arrangements with EMC during the three and nine months ended September 30, 2014 and 2013 and unearned revenues as of September 30, 2014 and December 31, 2013 consisted of the following (table in millions):
Revenues and Receipts from EMC | Unearned Revenues from EMC | ||||||||||||||||||||||
Three Months Ended | Nine Months Ended | As of | As of | ||||||||||||||||||||
September 30, | September 30, | September 30, | December 31, | ||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | ||||||||||||||||||
Reseller revenues | $ | 47 | $ | 37 | $ | 136 | $ | 108 | $ | 195 | $ | 188 | |||||||||||
Professional services revenues | 13 | 14 | 53 | 60 | 11 | 12 | |||||||||||||||||
Internal-use revenues | 4 | 3 | 17 | 9 | 11 | 20 | |||||||||||||||||
Collaborative technology project receipts | — | 2 | — | 6 | n/a | n/a |
VMware and EMC engaged in the following ongoing intercompany transactions, which resulted in costs to VMware:
• | VMware purchases and leases products and purchases services for internal use from EMC. |
• | From time to time, VMware and EMC enter into agreements to collaborate on technology projects, and VMware pays EMC for services provided to VMware by EMC related to such projects. |
• | In certain geographic regions where VMware does not have an established legal entity, VMware contracts with EMC subsidiaries for support services and EMC personnel who are managed by VMware. The costs incurred by EMC on VMware's behalf related to these employees are passed on to VMware and VMware is charged a mark-up intended to approximate costs that would have been charged had VMware contracted for such services with an unrelated third party. These costs are included as expenses in VMware's condensed consolidated statements of income and primarily include salaries, benefits, travel and rent. EMC also incurs certain administrative costs on VMware's behalf in the U.S. that are recorded as expenses in VMware's condensed consolidated statements of income. |
• | VMware incurs interest expense on its notes payable with EMC. See below. |
Information about VMware's costs from such arrangements with EMC during the three and nine months ended September 30, 2014 and 2013 consisted of the following (table in millions):
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Purchases and leases of products and purchases of services | $ | 15 | $ | 20 | $ | 48 | $ | 45 | |||||||
Collaborative technology project costs | 3 | 5 | 10 | 7 | |||||||||||
EMC subsidiary support and administrative costs | 31 | 29 | 107 | 94 | |||||||||||
Interest expense on notes payable | 7 | 1 | 18 | 3 |
19
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Certain Stock-Based Compensation
Effective September 1, 2012, Pat Gelsinger succeeded Paul Maritz as Chief Executive Officer of VMware. Prior to joining VMware, Pat Gelsinger was the President and Chief Operating Officer of EMC Information Infrastructure Products. Paul Maritz remains a board member of VMware and currently serves as Chief Executive Officer of Pivotal, a majority-owned subsidiary of EMC in which VMware has an ownership interest, and as an executive officer of EMC. Both Paul Maritz and Pat Gelsinger retain and continue to vest in certain of their respective equity awards that they held as of September 1, 2012. Stock-based compensation related to Pat Gelsinger’s EMC awards are being recognized in VMware’s condensed consolidated statements of income over the awards’ remaining requisite service periods. Effective since September 1, 2012, stock-based compensation costs related to Paul Maritz’s VMware awards have been charged to EMC and have not been recognized by VMware.
Pivotal
During 2013, VMware transferred certain assets and liabilities to Pivotal. VMware contributed certain assets, including intellectual property, to Pivotal, and Pivotal assumed substantially all liabilities related to certain VMware Cloud Application Platform products and services, including VMware’s Cloud Foundry, VMware vFabric (including Spring and GemFire) and Cetas organizations, except for certain tangible assets related to Cloud Foundry. As of September 30, 2014, VMware's ownership interest in Pivotal was 28%.
Additionally, VMware and Pivotal entered into an agreement pursuant to which VMware will act as the selling agent for the products and services it contributed to Pivotal in exchange for a customary agency fee. VMware also agreed to provide various transition services to Pivotal. Pursuant to the support agreement, costs incurred by VMware to support Pivotal services are reimbursed to VMware by Pivotal and are recorded as a reduction to the costs incurred by VMware. Information about VMware's revenues and costs from such arrangement with Pivotal during the three and nine months ended September 30, 2014 and 2013 consisted of the following (table in millions):
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Revenues | $ | 1 | $ | 2 | $ | 4 | $ | 3 | |||||||
Transition services | — | 2 | 1 | 10 |
Additionally, VMware purchased an immaterial amount of products and services for internal use from Pivotal during the three and nine months ended September 30, 2014. During the three and nine months ended September 30, 2013, VMware purchased $1 million and $6 million, respectively, of products and services for internal use from Pivotal.
Tax Sharing Agreement with EMC
Pursuant to a tax sharing agreement between VMware and EMC, VMware has made payments to EMC and EMC has made payments to VMware. The following table summarizes these payments made between VMware and EMC during the three and nine months ended September 30, 2014 and 2013 (table in millions):
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Payments from VMware to EMC | $ | — | $ | — | $ | 20 | $ | — | |||||||
Payments from EMC to VMware | — | — | — | 16 |
Payments between VMware and EMC under the tax sharing agreement relate to VMware's portion of federal income taxes on EMC's consolidated tax return as well as state payments for combined states. Payments from EMC to VMware relate to periods where VMware had a stand-alone loss for U.S. federal and state income tax purposes or where VMware had federal tax credits in excess of federal tax liabilities. Payments from VMware to EMC are for estimated tax payments primarily for U.S. federal income tax purposes. The amounts that VMware either pays to or receives from EMC for its portion of federal income taxes on EMC’s consolidated tax return differ from the amounts VMware would owe on a separate return basis and the difference is presented as a component of stockholders’ equity. During the three and nine months ended September 30, 2014 and 2013, the difference between the amount of tax calculated on a stand-alone basis and the amount of tax calculated per the tax sharing agreement was not material.
20
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Due To/From Related Parties, Net
As a result of the related-party transactions with EMC and Pivotal described above, amounts due to and from related parties, net as of September 30, 2014 and December 31, 2013 consisted of the following (table in millions):
September 30, 2014 | December 31, 2013 | |||||
Due to EMC | $ | (66 | ) | $ | (92 | ) |
Due from EMC | 55 | 93 | ||||
Due to Pivotal | (7 | ) | (22 | ) | ||
Due from Pivotal | 1 | 3 | ||||
Due (to) from related parties, net | $ | (17 | ) | $ | (18 | ) |
Income tax payable due to EMC | $ | (139 | ) | $ | (22 | ) |
Balances due to or from related parties, which are unrelated to tax obligations, are generally settled in cash within 60 days of each quarter-end. The timing of the tax payments due to and from EMC is governed by the tax sharing agreement with EMC.
Notes Payable to EMC
In connection with VMware's acquisition of AirWatch, VMware and EMC entered into a note exchange agreement on January 21, 2014 providing for the issuance of three promissory notes in the aggregate principal amount of $1,500 million. The total debt of $1,500 million includes $450 million that was exchanged for the $450 million promissory note issued to EMC in April 2007, as amended and restated in June 2011.
The three notes issued may be prepaid without penalty or premium, and outstanding principal is due on the following dates: $680 million due May 1, 2018, $550 million due May 1, 2020 and $270 million due December 1, 2022. The notes bear interest, payable quarterly in arrears, at the annual rate of 1.75%. During the three and nine months ended September 30, 2014, $7 million and $18 million, respectively, of interest expense was recognized. During the three and nine months ended September 30, 2013, $1 million and $3 million, respectively, of interest expense was recognized.
L. Segment Information
VMware operates in one reportable operating segment, thus all required financial segment information can be found in the condensed consolidated financial statements. Operating segments are defined as components of an enterprise about which separate financial information is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assessing performance. VMware’s chief operating decision maker allocates resources and assesses performance based upon discrete financial information at the consolidated level.
Revenues by geographic area during the three and nine months ended September 30, 2014 and 2013 were as follows (table in millions):
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
United States | $ | 780 | $ | 614 | $ | 2,112 | $ | 1,773 | |||||||
International | 735 | 675 | 2,221 | 1,951 | |||||||||||
Total | $ | 1,515 | $ | 1,289 | $ | 4,333 | $ | 3,724 |
It is not practicable for VMware to determine revenues by country other than the United States during the three and nine months ended September 30, 2014 and 2013.
Long-lived assets by geographic area, which primarily include property and equipment, net, as of September 30, 2014 and December 31, 2013 were as follows (table in millions):
September 30, 2014 | December 31, 2013 | ||||||
United States | $ | 782 | $ | 741 | |||
International | 94 | 58 | |||||
Total | $ | 876 | $ | 799 |
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VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
No individual country other than the United States accounted for 10% or more of these assets as of September 30, 2014 and December 31, 2013, respectively.
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ITEM 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
The following management's discussion and analysis ("MD&A") is provided in addition to the accompanying condensed consolidated financial statements and notes to assist in understanding our results of operations and financial condition. Financial information as of September 30, 2014 should be read in conjunction with our consolidated financial statements for the year ended December 31, 2013 contained in our Form 10-K filed February 25, 2014.
All dollar amounts expressed as numbers in this MD&A (except share and per share amounts) are in millions. Period-over-period changes are calculated based upon the respective underlying, non-rounded data. Unless the context requires otherwise, we are referring to VMware, Inc. and its consolidated subsidiaries when we use the terms “VMware,” the “Company,” “we,” “our” or “us.”
Overview
We are the leader in virtualization infrastructure solutions utilized by organizations to help transform the way they build, deliver and consume information technology (“IT”) resources. We develop and market our product and service offerings within three main product groups, and we also seek to leverage synergies across these three product areas.
• | SDDC or Software-Defined Data Center |
• | End-User Computing |
• | Hybrid Cloud Computing |
We pioneered the development and application of virtualization technologies with x86 server-based computing, separating application software from the underlying hardware. The benefits to our customers include lower IT costs and a more automated and resilient systems infrastructure capable of responding dynamically to variable business demands. Our broad and proven suite of virtualization technologies are designed to establish secure and, reliable IT environments and address a range of complex IT challenges that include cost reduction, operational inefficiencies, access to cloud computing capacity, business continuity and corporate end-user computing device management. Our solutions enable organizations to aggregate multiple servers, storage infrastructure and networks together into shared pools of capacity that can be allocated dynamically, securely and reliably to applications as needed. Once created, these internal computing infrastructures, or “clouds,” can be dynamically extended by our customers to the public cloud environment. When linked, this results in a “hybrid” computing cloud of highly available internal and external computing resources that organizations can access on demand. Our customers' deployments range in size from a single virtualized server for small businesses to thousands of virtual machines for our Fortune 1000 enterprise customers.
We have articulated a vision for the software-defined data center (“SDDC”), where increasingly infrastructure is virtualized and delivered as a service, enabling control of the data center to be entirely automated by software. The SDDC is designed to transform the data center into an on-demand service that addresses application requirements by abstracting, pooling, and automating the services that are required from the underlying hardware. SDDC promises to dramatically simplify data center operations and lower costs. The VMware vCloud Suite, which is our first integrated solution toward realizing the SDDC vision and is based upon our VMware vSphere virtualization platform, was initially introduced in late 2012. The VMware vCloud Suite addresses virtualization of not only CPU and memory, but also networks and associated security services. In addition, the vCloud Suite delivers a new approach to management, leveraging policy-based automation. VMware vCloud Suite is engineered for hybrid cloud computing so that it federates with other pools of infrastructure.
We believe that our solutions enable organizations to realize significant operational and cost efficiencies as they transition their underlying legacy IT infrastructure. We work closely with more than 1,200 technology partners, including leading server, microprocessor, storage, networking, software and security vendors. We have shared the economic opportunities surrounding virtualization with our partners by facilitating solution development through open application programming interface (“APIs”) formats and protocols and providing access to our source code and technology. The endorsement and support of our partners further enhances the awareness, reputation and adoption of our virtualization solutions.
We expect to grow our business by building long-term relationships with our customers, which includes continuing to sell our solutions through enterprise license agreements (“ELAs”). ELAs are comprehensive volume license offerings offered both directly by us and through certain channel partners that provide for multi-year maintenance and support. Under a typical ELA, a portion of the revenues is attributed to license revenues and the remainder is primarily attributed to other deliverables, including software maintenance revenues. In addition, the initial maintenance and support period is typically longer for ELAs compared to our transactional business. We believe that ELAs facilitate our objective of building long-term relationships with our customers as they commit to our virtual infrastructure solutions in their data centers. ELAs comprised 29% and 33% of our overall sales during the third quarters of 2014 and 2013, respectively, and 31% and 33% of our overall sales during the nine months ended September 30, 2014 and 2013, respectively, with the balance primarily represented by our non-ELA, or transactional, business.
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On February 24, 2014, we acquired A.W.S. Holding, LLC (“AirWatch Holding”), the sole member and equity holder of AirWatch LLC (“AirWatch”). AirWatch is a leader in enterprise mobile management and security solutions. The acquisition of AirWatch expands our portfolio of mobile solutions within the enterprise mobile and security space.
Headcount during the three and nine months ended September 30, 2014 continued to increase due primarily to organic growth and the AirWatch acquisition. The increased headcount has resulted in higher cash and stock-based employee-related expenses across our income statement expense categories when compared to the same periods in 2013 and we expect this trend to continue. See further discussion under "Results of Operations" below.
Results of Operations
Revenues
Our revenues during the three and nine months ended September 30, 2014 and 2013 were as follows:
Three Months Ended | Nine Months Ended | ||||||||||||||||||||||||||||
September 30, | September 30, | ||||||||||||||||||||||||||||
2014 | 2013 | $ Change | % Change | 2014 | 2013 | $ Change | % Change | ||||||||||||||||||||||
Revenues: | |||||||||||||||||||||||||||||
License | $ | 639 | $ | 564 | $ | 76 | 13 | % | $ | 1,814 | $ | 1,583 | $ | 232 | 15 | % | |||||||||||||
Services: | |||||||||||||||||||||||||||||
Software maintenance | 779 | 644 | 136 | 21 | 2,217 | 1,864 | 354 | 19 | |||||||||||||||||||||
Professional services | 97 | 81 | 15 | 19 | 302 | 277 | 23 | 8 | |||||||||||||||||||||
Total services | 876 | 725 | 151 | 21 | 2,519 | 2,141 | 377 | 18 | |||||||||||||||||||||
Total revenues | $ | 1,515 | $ | 1,289 | $ | 226 | 18 | $ | 4,333 | $ | 3,724 | $ | 609 | 16 | |||||||||||||||
Revenues: | |||||||||||||||||||||||||||||
United States | $ | 780 | $ | 614 | $ | 166 | 27 | % | $ | 2,112 | $ | 1,773 | $ | 339 | 19 | % | |||||||||||||
International | 735 | 675 | 60 | 9 | 2,221 | 1,951 | 270 | 14 | |||||||||||||||||||||
Total revenues | $ | 1,515 | $ | 1,289 | $ | 226 | 18 | $ | 4,333 | $ | 3,724 | $ | 609 | 16 |
License Revenues
License revenues during the three and nine months ended September 30, 2014 were up 13% and 15%, respectively, compared to the three and nine months ended September 30, 2013. Our license revenue growth rate was favorably impacted during the three and nine months ended September 30, 2014 compared to the same periods in the prior year as a result of increased sales of our integrated product suites, including VMware vCloud Suite. Our customers continue to shift to purchasing our suite solutions rather than purchasing certain products sold on a standalone basis such as vSphere. Our integrated product suites include various product offerings and are generally sold at a higher price than our products that are sold on an individual basis. Additionally, increased sales of our end-user computing products, including AirWatch mobile solutions, also contributed to the increase in license revenues. Revenues from AirWatch include revenues recognized from our Software as a Service ("SaaS") offerings. SaaS revenues are included in both license and software maintenance revenues and the amounts have not been material for all periods presented.
Our license revenue growth rate was negatively impacted by the contribution to Pivotal and the disposition of other net assets under our realignment plan that occurred during fiscal 2013. License revenues related to Pivotal and all dispositions under our realignment plan were $2 and $18 during the three and nine months ended September 30, 2013, respectively.
Services Revenues
During the three and nine months ended September 30, 2014, software maintenance revenues benefited from renewals, multi-year software maintenance contracts sold in previous periods, and additional maintenance contracts sold in conjunction with new software license sales. In each period presented, customers bought, on average, more than 24 months of support and maintenance with each new license purchased, which we believe demonstrates our customers' commitment to our SDDC strategy.
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Our services revenue growth rate was negatively impacted by the contribution to Pivotal and the disposition of other net assets under our realignment plan. Service revenues related to Pivotal and all dispositions under our realignment plan were $2 and $37 during the three and nine months ended September 30, 2013, respectively.
Foreign Currency
We invoice and collect in the Euro, the British Pound, the Japanese Yen, the Australian Dollar and the Chinese Renminbi in their respective regions. As a result, our total revenues are affected by changes in the value of the U.S. Dollar against these currencies. Foreign currency fluctuations did not have a material impact when comparing license revenues during the three and nine months ended September 30, 2014 to the three and nine months ended September 30, 2013.
Unearned Revenues
Our unearned revenues as of September 30, 2014 and December 31, 2013 were as follows:
September 30, 2014 | December 31, 2013 | ||||||
Unearned license revenues | $ | 428 | $ | 465 | |||
Unearned software maintenance revenues | 3,558 | 3,304 | |||||
Unearned professional services revenues | 389 | 323 | |||||
Total unearned revenues | $ | 4,375 | $ | 4,092 |
Unearned license revenues are generally recognized upon delivery of existing or future products or services, or they are otherwise recognized ratably over the term of the arrangement. Future products include, in some cases, emerging products that are offered as part of product promotions where the purchaser of an existing product is entitled to receive the future product at no additional charge. To the extent the future product has not been delivered and vendor-specific objective evidence (“VSOE”) of fair value cannot be established, the revenue for the entire order is deferred until such time as all product delivery obligations have been fulfilled. In the event the arrangement does not include professional services, unearned license revenue may also be recognized ratably, if the customer is granted the right to receive unspecified future products or VSOE of fair value on the software maintenance element of the arrangement does not exist. Total unearned license revenues may vary over periods for a variety of factors, including the type and level of promotions offered, and the timing of when the products are delivered upon general availability.
Unearned software maintenance revenues are attributable to our maintenance contracts and are generally recognized ratably, typically over terms from one to five years with a weighted-average remaining term at September 30, 2014 of approximately two years. Unearned professional services revenues result primarily from prepaid professional services, including training, and are generally recognized as the services are delivered.
Cost of License and Services Revenues, and Operating Expenses
Cost of License Revenues
Our cost of license revenues principally consists of the cost of fulfillment of our software, royalty costs in connection with technology licensed from third-party providers and amortization of intangible assets and capitalized software. The cost of fulfillment of our software includes IT development efforts, personnel costs and related overhead associated with the physical and electronic delivery of our software products.
Three Months Ended | Nine Months Ended | ||||||||||||||||||||||||||||
September 30, | September 30, | ||||||||||||||||||||||||||||
2014 | 2013 | $ Change | % Change | 2014 | 2013 | $ Change | % Change | ||||||||||||||||||||||
Cost of license revenues | $ | 45 | $ | 50 | $ | (5 | ) | (9 | )% | $ | 141 | $ | 161 | $ | (20 | ) | (13 | )% | |||||||||||
Stock-based compensation | 1 | 1 | — | 10 | 2 | 2 | — | 15 | |||||||||||||||||||||
Total expenses | $ | 46 | $ | 51 | $ | (5 | ) | (9 | ) | $ | 143 | $ | 163 | $ | (20 | ) | (12 | ) | |||||||||||
% of License revenues | 7 | % | 9 | % | 8 | % | 10 | % |
Cost of license revenues decreased during the three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013 primarily due to a decrease of $8 and $34, respectively, in amortization of capitalized software development costs which was partially offset by an increase of $6 and $12, respectively, in amortization of intangible assets.
As of December 31, 2013, all previously capitalized software development costs were fully amortized and as such, we do not expect significant amortization of capitalized software development costs during 2014.
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Cost of Services Revenues
Our cost of services revenues primarily includes the costs of personnel and related overhead to deliver technical support for our products and to provide our professional services. As we continue to grow business from our SaaS and professional services offerings, we expect our total costs of services revenues to continue to increase.
Three Months Ended | Nine Months Ended | ||||||||||||||||||||||||||||
September 30, | September 30, | ||||||||||||||||||||||||||||
2014 | 2013 | $ Change | % Change | 2014 | 2013 | $ Change | % Change | ||||||||||||||||||||||
Cost of services revenues | $ | 185 | $ | 125 | $ | 61 | 49 | % | $ | 488 | $ | 354 | $ | 135 | 38 | % | |||||||||||||
Stock-based compensation | 11 | 7 | 3 | 42 | 31 | 21 | 9 | 44 | |||||||||||||||||||||
Total expenses | $ | 196 | $ | 132 | $ | 64 | 48 | $ | 519 | $ | 375 | $ | 144 | 38 | |||||||||||||||
% of Services revenues | 22 | % | 18 | % | 21 | % | 18 | % |
Cost of services revenues increased during the three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013 primarily driven by the growth in our SaaS and professional services offerings which led to higher costs of services. The increase includes growth in cash-based employee-related expenses of $37 and $88 due to incremental growth in headcount, both organic and through the AirWatch acquisition, and an increase in technical support costs of $2 and $16 during the three and nine months ended September 30, 2014, respectively. Additionally, increases in equipment and depreciation costs also contributed to the increases in cost of services revenues. The increase during the nine months ended September 30, 2014 was partially offset by a decrease of $10 in operating expenses related to Pivotal.
Research and Development Expenses
Our research and development (“R&D”) expenses include the personnel and related overhead associated with the R&D of new product offerings and the enhancements, including major upgrades, of our existing software offerings.
Three Months Ended | Nine Months Ended | ||||||||||||||||||||||||||||
September 30, | September 30, | ||||||||||||||||||||||||||||
2014 | 2013 | $ Change | % Change | 2014 | 2013 | $ Change | % Change | ||||||||||||||||||||||
Research and development | $ | 266 | $ | 214 | $ | 52 | 24 | % | $ | 749 | $ | 632 | $ | 117 | 19 | % | |||||||||||||
Stock-based compensation | 61 | 52 | 9 | 17 | 187 | 165 | 22 | 13 | |||||||||||||||||||||
Total expenses | $ | 327 | $ | 266 | $ | 61 | 23 | $ | 936 | $ | 797 | $ | 139 | 17 | |||||||||||||||
% of Total revenues | 22 | % | 21 | % | 22 | % | 21 | % |
R&D expenses increased during the three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013. The increases were primarily due to growth in cash-based employee-related expenses of $41 and $93 during the three and nine months ended September 30, 2014, respectively, and increases in stock-based compensation of $9 and $22, respectively, driven by incremental growth in headcount, both organic and through the AirWatch acquisition. Equipment and depreciation expenses increased by $12 and $21 during the three and nine months ended September 30, 2014, respectively. Additionally, contractor costs increased by $11 contributing to the growth in R&D expenses during the nine months ended September 30, 2014 compared to the same period in 2013. The increase during the nine months ended September 30, 2014 was partially offset by a decrease of $15 in R&D expenses related to Pivotal.
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Sales and Marketing Expenses
Our sales and marketing expenses include personnel costs, sales commissions and related overhead associated with the sale and marketing of our license and services offerings, as well as the cost of product launches. Sales commissions are generally earned and expensed when a firm order is received from the customer. Sales and marketing expenses also include the net impact from the expenses incurred and fees generated by certain marketing initiatives, such as our annual VMworld U.S. conference that occurred during August 2014.
Three Months Ended | Nine Months Ended | ||||||||||||||||||||||||||||
September 30, | September 30, | ||||||||||||||||||||||||||||
2014 | 2013 | $ Change | % Change | 2014 | 2013 | $ Change | % Change | ||||||||||||||||||||||
Sales and marketing | $ | 486 | $ | 412 | $ | 74 | 18 | % | $ | 1,422 | $ | 1,202 | $ | 218 | 18 | % | |||||||||||||
Stock-based compensation | 43 | 37 | 7 | 19 | 128 | 106 | 22 | 20 | |||||||||||||||||||||
Total expenses | $ | 529 | $ | 449 | $ | 81 | 18 | $ | 1,550 | $ | 1,308 | $ | 240 | 18 | |||||||||||||||
% of Total revenues | 35 | % | 35 | % | 36 | % | 35 | % |
Sales and marketing expenses increased during the three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013 primarily driven by growth in cash-based employee-related expenses of $64 and $175, respectively, and an increase in stock-based compensation expense of $7 and $22, respectively, due to incremental growth in headcount, both organic and through the AirWatch acquisition. Costs incurred for travel and marketing programs also increased by $30 during the nine months ended September 30, 2014 compared to the same period in 2013. The increase in expenses during the nine months ended September 30, 2014 was partially offset by a decrease of $10 in sales and marketing expenses related to Pivotal.
General and Administrative Expenses
Our general and administrative expenses include personnel and related overhead costs to support the overall business. These expenses include the costs associated with our finance, human resources, IT infrastructure and legal, as well as expenses related to corporate costs and initiatives and facilities costs.
Three Months Ended | Nine Months Ended | ||||||||||||||||||||||||||||
September 30, | September 30, | ||||||||||||||||||||||||||||
2014 | 2013 | $ Change | % Change | 2014 | 2013 | $ Change | % Change | ||||||||||||||||||||||
General and administrative | $ | 152 | $ | 87 | $ | 66 | 76 | % | $ | 447 | $ | 256 | $ | 192 | 75 | % | |||||||||||||
Stock-based compensation | 17 | 16 | 1 | 4 | 51 | 42 | 9 | 22 | |||||||||||||||||||||
Total expenses | $ | 169 | $ | 103 | $ | 66 | 65 | $ | 498 | $ | 298 | $ | 201 | 68 | |||||||||||||||
% of Total revenues | 11 | % | 8 | % | 11 | % | 8 | % |
General and administrative expenses increased during the three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013. Certain key employees of AirWatch may be paid consideration upon the achievement of specified future employment conditions. Compensation expense relating to future employment conditions of certain key AirWatch employees of $41 and $101 was recognized during the three and nine months ended September 30, 2014, respectively. Other cash-based employee-related expenses increased by $13 and $41 during the three and nine months ended September 30, 2014, respectively, due to incremental growth in headcount, both organic and through the AirWatch acquisition. Costs of $11 related to certain litigation and other contingencies and IT development costs further contributed to the increase in expenses during the nine months ended September 30, 2014 compared to the same period in 2013.
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Realignment Charges
Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
September 30, | September 30, | ||||||||||||||||||||||
2014 | 2013 | $ Change | 2014 | 2013 | $ Change | ||||||||||||||||||
Realignment charges | $ | 6 | $ | 1 | $ | 5 | $ | 4 | $ | 58 | $ | (54 | ) | ||||||||||
Stock-based compensation | — | — | — | — | 6 | (6 | ) | ||||||||||||||||
Total expenses | $ | 6 | $ | 1 | $ | 5 | $ | 4 | $ | 64 | $ | (60 | ) |
During the three months ended September 30, 2014, we eliminated approximately 90 positions across all major functional groups and geographies to streamline our operations. As a result of these actions, $7 of realignment charges was recognized during the three months ended September 30, 2014 on the condensed consolidated statements of income, which consisted of workforce reduction charges. An immaterial credit was recognized during the three months ended September 30, 2014. As of September 30, 2014, $5 remained in accrued expenses and other on the condensed consolidated balance sheet and is expected to be paid by the end of 2014.
Realignment charges during the nine months ended September 30, 2013 were incurred in connection with our realignment plan that was initiated in January. The realignment plan was completed at December 31, 2013.
Interest Expense with EMC
Interest expense with EMC of $7 and $18 during the three and nine months ended September 30, 2014, respectively, increased by $6 and $15 compared to the same periods in 2013 primarily as a result of the additional debt we assumed from EMC. See "Our Relationship with EMC" disclosure for further information.
Other Income (Expense), Net
Other income (expense), net, decreased by $17 and $31 during the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013, primarily due to a pre-tax gain of $12 and $44 recognized during the three and nine months ended September 30, 2013, respectively, as a result of exiting certain lines of business under our business realignment plan. Partially offsetting this gain was an other-than-temporary impairment charge of $13 that we recognized in connection with a strategic investment during the nine months ended September 30, 2013.
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Income Tax Provision
For the three months ended September 30, 2014 and 2013, our effective income tax rate was 20.4% and 15.3%, respectively. For the nine months ended September 30, 2014 and 2013, our effective income tax rate was 18.9% and 11.4%, respectively. Our effective income tax rate when comparing the three and nine months ended September 30, 2014, to the same periods in 2013 was primarily impacted by the expiration of the federal research credit on December 31, 2013. During January 2013, the United States Congress retroactively enacted the extension of the federal research credit through December 31, 2013. Our effective income tax rate was also adversely impacted during the three months ended September 30, 2014 by a greater proportion of our earnings being recognized in the U.S., which are taxed at a higher rate than our earnings in foreign jurisdictions.
Our rate of taxation in foreign jurisdictions is lower than our U.S. tax rate. Our foreign earnings are primarily earned by our subsidiaries organized in Ireland, and as such, our effective tax rate can be impacted by the mix of our earnings in the U.S. and foreign jurisdictions.
During October 2014, Ireland announced revisions to its tax regulations that will require foreign earnings earned by our subsidiaries organized in Ireland to be taxed at higher rates. We will be impacted by the changes in tax regulations in Ireland beginning in 2021. All income earned abroad, except for previously taxed income for U.S. tax purposes, is considered indefinitely reinvested in our foreign operations and no provision for U.S. taxes has been provided with respect to such income. Our intent is to indefinitely reinvest our non-U.S. funds in our foreign operations, and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations.
We are included in the EMC consolidated group for U.S. federal income tax purposes, and expect to continue to be included in such consolidated group for periods in which EMC owns at least 80% of the total voting power and value of our outstanding stock as calculated for U.S. federal income tax purposes. The percentage of voting power and value calculated for U.S. federal income tax purposes may differ from the percentage of outstanding shares beneficially owned by EMC due to the greater voting power of our Class B common stock as compared to our Class A common stock and other factors. Each member of a consolidated group during any part of a consolidated return year is jointly and severally liable for tax on the consolidated return of such year and for any subsequently determined deficiency thereon. Should EMC's ownership fall below 80% of the total voting power or value of our outstanding stock in any period, then we would no longer be included in the EMC consolidated group for U.S. federal income tax purposes, and our U.S. federal income tax would be reported separately from that of the EMC consolidated group.
Although we file a consolidated federal tax return with EMC, the income tax provision is calculated primarily as though we were a separate taxpayer. However, certain transactions that we and EMC are parties to are assessed using consolidated tax return rules. Our effective tax rate in the periods presented is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rates. The rate at which the provision for income taxes is calculated differs from the U.S. federal statutory income tax rate primarily due to different tax rates in foreign jurisdictions where income is earned.
Our future effective tax rate may be affected by such factors as changes in tax laws, changes in our business, regulations, or rates, changing interpretation of existing laws or regulations, the impact of accounting for stock-based compensation, the impact of accounting for business combinations, changes in our international organization, shifts in the amount of income before tax earned in the U.S. as compared with other regions in the world, and changes in overall levels of income before tax.
Our Relationship with EMC
As of September 30, 2014, EMC owned 43,025,000 shares of Class A common stock and all 300,000,000 shares of Class B common stock, representing 79.6% of our total outstanding shares of common stock and 97.2% of the combined voting power of our outstanding common stock.
EMC Reseller Arrangement, Other Services and Notes Payable
We and EMC engaged in the following ongoing intercompany transactions, which resulted in revenues and receipts and unearned revenues for VMware:
• | Pursuant to an ongoing reseller arrangement with EMC, EMC bundles our products and services with EMC's products and sells them to end-users. |
• | EMC purchases products and services from us for internal use. |
• | We recognize revenues for professional services based upon such contractual agreements with EMC. |
• | From time to time, we and EMC enter into agreements to collaborate on technology projects, and EMC pays us for services that we provide to EMC in connection with such projects. |
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Information about our revenues and receipts from such arrangements with EMC during the three and nine months ended September 30, 2014 and 2013 and unearned revenues as of September 30, 2014 and December 31, 2013 consisted of the following (table in millions):
Revenues and Receipts from EMC | Unearned Revenues from EMC | ||||||||||||||||||||||
Three Months Ended | Nine Months Ended | As of | As of | ||||||||||||||||||||
September 30, | September 30, | September 30, | December 31, | ||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | ||||||||||||||||||
Reseller revenues | $ | 47 | $ | 37 | $ | 136 | $ | 108 | $ | 195 | $ | 188 | |||||||||||
Professional services revenues | 13 | 14 | 53 | 60 | 11 | 12 | |||||||||||||||||
Internal-use revenues | 4 | 3 | 17 | 9 | 11 | 20 | |||||||||||||||||
Collaborative technology project receipts | — | 2 | — | 6 | n/a | n/a |
We and EMC engaged in the following ongoing intercompany transactions, which resulted in costs to us:
• | We purchase and lease products and purchase services for internal use from EMC. |
• | From time to time, we and EMC enter into agreements to collaborate on technology projects, and we pay EMC for services provided to us by EMC related to such projects. |
• | In certain geographic regions where we do not have an established legal entity, we contract with EMC subsidiaries for support services and EMC personnel who are managed by us. The costs incurred by EMC on our behalf related to these employees are passed on to us and we are charged a mark-up intended to approximate costs that would have been charged had we contracted for such services with an unrelated third party. These costs are included as expenses in our condensed consolidated statements of income and primarily include salaries, benefits, travel and rent. EMC also incurs certain administrative costs on our behalf in the U.S. that are recorded as expenses in our condensed consolidated statements of income. |
• | We incur interest expense on our notes payable with EMC. See below. |
Information about our costs from such arrangements with EMC during the three and nine months ended September 30, 2014 and 2013 consisted of the following (table in millions):
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Purchases and leases of products and purchases of services | $ | 15 | $ | 20 | $ | 48 | $ | 45 | |||||||
Collaborative technology project costs | 3 | 5 | 10 | 7 | |||||||||||
EMC subsidiary support and administrative costs | 31 | 29 | 107 | 94 | |||||||||||
Interest expense on notes payable | 7 | 1 | 18 | 3 |
Certain Stock-Based Compensation
Effective September 1, 2012, Pat Gelsinger succeeded Paul Maritz as Chief Executive Officer of VMware. Prior to joining VMware, Pat Gelsinger was the President and Chief Operating Officer of EMC Information Infrastructure Products. Paul Maritz remains a board member of VMware and currently serves as Chief Executive Officer of Pivotal, a majority-owned subsidiary of EMC in which we have an ownership interest, and as an executive officer of EMC. Both Paul Maritz and Pat Gelsinger retain and continue to vest in certain of their respective equity awards that they held as of September 1, 2012. Stock-based compensation related to Pat Gelsinger’s EMC awards are being recognized on our condensed consolidated statements of income over the awards’ remaining requisite service periods. Effective since September 1, 2012, stock-based compensation costs related to Paul Maritz’s VMware awards have been charged to EMC and have not been recognized by us.
Pivotal
During 2013, we transferred certain assets and liabilities to Pivotal. We contributed certain assets, including intellectual property to Pivotal, and Pivotal assumed substantially all liabilities, related to certain of our Cloud Application Platform products and services, including VMware’s Cloud Foundry, VMware vFabric (including Spring and GemFire) and Cetas organizations, except for certain tangible assets related to Cloud Foundry. As of September 30, 2014, our ownership interest in Pivotal was 28%.
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Additionally, we and Pivotal entered into an agreement pursuant to which we will act as the selling agent for the products and services we contributed to Pivotal in exchange for a customary agency fee. We also agreed to provide various transition services to Pivotal. Pursuant to the support agreement, costs incurred by us to support Pivotal services are reimbursed to us by Pivotal and are recorded as a reduction to the costs incurred by us. Information about our revenues and costs from such arrangement with Pivotal during the three and nine months ended September 30, 2014 and 2013 consisted of the following (table in millions):
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Revenues | $ | 1 | $ | 2 | $ | 4 | $ | 3 | |||||||
Transition services | — | $ | 2 | 1 | $ | 10 |
Additionally, we purchased an immaterial amount of products and services for internal use from Pivotal during the three and nine months ended September 30, 2014. During the three and nine months ended September 30, 2013, we purchased $1 and $6, respectively, of products and services for internal use from Pivotal.
Tax Sharing Agreement with EMC
Pursuant to a tax sharing agreement between us and EMC, we have made payments to EMC and EMC has made payments to us. The following table summarizes these payments made between us and EMC during the three and nine months ended September 30, 2014 and 2013 (table in millions):
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Payments from us to EMC | $ | — | $ | — | $ | 20 | $ | — | |||||||
Payments from EMC to us | — | — | — | 16 |
Payments between us and EMC under the tax sharing agreement relate to our portion of federal income taxes on EMC's consolidated tax return as well as state payments for combined states. Payments from EMC to us relate to periods where we had a stand-alone loss for U.S. federal and state income tax purposes or where we had federal tax credits in excess of federal tax liabilities. Payments from us to EMC are for estimated tax payments primarily for U.S. federal income tax purposes. The amounts that we either pay to or receive from EMC for our portion of federal income taxes on EMC’s consolidated tax return differ from the amounts we would owe on a separate return basis and the difference is presented as a component of stockholders’ equity. During the three and nine months ended September 30, 2014 and 2013, the difference between the amount of tax calculated on a stand-alone basis and the amount of tax calculated per the tax sharing agreement was not material.
Due To/From Related Parties, Net
As a result of the related-party transactions with EMC and Pivotal described above, amounts due to and from related parties, net as of September 30, 2014 and December 31, 2013 consisted of the following (table in millions):
September 30, 2014 | December 31, 2013 | |||||
Due to EMC | $ | (66 | ) | $ | (92 | ) |
Due from EMC | 55 | 93 | ||||
Due to Pivotal | (7 | ) | (22 | ) | ||
Due from Pivotal | 1 | 3 | ||||
Due (to) from related parties, net | $ | (17 | ) | $ | (18 | ) |
Income tax payable due to EMC | $ | (139 | ) | $ | (22 | ) |
Balances due to or from related parties, which are unrelated to tax obligations, are generally settled in cash within 60 days of each quarter-end. The timing of the tax payments due to and from EMC is governed by the tax sharing agreement with EMC.
Notes Payable to EMC
In connection with our acquisition of AirWatch, we and EMC entered into a note exchange agreement on January 21, 2014 providing for the issuance of three promissory notes in the aggregate principal amount of $1,500. The total debt of $1,500
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includes $450 that was exchanged for the $450 promissory note issued to EMC in April 2007, as amended and restated in June 2011.
The three notes issued may be prepaid without penalty or premium, and outstanding principal is due on the following dates: $680 due May 1, 2018, $550 due May 1, 2020 and $270 due December 1, 2022. The notes bear interest, payable quarterly in arrears, at the annual rate of 1.75%. During the three and nine months ended September 30, 2014, $7 and $18, respectively, of interest expense was recognized. During the three and nine months ended September 30, 2013, $1 and $3, respectively, of interest expense was recognized.
By nature of EMC’s majority ownership of us, the amounts we recorded for our intercompany transactions with EMC may not be considered arm’s length with an unrelated third party. Therefore the condensed consolidated financial statements included herein may not necessarily reflect our results of operations, financial position and cash flows had we engaged in such transactions with an unrelated third party during all periods presented. Accordingly, our historical results should not be relied upon as an indicator of our future performance as a stand-alone company.
Liquidity and Capital Resources
At September 30, 2014 and 2013, we held cash, cash equivalents and short-term investments as follows:
September 30, | |||||||
2014 | 2013 | ||||||
Cash and cash equivalents | $ | 2,293 | $ | 2,263 | |||
Short-term investments | 4,801 | 3,574 | |||||
Total cash, cash equivalents and short-term investments | $ | 7,094 | $ | 5,837 |
As of September 30, 2014, we held a diversified portfolio of money market funds and fixed income securities totaling $6,518. Our fixed income securities are denominated in U.S. Dollars and consisted of highly liquid debt instruments of the U.S. government and its agencies, U.S. municipal obligations, and U.S. and foreign corporate debt securities. We limit the amount of our domestic and international investments with any single issuer and any single financial institution, and also monitor the diversity of the portfolio, thereby diversifying the credit risk. As of September 30, 2014, our total cash, cash equivalents and short-term investments were $7,094, of which $4,954 was held outside the U.S. If these overseas funds were needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes on related undistributed earnings to repatriate these funds. However, our intent is to indefinitely reinvest our non-U.S. earnings in our foreign operations and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations.
We expect that cash generated by operations will be our primary source of liquidity. We also believe that existing cash and cash equivalents, together with any cash generated from operations will be sufficient to meet normal operating requirements for at least the next twelve months. While we believe our existing cash and cash equivalents and cash to be generated by operations will be sufficient to meet our normal operating requirements, our overall level of cash needs may be impacted by the number and size of acquisitions, investments and stock repurchases. On January 21, 2014, in connection with our agreement to acquire AirWatch, we and EMC entered into a note exchange agreement providing for the issuance of three promissory notes in the aggregate principal amount of $1,500. Please see below for further details regarding these promissory notes. Should we require additional liquidity, we may seek to arrange debt financing or enter into credit facilities.
Our cash flows summarized for the three and nine months ended September 30, 2014 and 2013 were as follows:
Three Months Ended | Nine Months Ended | ||||||||||||||
September 30, | September 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | ||||||||||||
Net cash provided by (used in): | |||||||||||||||
Operating activities | $ | 606 | $ | 637 | $ | 1,765 | $ | 1,848 | |||||||
Investing activities | (371 | ) | (189 | ) | (2,433 | ) | (963 | ) | |||||||
Financing activities | 4 | (25 | ) | 656 | (231 | ) | |||||||||
Net (decrease) increase in cash and cash equivalents | $ | 239 | $ | 423 | $ | (12 | ) | $ | 654 |
Operating Activities
Cash provided by operating activities decreased by $31 and $82 during the three and nine months ended September 30, 2014 from the three and nine months ended September 30, 2013, respectively. The decrease during the three and nine months ended September 30, 2014 was primarily driven by a decrease in net income, change in deferred taxes, and change in unearned
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revenues compared to the same periods in 2013. The decrease was partially offset by the change in both accounts payable and income taxes payable.
Investing Activities
Cash used in investing activities is generally attributable to the purchase of fixed income securities, business acquisitions, and capital expenditures. Cash provided by investing activities is also impacted by the timing of purchases, sales and maturities of our available-for-sale securities.
Cash used in investing activities increased during the three and nine months ended September 30, 2014 compared to the same periods in 2013 primarily due to increases in purchases of available-for-sale securities partially offset by increases in sales of available-for-sale securities. Additionally, cash used in investing activities during the nine months ended September 30, 2014 increased significantly as a result of our acquisition of AirWatch during the first quarter of 2014. The increase in restricted cash during the nine months ended September 30, 2014 primarily relates to amounts due to certain AirWatch employees, subject to achievement of certain employment conditions.
Financing Activities
Net cash provided by financing activities during the three months ended September 30, 2014 changed compared to net cash used in financing activities during the same period in 2013 primarily as a result of the change in the repurchase of our common stock. The notes payable exchange agreement we entered into with EMC in connection with our acquisition of AirWatch significantly increased net cash provided by financing activities during the nine months ended September 30, 2014. The increase was partially offset by the change in the repurchase of our common stock during the nine months ended September 30, 2014.
Notes Payable to EMC
As of September 30, 2014, $1,500 remained outstanding on notes payable to EMC, with interest payable quarterly in arrears.
In connection with our acquisition of AirWatch, we entered into a note exchange agreement with EMC on January 21, 2014 providing for the issuance of three promissory notes in the aggregate principal amount of $1,500. The total debt of $1,500 includes $450 that was exchanged for the $450 promissory note issued to EMC in April 2007, as amended and restated in June 2011.
The three notes issued have the following principal amounts and maturity dates: $680 due May 1, 2018, $550 due May 1, 2020 and $270 due December 1, 2022.
The notes bear interest at the annual rate of 1.75%. Interest is payable quarterly in arrears. The notes may be prepaid without penalty or premium. We drew down on all three notes in late January 2014.
Critical Accounting Policies
Our condensed consolidated financial statements are based on the selection and application of accounting principles generally accepted in the United States of America that require us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to our financial statements. We believe that the critical accounting policies set forth within Item 7 of our 2013 Annual Report on Form 10-K may involve a higher degree of judgment and complexity in their application than our other significant accounting policies and represent the critical accounting policies used in the preparation of our financial statements. If different assumptions or conditions were to prevail, the results could be materially different from our reported results.
New Accounting Pronouncements
During May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606). The updated revenue standard establishes principles for recognizing revenue and develops a common revenue standard for all industries. Upon adoption, entities will be required to recognize the amount of revenue that they expect to be entitled to for the transfer of promised goods or services to their customers. The updated standard is effective for us in the first quarter of 2017 and permits the use of either the retrospective or cumulative effect transition method. Early adoption is not permitted.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements, including, without limitation, statements regarding: achieving future business growth by building long-term relationships with our customers through the adoption of
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enterprise license agreements; our vision and expected benefits of the SDDC; expectations that cash and stock-based compensation will increase in future periods; maintaining our industry leadership position; benefits of our products and services to customers; expectations that we will grow our business from SaaS and professional services offerings; increased cost of services revenues; the recognition of unearned revenue; the impact of our relationship with EMC Corporation on taxes; acquisition accounting and the deductibility of goodwill and identifiable intangible assets for U.S. income tax purposes; the sufficiency of our liquidity and capital reserves to fund our operations and business strategy; our ability to generate positive cash flows from operations; continuation of our stock repurchase program; our effective tax rate and the effects of potential developments in U.S. and non-U.S. tax jurisdictions; future amortization of definite-lived intangibles; our intent to indefinitely reinvest our overseas earnings in our foreign operations; the lack of a material adverse effect on us due to the resolution of pending claims, legal proceedings and investigations including the GSA and DOJ inquiries; and gains and losses associated with foreign currency fluctuations.
These forward-looking statements involve risks and uncertainties and the cautionary statements set forth above and those contained in the section of this report entitled “Risk Factors” identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. We assume no obligation to, and do not currently intend to, update these forward-looking statements.
Available Information
Our website is located at www.vmware.com, and our investor relations website is located at http://ir.vmware.com. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent information about us, all of which is made available free of charge, including:
• | our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”); |
• | announcements of investor conferences, speeches and events at which our executives talk about our products, services and competitive strategies; |
• | webcasts of our quarterly earnings calls and links to webcasts of investor conferences at which our executives appear (archives of these events are also available for a limited time); |
• | additional information on financial metrics, including reconciliations of non-GAAP financial measures discussed in our presentations to the nearest comparable GAAP measure; |
• | press releases on quarterly earnings, product and service announcements, legal developments and international news; |
• | corporate governance information including our certificate of incorporation, bylaws, corporate governance guidelines, board committee charters, business conduct guidelines (which constitutes our code of business conduct and ethics) and other governance-related policies; |
• | other news, blogs and announcements that we may post from time to time that investors might find useful or interesting; and |
• | opportunities to sign up for email alerts and RSS feeds to have information pushed in real time. |
The information found on our website is not part of, and is not incorporated by reference into, this or any other report we file with, or furnish to, the SEC.
ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
There were no material changes to our market risk exposures in the nine months ended September 30, 2014. See Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” of our 2013 Annual Report on Form 10-K for a detailed discussion of our market risk exposures.
ITEM 4. | CONTROLS AND PROCEDURES |
Evaluation of Disclosure Controls and Procedures
We carried out an evaluation required by the Exchange Act, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) of the Exchange Act, as of the end of the period covered by this report. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed,
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summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and to provide reasonable assurance that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosures.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting during the most recent fiscal quarter ended September 30, 2014 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Limitations on Controls
Our disclosure controls and procedures and internal control over financial reporting are designed to provide reasonable assurance of achieving their objectives as specified above. Management does not expect, however, that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and fraud. Any control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected.
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PART II
OTHER INFORMATION
ITEM 1. | LEGAL PROCEEDINGS |
See Note I to the condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for a description of legal proceedings. See also the risk factor entitled “We may become involved in litigation and regulatory inquiries and proceedings that could negatively affect us” in Part II, Item 1A of this Quarterly Report on Form 10-Q for a discussion of potential risks to our results of operations and financial condition that may arise from legal proceedings.
ITEM 1A. | RISK FACTORS |
The risk factors that appear below could materially affect our business, financial condition and results of operations. The risks and uncertainties described below are not the only risks and uncertainties facing us. Our business is also subject to general risks and uncertainties that affect many other companies.
Risks Related to Our Business
As the market for our computer virtualization products has matured, we have been increasingly developing and marketing products and services targeted toward the delivery, management and automation of information technology (“IT”) infrastructure, platforms and services through cloud-based solutions. If businesses do not find our cloud computing solutions compelling, our revenue growth and operating margins may decline.
Our products and services are based on computer virtualization and related technologies that have primarily been used for virtualizing on-premises data centers. As the market for data center virtualization has matured, we have increasingly directed our product development and marketing toward products and services that enable businesses to utilize virtualization as the foundation for cloud-based computing, management and automation of the delivery of IT resources, end-user computing and Infrastructure as a service (“IaaS”) offerings including hybrid cloud services. Our success depends on organizations and our customers perceiving technological and operational benefits and cost savings associated with the increasing adoption of our virtualization-based infrastructure and management solutions for cloud computing, hybrid cloud services and end-user computing. As the market for our data center virtualization products mature and the scale of our business increases, it may be difficult to maintain previous rates of growth in our product sales. In addition, to the extent that our newer cloud computing infrastructure management and automation, or software-defined data center (“SDDC”), solutions, end-user computing, and hybrid cloud solutions are adopted more slowly or less comprehensively than we expect, our revenue growth rates may slow materially or our revenue may decline substantially.
The large majority of our revenues have come from our data center virtualization products including our flagship VMware vSphere product line. Decreases in demand for our data center virtualization products could adversely affect our results of operations and financial condition.
The large majority of our revenues have come from our data center virtualization products. Although we continue to develop other applications for our virtualization technology such as our end-user computing products and hybrid cloud services and expand our offerings into related areas, we expect that our data center virtualization products and related enhancements and upgrades will constitute a majority of our revenue for the foreseeable future. Declines and variability in demand for our data center virtualization products could occur as a result of:
• | improved products or product versions being offered by competitors in our markets; |
• | competitive pricing pressures; |
• | failure to timely execute and implement our product strategy, which could lead to quality issues, integration issues with ecosystem partners, and difficulties in creating and marketing suites of interoperable solutions; |
• | failure to release new or enhanced versions of our data center virtualization products on a timely basis, or at all; |
• | technological change that we are unable to address with our data center virtualization products or that changes the way enterprises utilize our products; and |
• | general economic conditions. |
Also, as more and more businesses achieve the virtualization of their data centers and other IT functions, the market for our VMware vSphere product line may become saturated. If we fail to introduce compelling new features in future upgrades to our VMware vSphere product line, develop new applications for our virtualization technology or provide product suites based on the VMware vSphere platform that address customer requirements for integration, automation and management of their IT systems, demand for VMware vSphere may decline.
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Due to our product concentration, our business, financial condition, results of operations, and cash flows would therefore be adversely affected by a decline in demand for our data center virtualization products.
Our new product and technology initiatives subject us to additional business, legal and competitive risks.
Over the last several years, we have introduced new product and technology initiatives that aim to leverage our virtualization infrastructure software products into the emerging areas of cloud computing and end-user computing as alternatives to the provisioning of physical computing resources.
One of VMware’s core strategies is to deliver the software-defined data center. In 2010, we introduced the first of our vCenter and vCloud products, which we combined in 2011 with our vShield security product line to create our Cloud Infrastructure and Management (“CIM”) Suite offering. In 2012, we delivered the vCloud Suite, which delivers a comprehensive suite for cloud computing in a single SKU with simplified licensing.
In 2012, we acquired two companies that furthered VMware’s SDDC strategy - Dynamic Ops, a provider of cloud automation solutions that enable provisioning and management of IT services across heterogeneous environments, and Nicira, a developer of software-defined networking and a leader in network virtualization for open source initiatives. In 2013, we acquired Virsto Software, a developer of software that optimizes storage performance and utilization in virtual environments.
We also continue to expand and enhance our end-user computing offerings, such as VMware View and Horizon Suite, a solution that provides end users with a single place to get access to their applications, data and desktops and gives IT a single management console to manage entitlements, policies and security. In 2012, we acquired Wanova, a leading provider of intelligent desktop solutions that centralize and simplify the management of physical desktop images while enabling users to take advantage of the native performance of a PC. In 2013, we acquired Desktone, a leader in the Desktop-as-a-Service space.
In the second quarter of 2013, we introduced our hybrid cloud service called vCloud Air (formerly, vCloud Hybrid Service). vCloud Air is designed to deliver a public cloud as a service offering that is interoperable with our customers’ existing VMware virtualized infrastructure, enabling customers to extend the same skills, tools, networking and security models across both on-premise and off-premise environments. We are currently making significant investments in developing and introducing new technologies and product offerings related to our SDDC, vCloud Air and end user and mobile computing initiatives.
In the first quarter of 2014, we acquired AirWatch, a leader in enterprise mobility management and security solutions. The acquisition of AirWatch expands our portfolio of mobile solutions within the enterprise mobility and security space. In the third quarter of 2014, we announced that we had entered into a joint venture with the Softbank Group to expand our vCloud Air service to Japan.
The expansion of our offerings to deliver the SDDC, address IT management and automation, and enhance our end-user computing capabilities and our hybrid cloud offerings subjects us to additional risks, such as the following:
• | These initiatives may present new and difficult technological challenges. Significant investments will be required to acquire and develop solutions to those challenges. Customers may choose not to adopt our new product or service offerings and we may be unable to recoup or realize a reasonable return on our investments. |
• | Some of our new initiatives are hosted by third parties whom we do not control but whose failure to prevent service disruptions, or other failures or breaches may require us to issue credits or refunds or indemnify or otherwise be liable to customers or third parties for damages that may occur. Any transition of our services from a third party hosting service to our own data centers would also entail a risk of service disruption during a transition. We may be subject to claims if customers of these service offerings experience service disruptions or failures, security breaches, data losses or other quality issues. |
• | The success of these new offerings depends upon the cooperation of hardware, software and cloud hosting vendors to ensure interoperability with our products and offer compatible products and services to end users. If we are unable to obtain such cooperation, it may be difficult and more costly for us to achieve functionality and service levels that would make our new products and services attractive to end users. |
• | We will need to develop and implement appropriate go-to-market strategies and train our sales force in order to effectively market offerings in product categories in which we may have less experience than our competitors. Accordingly, end users could choose competing products and services over ours, even if such offerings are less advanced than ours. |
• | Our increasing focus on developing and marketing IT management and automation and IaaS (including software-defined networking and vCloud Air), offerings that enable customers to transform their IT systems will require a greater focus on marketing and selling product suites and more holistic solutions, rather than selling on a product-by-product basis. Consequently, we will need to develop new strategies for marketing and selling our offerings, our |
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customers’ purchasing decisions may become more complex and require additional levels of approval and the duration of sales cycles for our offerings may increase.
• | We will need to develop appropriate pricing strategies for our new product initiatives. For example, it has frequently been challenging for software companies to derive significant revenue streams from open source projects, such as certain of our offerings. Additionally, in some cases our new product initiatives are predicated on converting free and trial users to paying customers of the premium tiers of these services, and therefore we must maintain a sufficient conversion ratio for such services to be profitable. Also, certain of our new product initiatives have a subscription model. We may not be able to accurately predict subscription renewal rates or their impact on results, and because revenue is recognized for our services over the term of the subscription, downturns or upturns in sales may not be immediately reflected in our results. |
• | The success of vCloud Air will be dependent on the final global implementation of the offering and building successful go-to-market strategies. We will need to build sales expertise and infrastructure to support the new offering. This hybrid cloud offering involves significant risk and may not be accepted by customers. Further, this offering may lead our team to reduce the time spent on selling our existing product portfolio, which could have a material negative impact on revenues. |
• | As we expand our IaaS and SaaS offerings globally, we may rely more upon joint ventures with established providers of IT products and services in particular regions, such as our joint venture with the Softbank Group to expand our vCloud Air hybrid cloud service to Japan. Joint ventures require close ongoing cooperation and commitments from the joint venture partners, and the willingness to devote adequate resources as required. If we are unable to continue our strategic alignment with joint venture partners or obtain the cooperation and commitments we are relying upon, our ability to successfully expand our IaaS and SaaS offerings globally will diminish. |
• | Our new products and services may compete with offerings from companies who are members of our developer and technology partner ecosystem. Consequently, we may find it more difficult to continue to work together productively on other projects, and the advantages we derive from our ecosystem could diminish. |
• | The cloud computing and virtualized end-user computing industries are in early stages of development. Other companies seeking to enter and develop competing standards for the cloud computing space, such as Microsoft, IBM, Oracle, Google, Amazon and Cisco, and the end-user computing space, such as Citrix and Microsoft, have introduced or are likely to introduce their own initiatives that may compete with or not be compatible with our cloud and end-user computing initiatives which could limit the degree to which other vendors develop products and services around our offerings and end users adopt our platforms. |
• | Emerging IT sectors, such as those within IaaS, are frequently subject to a “first mover” effect pursuant to which certain product and service offerings can rapidly capture a significant portion of market share and developer attention. Therefore, if competitive product and service offerings in these sectors gain broad adoption before ours, it may be difficult for us to displace such offerings regardless of the comparative technical merit, efficacy or cost of our products and services. |
• | Developing and launching new technologies in new areas, as we are doing with our VMware NSX virtual networking, Virtual SAN virtual storage and vCloud Air initiatives, requires significant investments of resources and often entails greater risk than incremental investments in existing industries. If these investments are not successful, our rate of growth may decline or reverse and our operating results will be negatively affected. |
• | Marketing and selling new technologies to enterprises requires significant investment of time and resources in order to educate customers on the benefits of our new product offerings. These investments can be costly and the additional effort required to educate both customers and our own sales force can distract from their efforts to sell existing products and services. |
As our vSphere-related products continue to mature, our future revenue growth is increasingly dependent on revenue from our new product and technology offerings. Our newer initiatives may be less profitable than our established products, and we may not be successful enough in these newer activities to recoup our investments in them. If any of these risks were to occur, it could damage our reputation, limit our growth and negatively affect our operating results.
Our vCloud Air offering relies upon a number of third-party providers for data center space, equipment, maintenance and other colocation services, and the loss of, or problems with, one or more of these providers may impede the growth of our vCloud Air offerings, adversely impact our plans to expand the service and damage our reputation.
We launched our vCloud Air cloud service offerings in 2013 in the United States and announced plans to expand the services globally. Our vCloud Air offerings rely upon third-party providers to supply data center space, equipment maintenance and other colocation services. While we have entered into various agreements for the lease of data center space, equipment
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maintenance and other services, third parties could fail to live up to the contractual obligations under those agreements. For example, a data center landlord may fail to adequately maintain its facilities or provide an appropriate data center infrastructure for which it is responsible. If that were to happen, our ability to deliver services at levels acceptable to our customers and at levels that we have committed to could be impaired. Additionally, if the third parties that we rely on do fail to deliver on their obligations, our reputation could be damaged, our customers could lose confidence in us, and our ability to maintain and expand our vCloud Air offerings would be impaired.
Ongoing uncertainty regarding global economic conditions and the stability of regional financial markets may reduce information technology spending below current expectations and therefore adversely impact our revenues, impede end-user adoption of new products and services and product and service upgrades, and adversely impact our competitive position.
Our business depends on the overall demand for information technology and on the economic health of our current and prospective customers. The purchase of our products and services is often discretionary and may involve a significant commitment of capital and other resources. Weak economic conditions or significant uncertainty regarding the stability of financial markets could adversely impact our business, financial condition and results of operations in a number of ways, including by lengthening sales cycles, affecting the size of enterprise license agreements (“ELAs”) that customers will commit to, reducing the level of our non-ELA transactional sales, lowering prices for our products and services, reducing unit sales and reducing the rate of adoption of our products and services by new customers and the willingness of current customers to purchase upgrades to our existing products and services. For example, a recurrence of the sovereign debt crisis in Europe or that region's failure to recover from recession would threaten to suppress demand and our customers’ access to credit in that region, which is an important market for our products and services. Additionally, in response to sustained economic uncertainty, many national and local governments that are current or prospective customers for our products and services, including the U.S. federal government, have made, or threatened to make, significant spending cutbacks which could reduce the amount of government spending on IT and the potential demand for our products and services from the government sector.
Regional economic uncertainty can also result in general and ongoing tightening in the credit markets, lower levels of liquidity, increases in the rates of default and bankruptcy and significant volatility in the credit, equity and fixed income markets. As a result, current or potential customers may be unable to fund software purchases, which could cause them to delay, decrease or cancel purchases of our products and services. Even if customers are willing to purchase our products and services, if they do not meet our credit requirements, we may not be able to record accounts receivable or unearned revenue or recognize revenues from these customers until we receive payment, which could adversely affect the amount of revenues we are able to recognize in a particular period.
In addition, although we plan to continue making strategic investments in our business, many of our competitors have significantly greater financial, technical and other resources than we do, and if the economic recovery is anemic or not sustained, they may be better positioned to continue investment in competitive technologies.
We expect to face increasing competition that could result in a loss of customers, reduced revenues or decreased operating margins.
The virtualization, cloud computing, end-user computing and software-defined data center industries are inter-related and rapidly evolving. We experienced increased competition during 2013 and expect it to remain intense going forward. For example, Microsoft continues to make incremental improvements to its virtual infrastructure and virtual management products and is expected to release updated versions of its Hyper V virtualization product. In September 2012, Microsoft began shipping Windows Server 2012, which includes a more advanced version of its Hyper-V virtualization product which continues its push into the virtualization space, its System Center 2012 bundle of management products targeted at legacy and virtual environments and its VDI offering for smaller businesses. Microsoft also offers IaaS capabilities in Azure with a similar hybrid cloud message. We also face competition from other companies that have announced a number of new product initiatives, alliances and consolidation efforts. For example, Citrix Systems continues to enhance its end-user desktop and mobility offerings and their networking and cloud platform offerings. IBM, Google and Amazon have existing cloud computing offerings and announced new cloud computing initiatives. For example, Amazon released their Workspaces offering for the DaaS space. Additionally, Red Hat has released commercial versions of Linux that have virtualization capabilities as part of the Linux kernel (“KVM”) and has also announced plans for cloud computing products. Other companies have indicated their intention to expand offerings of virtual management and cloud computing solutions as well. Additionally, our hybrid cloud computing offering, which allows enterprises to pool internal and external IT resources running on a common vSphere infrastructure, competes with low-cost public cloud infrastructure offerings such as Amazon EC2 and Google Compute Engine. Enterprises and service providers have also shown significant interest in building their own clouds based on open source projects such as OpenStack.
Following our acquisition of Nicira and the resulting release of our NSX product, a number of competitors have announced software-defined networking offerings. For example, Cisco has announced its Application Centric Infrastructure initiative.
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We believe that the key competitive factors in the virtualization and cloud computing spaces include:
• | the level of reliability, security and new functionality of product offerings; |
• | the ability to provide comprehensive and scalable solutions, including management and security capabilities; |
• | the ability to offer products and services that support multiple hardware platforms, operating systems, applications and application development frameworks; |
• | the ability to deliver an intuitive end-user experience for accessing data, applications and services from a wide variety of end-user devices; |
• | the ability to effectively run traditional IT applications and emerging applications; |
• | the proven track record of formulating and delivering a roadmap of virtualization and cloud computing capabilities; |
• | the ability to attract and preserve a large installed base of customers; |
• | pricing of products and services, individually and in bundles; |
• | the ability to attract and preserve a large number of application developers to develop to a given cloud ecosystem; |
• | the ability to create and maintain partnering opportunities with hardware vendors, infrastructure software vendors and cloud service providers; |
• | the ability to develop robust indirect sales channels; and |
• | the ability to attract and retain cloud, virtualization and systems experts as key employees. |
Existing and future competitors may introduce products and services in the same areas we serve or intend to serve, and competing products and services may have better performance, lower prices, better functionality and broader acceptance than our products and services. Our competitors may also add features to their virtualization, end-user and cloud computing products similar to features that presently differentiate our product offerings from theirs. Many of our current or potential competitors also have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, sales, marketing and other resources than we do. This competition could result in increased pricing pressure and sales and marketing expenses, thereby materially reducing our operating margins, and could also prevent our new products and services from gaining market acceptance, thereby harming our ability to increase, or causing us to lose, market share. Increased competition also may prevent us from entering into or renewing service contracts on terms similar to those that we currently offer and may cause the length of our sales cycle to increase. Additionally, some of our competitors and potential competitors supply a wide variety of products and services to, and have well-established relationships with, our current and prospective end users. For example, small to medium sized businesses and companies in emerging markets that are evaluating the adoption of virtualization-based technologies and solutions may be inclined to consider Microsoft solutions because of their existing use of Windows and Office products. Some of these competitors have in the past and may in the future take advantage of their existing relationships to engage in business practices that make our products and services less attractive to our end users. Other competitors have limited or denied support for their applications running in VMware virtualization environments. These distribution, licensing and support restrictions, as well as other business practices that may be adopted in the future by our competitors, could materially impact our prospects regardless of the merits of our products and services. In addition, competitors with existing relationships with our current or prospective end users could in the future integrate competitive capabilities into their existing products and services and make them available without additional charge. For example, Oracle provides free server virtualization software intended to support Oracle and non-Oracle applications, and Microsoft offers its own server virtualization software packaged with its Windows Server product and offers built-in virtualization in the client version of Windows. As a result, existing VMware customers may elect to use products that are perceived to be “free” or “very low cost” instead of purchasing VMware products and services for certain applications where they do not believe that more advanced and robust capabilities are required. Competitors may also leverage open source technologies to offer zero or low cost products and services capable of putting pricing pressure on our own product offerings. By engaging in such business practices, our competitors can diminish competitive advantages we may possess by incentivizing end users to choose products that lack some of the technical advantages of our own offerings. In addition, even if customers find our products and services to be technically superior, they may choose to employ a “multiple-vendor” strategy, where they purposely deploy multiple vendors in their environment in order to prevent any one vendor from gaining too much control over their IT operations.
We also face potential competition from our partners. For example, third parties currently selling our products and services could build and market their own competing products and services or market competing products and services of other vendors. If we are unable to compete effectively, our growth and our ability to sell products and services at profitable margins could be materially and adversely affected, which could materially and adversely impact our financial condition and results of operations.
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Industry alliances or consolidation may result in increased competition.
Some of our competitors have made acquisitions and entered into or extended partnerships or other strategic relationships to offer more comprehensive virtualization and cloud computing solutions than they individually had offered. Citrix Systems continues to invest in desktop virtualization marketing by continuing its collaboration with Microsoft and has acquired smaller players like Zenprise, Virtual Computer and Framehawk. IBM acquired SoftLayer to increase their data center footprint and grow their cloud business. Moreover, information technology companies are increasingly seeking to deliver top-to-bottom IT solutions to end users that combine enterprise-level hardware and software solutions to provide an alternative to our virtualization platform. For example, Oracle offers integrated hardware and software virtualization solutions, and Microsoft and Hewlett-Packard continue their collaboration based on Microsoft’s cloud computing and virtualization platforms. In addition, Citrix offers an IaaS cloud services solution, and Red Hat continues to invest in the Open Virtualization Alliance (“OVA”) to bolster KVM as a direct competitor to VMware vSphere. A number of competitors are active in the emerging software-defined networking space. For example, in 2013, Cisco acquired Insieme, and Juniper acquired Contrail Systems in late 2012. In June 2013, Oracle and Microsoft entered into a partnership pursuant to which Oracle now supports the use of Oracle products in Microsoft Hyper-V deployments as well as Windows Azure. In July 2014, Cisco and Microsoft announced an initiative to integrate Cisco data center solutions and networking switches with Microsoft cloud offerings and to jointly market and sell their data center and hybrid cloud solutions. In September, 2014, Cisco and RedHat announced a new integrated infrastructure solution for OpenStack-based cloud deployments. In addition, the companies announced an expansion of their relationship, accelerating collaboration around OpenStack, Application Centric Infrastructure and Intercloud. We expect these trends to continue as companies attempt to strengthen or maintain their positions in the evolving virtualization infrastructure and enterprise IT solutions industry. Many of the companies driving this trend have significantly greater financial, technical and other resources than we do and may be better positioned to acquire and offer complementary products and technologies. The companies and alliances resulting from these possible combinations may create more compelling product and service offerings and be able to offer greater pricing flexibility than we can or may engage in business practices that make it more difficult for us to compete effectively, including on the basis of price, sales and marketing programs (such as providing greater incentives to our channel partners to sell a competitor’s product), technology or product functionality. This competition could result in a substantial loss of customers or a reduction in our revenues, which could materially and adversely impact our financial condition and results of operations.
We may not be able to respond to rapid technological changes with new solutions and services offerings, which could have a material adverse effect on our sales and profitability.
The virtualization, cloud computing, end-user computing and SDDC industries are characterized by rapid technological changes, changing customer needs, frequent new software product introductions and evolving industry standards. The introduction of third-party solutions embodying new technologies and the emergence of new industry standards could make our existing and future software solutions obsolete and unmarketable. Cloud computing is proving to be a disruptive technology that will alter the way that businesses consume, manage and provide physical IT resources, applications, data and IT services. We may not be able to establish or sustain our thought leadership in the cloud computing and enterprise software fields, and our customers may not view our products and services as innovative and best-of-breed, which could result in a reduction in market share and our inability to command a pricing premium over competitor products and services. We may not be able to develop updated products and services that keep pace with technological developments and emerging industry standards and that address the increasingly sophisticated needs of our customers or that interoperate with new or updated operating systems and hardware devices or certify our products and services to work with these systems and devices. As a result, we may not be able to accurately predict the lifecycle of our software solutions, and they may become obsolete before we receive the amount of revenues that we anticipate from them. There is no assurance that any of our new offerings would be accepted in the marketplace. Significant reductions in server-related costs or the rise of more efficient infrastructure management software could also affect demand for our software solutions. As hardware and processors become more powerful, we will have to adapt our product and service offerings to take advantage of the increased capabilities. For example, while the introduction of more powerful servers presents an opportunity for us to provide better products for our customers, the migration of servers to microprocessors with an increasing number of multiple cores also allows an end user with a given number of licensed copies of our software to multiply the number of virtualization machines run per server socket without having to purchase additional licenses from us. If we are unable to revise our solutions and offerings in response to new technological developments, our ability to retain or increase market share and revenues in the virtualization software space could be materially adversely affected.
Our operating results may fluctuate significantly, which makes our future results difficult to predict and may result in our operating results falling below expectations or our guidance and cause the price of our Class A common stock to decline.
Our operating results may fluctuate due to a variety of factors, many of which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. Our past results should not be relied upon as an indication of our future performance. In addition, a significant portion of our quarterly sales typically occurs during the
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last month of the quarter, which generally reflects customer buying patterns for enterprise technology. As a result, our quarterly operating results are difficult to predict even in the near term. If our revenues or operating results fall below the expectations of investors or securities analysts or below any guidance we may provide to the market, the price of our Class A common stock would likely decline substantially.
In addition, factors that may affect our operating results include, among others:
• | general economic conditions in our domestic and international markets and the effect that these conditions have on our customers’ capital budgets and the availability of funding for software purchases; |
• | fluctuations in demand, adoption rates, sales cycles and pricing levels for our products and services; |
• | fluctuations in foreign currency exchange rates; |
• | changes in customers’ budgets for information technology purchases and in the timing of their purchasing decisions; |
• | the timing of recognizing revenues in any given quarter, which, as a result of software revenue recognition policies, can be affected by a number of factors, including product announcements, beta programs and product promotions that can cause revenue recognition of certain orders to be deferred until future products to which customers are entitled become available; |
• | the sale of our products and services in the time frames we anticipate, including the number and size of orders in each quarter; |
• | our ability to develop, introduce and ship in a timely manner new products and services and enhancements that meet customer demand, certification requirements and technical requirements; |
• | the introduction of new pricing and packaging models for our product offerings; |
• | the timing of the announcement or release of upgrades or new products and services by us or by our competitors; |
• | our ability to maintain scalable internal systems for reporting, order processing, license fulfillment, product delivery, purchasing, billing and general accounting, among other functions; |
• | our ability to control costs, including our operating expenses; |
• | changes to our effective tax rate; |
• | the increasing scale of our business and its effect on our ability to maintain historical rates of growth; |
• | our ability to attract and retain highly skilled employees, particularly those with relevant experience in software development and sales; |
• | our ability to conform to emerging industry standards and to technological developments by our competitors and customers; |
• | renewal rates and the amounts of the renewals for ELAs as original ELA terms expire; |
• | the timing and amount of software development costs that may be capitalized beginning when technological feasibility has been established and ending when the product is available for general release; |
• | unplanned events that could affect market perception of the quality or cost-effectiveness of our products and solutions; and |
• | the recoverability of benefits from goodwill and acquired intangible assets, and the potential impairment of these assets. |
The failure by customers to renew large license agreement transactions on a satisfactory basis could materially adversely affect our business, financial condition, operating results and cash flow.
Our core customers are large enterprises with multi-year enterprise license agreements, each of which involves substantial aggregate fee amounts. The failure to renew those transactions in the future, or to replace those enterprise license agreements with new transactions of similar scope, on terms that are commercially attractive to us could materially adversely affect our business, financial condition, operating results and cash flow.
Our current research and development efforts may not produce significant revenues for several years, if at all.
Developing our products and services is expensive. Our investment in research and development may not result in marketable products or services or may result in products and services that take longer to generate revenues, or may generate less revenues, than we anticipate. Our research and development expenses were approximately 22% of our total revenues during the first nine months of 2014 and approximately 21% in the fiscal year 2013. Our future plans include significant
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investments in software research and development and related product opportunities. We believe that we must continue to dedicate a significant amount of resources to our research and development efforts to maintain our competitive position. However, we may not receive significant revenues from these investments for several years, if at all.
Our products and services are sold using ELAs and through our transactional business, and this strategy may not drive long-term sales and revenue growth.
We sell our products and services through two primary means, which we refer to as our ELA and our non-ELA, or transactional, sales.
ELAs are comprehensive long-term license agreements that provide for multi-year maintenance and support and constitute an increasing percentage of total overall sales. In recent periods, 25% to 40% of our overall sales each quarter have been comprised of ELAs. These are generally larger size transactions, typically driven by our direct sales force and are primarily attractive to our larger enterprise customers.
Transactional sales, in contrast, tend to be smaller in scope, shorter in duration with a standard one-year maintenance term, and are principally driven by our sales channel partners. Historically, they have represented two-thirds to three-quarters of our overall sales.
During 2013, we expanded the sales of product suites, such as our vCloud suite, that integrate advanced management and automation features with our vSphere cloud infrastructure platform and which are primarily sold through ELAs. We believe that ELAs help us grow our business by building long-term relationships with our enterprise customers.
Although our year-over-year growth rates for overall sales and ELA sales both increased in 2013 compared to 2012, the year-over-year growth rate for our transactional sales declined in 2013 compared to 2012. Although the growth rate for our transactional business has increased during 2014, as we develop and add new product and service capabilities to our higher-end product offerings, and as our ELA volume continues to grow, we may not be successful in our strategy to increase the value of the products and services sold through the transactional business. Consequently, we may not be able to increase sales volumes in our transactional business or help attract new customers to our product ecosystem with our enhanced product features and capabilities.
If our overall go-to-market strategy is not successful, our growth rates may decline further, and our business, financial condition and results of operations could be materially adversely affected.
Our sales cycles can be long and unpredictable, our sales efforts require considerable time and expense, and timing of sales is subject to changing purchasing behaviors of our customers. As a result, our sales are difficult to predict and may vary substantially from quarter to quarter, which may cause our operating results to fluctuate significantly.
The timing of our revenues is difficult to predict. Our sales efforts involve educating our customers about the use and benefit of our products and services, including their technical capabilities, potential cost savings to an organization and advantages compared to lower-cost products and services offered by our competitors. Customers typically undertake a significant evaluation process that has in the past resulted in a lengthy sales cycle which typically lasts several months, and may last a year or longer. We spend substantial time, effort and money on our sales efforts without any assurance that our efforts will produce any sales. In addition, product and service purchases are frequently subject to budget constraints, economic conditions, multiple approvals, and unplanned administrative, processing and other delays. Moreover, the greater number of competitive alternatives, as well as announcements by our competitors that they intend to introduce competitive alternatives at some point in the future, can lengthen customer procurement cycles, cause us to spend additional time and resources to educate end users on the advantages of our product and service offerings and delay product and service sales. Economic downturns and uncertainty can also cause customers to add layers to their internal purchase approval processes, adding further time to a sales cycle. Additionally, as we sell more products and services to domestic and foreign governments, we may encounter lengthier sales cycles, complicated budgeting processes and complex procurement regulations. These factors can have a particular impact on the timing and length of our ELA sales cycles and our overall sales during any particular fiscal period may have greater variability as a greater portion of our sales is made utilizing ELAs.
Additionally, our quarterly sales have historically reflected an uneven pattern in which a disproportionate percentage of a quarter’s total sales occur in the last month, weeks and days of each quarter. Similarly, our yearly sales have historically reflected a disproportionate percentage of the year’s sales in the fourth fiscal quarter. These patterns make prediction of revenues, earnings and working capital for each financial period especially difficult and uncertain and increase the risk of unanticipated variations in financial condition and results of operations. We believe this uneven sales pattern is a result of many factors including the following:
• | the tendency of customers to wait until late in a quarter to commit to a purchase in the hope of obtaining more favorable pricing; |
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• | the fourth quarter influence of customers spending their remaining capital budget authorization prior to new budget constraints in the following year; and |
• | seasonal influences, such as holiday or vacation periods. |
If sales expected from specific customers for a particular quarter are not realized in that quarter or at all, our results could fall short of public expectations and our business, financial condition and results of operations could be materially adversely affected.
We are dependent on our management and our key development personnel, and the loss of key personnel may prevent us from implementing our business plan in a timely manner.
Our success depends largely upon the continued services of our existing management. We are also substantially dependent on the continued service of our key development personnel for product and service innovation and timely development and delivery of upgrades and enhancements to our existing products and services. The market for expert software developers upon whom we rely has become increasingly competitive. We generally do not have employment or non-compete agreements with our existing management or development personnel, and, therefore, they could terminate their employment with us at any time without penalty and could pursue employment opportunities with any of our competitors. Changes to management and key employees can also lead to additional unplanned losses of key employees. The loss of key employees could seriously harm our ability to release new products and services on a timely basis and could significantly help our competitors.
Because competition for our target employees is intense, we may not be able to attract and retain the highly skilled employees we need to support our planned growth, and our compensation expenses may increase.
To execute on our strategy, we must continue to attract and retain highly qualified personnel. Competition for these personnel is intense, especially for senior sales executives and engineers with high levels of experience in designing and developing software. We may not be successful in attracting and retaining qualified personnel. We have from time to time in the past experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. Many of the companies with which we compete for experienced personnel have greater resources than we have. Research and development personnel are also aggressively recruited by startup and emerging growth companies, which are especially active in many of the technical areas and geographic regions in which we conduct product and service development. In addition, in making employment decisions, particularly in the high-technology industry, job candidates often consider the value of the stock-based compensation they are to receive in connection with their employment. Declines in the value of our stock could adversely affect our ability to attract or retain key employees and result in increased employee compensation expenses. If we fail to attract new personnel or fail to retain and motivate our current personnel, our business and future growth prospects could be severely harmed.
Our success depends upon our ability to develop new products and services, integrate acquired products and services, enhance our existing products and services and develop appropriate business and pricing models.
If we are unable to develop new products and services, integrate acquired products and services, enhance and improve our products and support services in a timely manner, or position or price our products and services to meet market demand, customers may not buy new software licenses from us, update to new versions of our software or renew product support. In addition, information technology standards from both consortia and formal standards-setting forums as well as de facto marketplace standards are rapidly evolving. We cannot provide any assurance that the standards on which we choose to develop new products and services will allow us to compete effectively for business opportunities in emerging areas such as cloud computing.
New product and service development and introduction involve a significant commitment of time and resources and is subject to a number of risks and challenges including:
• | managing the length of the development cycle for new products and services and product and service enhancements, which has frequently been longer than we originally expected; |
• | increasing complexity of our product offerings as we introduce product suites such as our vCloud Suite, which can significantly increase the development time and effort necessary to achieve the interoperability of product suite components while maintaining product quality; |
• | growth rates of our emerging products and services may be negatively impacted despite their technical merit by the need to package such products and services in more complex product suite offerings that require more time for customer evaluation and purchase decisions; |
• | managing customers’ transitions to new products and services, which can result in delays in their purchasing decisions; |
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• | adapting to emerging and evolving industry standards and to technological developments by our competitors and customers; |
• | entering into new or unproven markets with which we have limited experience; |
• | reacting to trends and predicting which technologies will be successful and develop into industry standards; |
• | tailoring our business and pricing models appropriately as we enter new markets and respond to competitive pressures and technological changes; |
• | incorporating and integrating acquired products and technologies; and |
• | developing or expanding efficient sales channels. |
In addition, if we cannot adapt our business models to keep pace with industry trends, our revenues could be negatively impacted. For example, if we increase our adoption of subscription-based pricing models for our products, we may fail to set pricing at levels appropriate to maintain our revenue streams or our customers may choose to deploy products from our competitors that they believe are priced more favorably. Additionally, we may fail to accurately predict subscription renewal rates or their impact on results of operations, and because revenue from subscriptions is recognized for our services over the term of the subscription, downturns or upturns in sales may not be immediately reflected in our results. As we offer more products that depend on converting users of free services to users of premium services and as such services grow in size, our ability to maintain or improve and to predict conversion rates will become more important.
Breaches of our cybersecurity systems could degrade our ability to conduct our business operations and deliver products and services to our customers, delay our ability to recognize revenue, compromise the integrity of our software products, result in significant data losses and the theft of our intellectual property, damage our reputation, expose us to liability to third parties, and require us to incur significant additional costs to maintain the security of our networks and data.
We increasingly depend upon our IT systems to conduct virtually all of our business operations, ranging from our internal operations and product development activities to our marketing and sales efforts and communications with our customers and business partners. Unauthorized parties have attempted to penetrate our network security and our website. Such cyberattacks threaten to misappropriate our proprietary information and cause interruptions of our IT services. Because the techniques used by unauthorized persons to access or sabotage networks change frequently and may not be recognized until launched against a target, we may be unable to anticipate these techniques. Further, if unauthorized access or sabotage remains undetected for an extended period of time, the effects of such breach could be exacerbated. In addition, sophisticated hardware and operating system software and applications that we produce or procure from third parties may contain defects in design or manufacture, including “bugs” and other problems that could unexpectedly interfere with the operation of the system. Our exposure to cybersecurity threats and negative consequences of cybersecurity breaches will likely increase as our vCloud Air business expands and we store increasing amounts of customer data and host or manage parts of customers’ businesses in cloud-based IT environments.
We have also outsourced a number of our business functions to third party contractors, and our business operations also depend, in part, on the success of our contractors’ own cybersecurity measures. We also use third parties to provide colocation services (i.e. data center services) for our hybrid cloud offering. Similarly, we rely upon distributors, resellers, system vendors and systems integrators to sell our products and our sales operations depend, in part, on the reliability of their cybersecurity measures. Additionally, we depend upon our employees to appropriately handle confidential data and deploy our IT resources in safe and secure fashion that does not expose our network systems to security breaches and the loss of data. Accordingly, if our cybersecurity systems and those of our contractors, partners and vendors fail to protect against unauthorized access, sophisticated cyberattacks and the mishandling of data by our employees, contractors, partners or vendors, our ability to conduct our business effectively could be damaged in a number of ways, including:
• | sensitive data regarding our business, including intellectual property and other proprietary data, could be stolen; |
• | our electronic communications systems, including email and other methods, could be disrupted, and our ability to conduct our business operations could be seriously damaged until such systems can be restored and secured; |
• | our ability to process customer orders and electronically deliver products and services could be degraded, and our distribution channels could be disrupted, resulting in delays in revenue recognition; |
• | defects and security vulnerabilities could be exploited or introduced into our software products or our hybrid cloud offering, thereby damaging the reputation and perceived reliability and security of our products and services and potentially making the data systems of our customers vulnerable to further data loss and cyberincidents; and |
• | personally identifiable or confidential data of our customers, employees and business partners could be stolen or lost. |
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Should any of the above events occur, we could be subject to significant claims for liability from our customers, regulatory actions from governmental agencies, our ability to protect our intellectual property rights could be compromised and our reputation and competitive position could be significantly harmed. Also, the regulatory and contractual actions, litigations, investigations, fines, penalties and liabilities relating to data breaches that result in losses of personally identifiable or credit card information of users of our services can be significant in terms of fines and reputational impact, and necessitate changes to our business operations that may be disruptive to us. Additionally, we could incur significant costs in order to upgrade our cybersecurity systems and remediate damages. Consequently, our financial performance and results of operations could be adversely affected.
Our products and services are highly technical and may contain errors, defects or security vulnerabilities which could cause harm to our reputation and adversely affect our business.
Our products and services are highly technical and complex and, when deployed, have contained and may contain errors, defects or security vulnerabilities. Some errors in our products or services may only be discovered after a product or service has been installed and used by customers. Any errors, defects or security vulnerabilities discovered in our products or services after commercial release could result in loss of revenues or delay in revenue recognition, loss of customers and increased service and warranty cost, any of which could adversely affect our business, financial condition and results of operations. Undiscovered vulnerabilities in our products or services could expose them to hackers or other unscrupulous third parties who develop and deploy viruses, worms, and other malicious software programs that could attack our products or services. In the past, VMware has been made aware of public postings by hackers of portions of our source code. It is possible that the released source code could expose unknown security vulnerabilities in our products and services that could be exploited by hackers or others. We may also inherit unknown security vulnerabilities when we integrate the products or services of companies that we acquire into existing and new VMware products or services.
Actual or perceived security vulnerabilities in our products or services could harm our reputation and lead some customers to return products or services, to reduce or delay future purchases or to use competitive products or services. End users, who rely on our products and services for the interoperability of enterprise servers and applications that are critical to their information systems, may have a greater sensitivity to product errors and security vulnerabilities than customers for software products generally. Any security breaches could lead to interruptions, delays and data loss and protection concerns. By their nature, security breaches are often difficult to detect and the failure to detect a breach for an extended period of time could significantly increase the damage it could cause. In addition, we could face claims for product liability, tort or breach of warranty, including claims relating to changes to our products and services made by our channel partners. Our contracts with customers contain provisions relating to warranty disclaimers and liability limitations, which may not be upheld, and customers and channel partners may seek indemnification from us for their losses and those of their customers. Defending a lawsuit, regardless of its merit, is costly and time-consuming and may divert management’s attention and adversely affect the market’s perception of us and our products and services. In addition, if our business liability insurance coverage proves inadequate or future coverage is unavailable on acceptable terms or at all, our business, financial condition and results of operations could be adversely impacted.
Operating in foreign countries subjects us to additional risks that may harm our ability to increase or maintain our international sales operations and investments.
Revenues from customers outside the United States comprised approximately 52% of our total revenues in both the first nine months ended 2014 and 2013. We have sales, administrative, research and development and technical support personnel in numerous countries worldwide. We expect to continue to add personnel in additional countries. Additionally, our investment portfolio includes investments in non-U.S. financial instruments and holdings in non-U.S. financial institutions, including